An Update On Dealing With The DTC Following The SEC’s Ruling On International Power Group, Ltd.

Background

Back in October and November of 2011, I wrote a series of blogs regarding DTC eligibility for OTC (over-the-counter) Issuers.  OTC Issuers include all companies, whose securities trade on the over-the-counter market, including the OTCBB, OTCQB and pinksheets.  Many OTC Issuers have faced a “DTC chill” without understanding what it is, let alone how to correct the problem.  In technical terms, a DTC chill is the suspension of certain DTC services with respect to an Issuer’s securities.  Those services can be book-entry clearing and settlement services, deposit services or withdrawal services.  A chill can pertain to one or all of these services.  In the case of a chill on all services, the term of art is a “global lock.”

I have previously blogged on how to become DTC-eligible.  From the DTC perspective, a chill does not change the eligibility status of an Issuer’s securities, just what services the DTC will offer for those securities.  So while an Issuer’s securities may still be in street name (a CEDE account), DTC can refuse to allow the book entry trading and settlement of those securities.

Although I’m sure unintentional, the term “chill” speaks volumes as to the reality of the effects of a DTC chill.  A DTC chill results in a chilling of trading in a security, a chilling of any financing negotiations, a chilling of potential reverse or forward acquisitions or mergers, and a chill as to shareholder protections and ability to assert control over their own property.

As noted by the SEC, “…DTC provides clearance, settlement, custodial, underwriting, registration, dividend, and proxy services for a substantial portion of all equities, corporate and municipal debt, exchange traded funds, and money market instruments available for trading in the United States.  In 2010, DTC processed 295,000,000 book entry transfers of securities worth $273.8 trillion.”

If DTC doesn’t process and settle trading in your securities, it just doesn’t happen.

In the Matter of the Application of International Power Group, Ltd

On March 15, 2012, the Securities and Exchange Commission (SEC) issued an administrative opinion stating that an Issuer is entitled to due process proceedings by DTC as a result of a DTC chill placed on an Issuers securities  (In the Matter of the Application of International Power Group, Ltd. Admin. Proc. File No. 3-13687).

In September 2009, DTC put a chill on the trading of International Power Group, Ltd. (IPWG) securities following the initiation by the SEC of an action against certain defendants, not IPWG, for improper issuance and trading in certain OTC securities, including IPWG and three other Issuers.  Neither IPWG nor any of its officers or directors was a party to the SEC proceeding.  The portion of the SEC action related to IPWG indicated that about 80,000,000 shares of IPWG stock were sold in the public markets without proper registration or an exemption from registration.  In May 2010, the SEC settled with the Defendants related to IPWG for the usual penalties and permanent injunctions; this settlement did not address the already issued securities.

Upon learning of the DTC chill, IPWG requested that DTC provide a hearing in accordance with its Rule 22, the only DTC rule that allows for any sort of hearing process.  Rule 22 provides an opportunity for Interested Persons to be heard on any determination by DTC that an Issuer’s security is no longer an eligible security.  DTC denied IPWG’s request for a hearing stating that IPWG’s securities were still eligible and that it would lift the chill “once the matter of the unregistered IPWG shares is resolved with the SEC.”  DTC suggested that IPWG take the matter up with the SEC.   IPWG was in a quandary.  There was no action pending with the SEC within which IPWG was a party and the SEC action related to IPWG shares had been settled, without addressing the “matter of the unregistered IPWG shares.”

There was no clear way to take the matter up with the SEC.  In addition, there was no clear way to take the matter up with DTC.  DTC works through Participants – i.e. licensed broker-dealers, not Issuers.  (See my previous blog on DTC eligibility.)  Moreover, the shares it actually holds and trades are already issued and belong to shareholders, not the Issuer.  So, although IPWG was clearly and undeniably greatly impacted by the DTC chill, DTC took the position that it didn’t have any particular obligation to IPWG for its actions.

IPWG filed an administrative appeal with the SEC looking for assistance.  A discussion of jurisdiction and the rules vis-a-vis getting this matter in front of the SEC is beyond the scope of this blog, but suffice it to say, after much legal wrangling and a realization by all involved that there was no precedent to look upon, the SEC agreed to take the matter on.

In its opinion, the SEC held that an Issuer, in this case IPWG, was an Interested Person for purposes of Rule 22 and was impacted by the DTC chill such that they are entitled to due process and fair proceedings.  The SEC did not tell DTC what the criteria for determining whether the chill was appropriate or not should be, but only that the Issuer is entitled to “fair procedures.”

However, prior to the March 15, 2012 opinion, DTC could impose a chill on the trading of an Issuer’s security for an indefinite time, at its sole discretion, without recourse.  In fact, the way Rule 22 was written, prior to the March 15 ruling, not even a Participant broker dealer could appeal a chill. Although this problem has been somewhat addressed, as discussed below, it has not been rectified.

Moreover, and importantly, the SEC held that in the future, an Issuer who is negatively impacted by DTC action can avail itself of the SEC administrative proceedings process for appeal following a negative decision in a DTC hearing and proceeding.

Finally, the SEC confirmed that in an emergency situation, DTC can still put a chill on an Issuer’s security prior to giving notice and an opportunity to be heard to that Issuer, stating, “[H]owever, in such circumstances, these processes should balance the identifiable need for emergency action with the issuer’s right to fair procedures under the Exchange Act.  Under such procedures, DTC would be authorized to act to avert imminent harm, but it could not maintain such a suspension indefinitely without providing expedited fair process to the affected issuer.”

The Impact of International Power as of December, 2012

DTC chills remain a proliferating and serious problem for OTC Issuers.  DTC has not amended its rules, nor has it promulgated or proposed any rules related to fair procedures for issuers or related to chills.  DTC has not provided Issuers with any guidance as to fair procedures, except for after the fact and on an evolving basis.  DTC has not implemented any due process standards.  Moreover, DTC continues to regularly impose chills on Issuer’s securities prior to giving notice or an opportunity to be heard. In fact, many issuers continue to learn that a chill was imposed at some point in the past, when shareholders contact them due to an inability to sell, trade, transfer or access their personal property – that is, shares of the subject issuer that are in DTC’s CEDE account.

Despite the shortcomings, there has been significant progress for issuers in dealing with DTC post International Power.  In particular, DTC will now respond to an issuer and communicate with an issuer, which in and of itself is significant progress.  It appears that DTC is, at least internally, working on creating a system for dealing with issuers.  At this point, once contacted by an issuer, DTC will provide the issuer with a letter setting forth the reason for the chill and allowing the opportunity for the issuer to submit a statement in response and an opinion letter attesting to the free tradability of the subject shares of that issuer.

DTC provides the acceptable format for the opinion letter and is extremely particular that the particular format be followed.  Not lost on issuers is the fact that opinion letters by counsel would have necessarily already been provided to free up the shares in the first place.  There is a great deal of legal overlap and expense.

Current letters from DTC request a response within 20 days and indicate that DTC will review the response within 30 days after that.  Moreover, DTC is regularly late in responding within the 30-day deadline, and the responses are generally a request for additional information or minor changes to the previous submissions.  Following the promise of a first 30-day response time, DTC does not provide any indication of timing for further action.  No expedited review process is afforded.

Each of DTC’s explanation letters, and DTC internal and external counsel, site that DTC has obligations to the SEC, including monitoring compliance with Section 17A of the Securities Exchange Act of 1934, as amended (“Exchange Act”).  However, to the frustration of the issuers and counsel alike, DTC has ignored the SEC’s mandate in International Power which specifically counseled DTC to promulgate rules and procedures consistent with the due process safeguards required under Sections 17A(b)(3)(H) and Section 19(f) under the Exchange Act.  Nothing in Section 17 of the Exchange Act or the rules promulgated thereunder authorizes the DTC to restrict an issuer’s access to the marketplace without notice and, barring an emergency, a reasonable and meaningful opportunity to be heard prior to the imposition of such a measure.

When new chills are imposed, DTC has, on occasion, provided the issuer with the correspondence outlining the reason within a day or two of imposing such chill.  I am unaware of any instance in which DTC has provided pre-chill notice or an opportunity to be heard.

Unfortunately for issuers, the reasons for the chills have been fairly random and include explanations such as a large volume of transactions.  I’ve had at least one client whose securities were chilled as a result of a large volume of transactions, where the volume was directly related to the effectiveness of a resale registration statement—a fact the DTC could easily have uncovered with a cursory review of the issuer’s filings on the EDGAR system.  The issuer still had to provide an explanation and opinion letter and fight to have the chill removed.  In several instances, the factual basis for the imposition of the chill has been factually erroneous (such as mixing up the names of shareholders, double-counting shares, and the like).

There also appears to be no limit on the time of transactions for which DTC can impose a current chill.  Issuers are learning that chills are being imposed due to transactions 8 and 10 years ago and are being requested to track down documents and information related to these transactions, which can often be between two parties unrelated to the issuer itself, such as broker to broker.  For some issuers, not only is this an impossible task, but even if possible, the time and expense would be unreasonable.  Although none of my clients have experienced this, I am aware that some issuers are being put out of business as a direct result of DTC chills and global locks.  Innocent shareholders are paying the price.

Conclusion

I represent many issuers through the DTC process and have a respectful relationship with DTC and its outside counsel.  Many of my clients have successfully removed their chills, and many more are in the process.  Significant progress has been made, but the current unregulated, open-ended, one-sided process cannot continue.

The Author

Attorney Laura Anthony,
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Merger and Corporate Attorneys

Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public companies as well as private companies intending to go public on the over-the-counter market, including the OTCBB and OTCQB. For nearly two decades, Ms. Anthony has dedicated her securities law practice to being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.

Ms. Anthony’s focus includes, but is not limited to, crowdfunding, registration statements, PIPE transactions, private placements, reverse mergers, and compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, as well as the proxy requirements of Section 14. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for corporate changes such as name changes, reverse and forward splits and change of domicile.

Contact Legal & Compliance LLC for a free initial consultation or second opinion on an existing matter.

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