OTC Markets Issues Comment Letters On FINRA Rules 6432 And 5250; The 15c2-11 Rules
January 8, 2018, OTC Markets Group, Inc. (“OTC Markets”) submitted a comment letter to FINRA related to FINRA Rule 6432. Rule 6432 requires that a market maker or broker-dealer have the information specified in Securities Exchange Act Rule 15c2-11 before making a quotation in a security on the over-the-counter market. Although I summarize the salient points of the OTC Markets comment letter, I encourage those interested to read the entire letter, which contains an in-depth analysis and comprehensive arguments to support its position. On February 8, 2018, OTC Markets submitted a second comment letter to FINRA, this one related to FINRA Rule 5250. Rule 5250 prohibits companies from compensating market makers in connection with the preparation and filing of a Form 211 application.
Rule 6432 – Compliance with the Information Requirements of SEA Rule 15c2-11
Subject to certain exceptions, including the “piggyback exception” discussed below, Rule 6432 requires that all broker-dealers have and maintain certain information on a non-exchange traded company security prior to resuming or initiating a quotation of that security. Generally, a non-exchange traded security is quoted on the OTC Markets. Compliance with the rule is demonstrated by filing a Form 211 with FINRA. Although the rule requires that the Form 211 be filed at least three days prior to initiating a quotation, in reality FINRA reviews and comments on the filing in a back-and-forth process that can take several weeks or even months.
The specific information required to be maintained by the broker-dealer is delineated in Securities Exchange Act (“Securities Act”) Rule 15c2-11. The core principle behind Rule 15c2-11 is that adequate current information be available when a security enters the marketplace. The information required by the Rule includes either: (i) a prospectus filed under the Securities Act of 1933, such as a Form S-1, which went effective less than 90 days prior; (ii) a qualified Regulation A offering circular that was qualified less than 40 days prior; (iii) the company’s most recent annual reported filed under Section 13 or 15(d) of the Exchange Act or under Regulation A and quarterly reports to date; (iv) information published pursuant to Rule 12g3-2(b) for foreign issuers (see HERE); or (v) specified information that is similar to what would be included in items (i) through (iv).
In addition, Rule 6432 requires the submittal of specified information about the security being quoted (for example, common stock, an ADR or warrant), the quotation medium (for example, OTCQB) and if priced, the basis upon which the price was determined.
Rule 6432 requires a certification confirming that the member broker-dealer has not accepted any payment or other consideration in connection with the submittal of the Form 211 application as prohibited by Rule 5250.
Rule 15c2-11(f)(2) allows a member firm to quote or process an unsolicited order on behalf of a customer without compliance with the information requirements. In such case, the member must document the name of the customer, date and time of the unsolicited order and identifying information on the security.
Rule 5250 – Payments for Market Making
Rule 5250 specifically prohibits a market maker from accepting any payments or other consideration, directly or indirectly, in association or connection with publishing a quotation, acting as a market maker or submitting an application in connection therewith. In other words, a market maker cannot accept any consideration whatsoever for preparing and submitting a Form 211 application with FINRA.
However, the fact is that putting together the information required by the Form 211 and responding to FINRA comments takes administrative time and effort, and I would advocate that a broker-dealer should be able to accept some form of compensation to cover this internal expense. Moreover, the Form 211 process has changed over time, becoming much more arduous for the submitting market maker. I remember when a Form 211 could actually be submitted three days prior to a quotation and based on the market maker’s assertion that they were in possession of the required information, the Form was processed, oftentimes in 24 hours.
Today, a Form 211 goes through an extensive review, comment and response process similar to an SEC review of a filing. The comment and review process is completed when FINRA either clears the Form 211 or refuses to clear the Form. The market maker is required to provide FINRA with a copy of all information and documents in their possession, and FINRA reviews the information and challenges the market maker’s position that the information is adequate. This process takes weeks at a minimum and oftentimes much longer.
Since a market maker cannot even cover their internal costs for this labor-intensive process, fewer market makers are willing to engage in the process at all.
The “Piggyback” Exception
The 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted on at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. In other words, once an initial Form 211 has been filed and approved by FINRA by a market maker and the stock quoted for 30 days by that market maker, subsequent broker-dealers can quote the stock and make markets without resubmitting information to FINRA. The piggyback exception lasts in perpetuity as long as a stock continues to be quoted.
As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade.
The OTC Markets Comment Letter on Rule 6432
The opening paragraph of OTC Markets’ comment letter sets the tone for the entire letter, stating, “[W]e continue to believe that the cumbersome operational processes around Rule 6432, and the related Rule 15c2-11… under the… Exchange Act, unnecessarily impede capital formation by small issuers.” They continue, and I agree, that the process creates an unnecessary difficulty on smaller companies seeking to access public markets in the U.S.
OTC Markets suggests that the recent boom in ICO’s is a natural response to the difficulties with navigating the capital and secondary markets for smaller companies, including the Form 211 process, DTC eligibility, depositing non-exchange traded securities (see HERE, which factors have only intensified since publication of that blog), and market liquidity. A re-working of Rule 6432 and the interaction with the 45-year-old Rule 15c2-11 would help improve the marketplace dramatically.
Rule 15c2-11 was enacted in 1970 to ensure that proper information was available prior to quoting a security in an effort to prevent microcap fraud. At the time of enactment of the rule, the Internet was not available for access to information. The premise of the rule was to require broker-dealers, who would be quoting the securities, to maintain information and provide that information to investors upon request. Rule 6432 requires FINRA member firms to comply with Rule 15c2-11 by filing a Form 211 with FINRA. In reality, a broker-dealer never provides the information to investors, FINRA does not make or require the information to be made public, and the broker-dealer never updates information, even after years and years. Moreover, since enactment of the rules, the Internet has created a whole new disclosure possibility and OTC Markets itself has enacted disclosure requirements, processes and procedures.
The current system does not satisfy the intended goals or legislative intent and is unnecessarily cumbersome at the beginning of a company’s quotation life with no follow-through. OTC Markets proposes the following changes to Rule 6432 and its administration:
(i) Make the Form 211 review process more objective and efficient. FINRA’s role should be changed from a subjective gatekeeper to an objective administrator, only ensuring that the market maker has the required information. FINRA should not review the merits of the information itself. Furthermore, FINRA should be bound by the three-day requirement set forth in Rule 15c2-11 such that a market maker can proceed with a quote (and receive a ticker symbol where necessary) within the mandated three days. The goal should be to ensure a market maker has the information mandated by Rule 15c2-11, that such information is publicly available for the investing community, and that an issuer has the responsibility for the accuracy of the information.
I agree with this suggestion. FINRA can adequately address its gatekeeper role in its annual or biannual audit and review of member firms. Moreover, if FINRA believes that a member firm has violated its requirements under Rule 6432, as a self-regulatory organization, it has the authority and ability to institute an investigation into such member firm. By performing subjective reviews of the information itself and merits of such information, FINRA is asserting substantive control over issuers for which it lacks jurisdiction and for which such issuer has no due process rights or recourse. The same overreaching of authority relates to Rule 6490 and the processing of corporate actions. See HERE. The SEC itself, who has direct jurisdiction over a company, does not review the merits of a company’s operations, business model or capital structure, but rather only the proper disclosure of same such that an investor can make an informed decision. FINRA, who does not have direct jurisdiction or governing authority over a company, has found a way to exert subjective influence, without due process, or even published rules or information as to the criteria used in their subjective analysis.
(ii) Form 211 materials should be made public and issuers should be liable for any misrepresentations. Currently, Form 211 materials are not publicly available. Making the information publicly available would further the clear objective of SEC Rule 15c2-11.
In practice, as part of its review process, FINRA not only requests additional information, but often material non-public information, which is not only beyond the scope of Rule 15c2-11, but which information has no reasonable expectation of being made public. Clearly, if information is important for the marketplace and investors to make informed investment decisions, it should be required by the rules and should be publicly available.
(iii) Outsource Form 211 processes to IDQS’s. A broker-dealer should file a Form 211 directly with the interdealer quotation system (IDQS) on which it plans to quote the security. The IDQS should review such information for completeness and submit the package to FINRA within the three-day rule time frame. Also, FINRA member IDQS’s should be allowed to submit their own Form 211 application for issuers that meet certain lower risk criteria, such as those already trading on a Qualified Foreign Exchange.
(iv) Allow IDQS’s to monitor ongoing disclosure and institute trading halts. FINRA member IDQS’s should be responsible for developing a system that ensures ongoing disclosure of Rule 15c2-11 information for quoted securities, including the power to respond to indications of fraud and institute trading halts.
This seems so obvious to me. Where FINRA exercises subjective merit reviews of initial Form 211 applications, it then takes no action whatsoever to ensure ongoing current information. I have seen stocks trade large volumes that have been completely dark or devoid of current information for years. By allowing an IDQS to require ongoing public information by an issuer for the privilege of having market makers make markets, the SEC and FINRA would add a layer of gatekeeping responsibility that does not exist today. Separately, I note that OTC Markets does have a system and regime that responds to certain issues, such as improper stock promotion (see HERE), but has no power to institute a trading halt.
(v) Allow broker-dealer compensation for Form 211 filing. See more discussion on this topic below. I agree that allowing compensation for a Form 211 filing is not only advisable but if structured properly, has no downside. The compensation can be capped and subject to specific disclosure and reasonableness rules, including compliance with Section 17(b) of the Securities Act (see HERE).
(vi) Allow multiple market makers to quote a security after a Form 211 is cleared. This would replace the current rules of only allowing one market maker to quote a security for the first 30 days. Moreover, I would go further and suggest that the piggyback exception only be allowed if there is publicly available current information.
Encouraging Capital Markets
Following its discussion on the rules and suggested changes, the OTC Markets comment letter turns to the need to encourage secondary trading of securities as an important aspect of encouraging capital formation for smaller companies as a whole. Investors are much more likely to participate in capital raising if they have an exit strategy such as a liquid secondary marketplace where they can reasonably deposit and re-sell freely tradeable securities.
The costs and burdens of being public on a national exchange are a huge disincentive for smaller companies. The decline in the US IPO markets is a constant discussion by SEC top brass, other regulators and politicians (for example, see HERE and HERE). As the OTC Markets comment letter points out, a small company seeking to raise $10 million to finance a promising new software, is in no position to shoulder the costs and burdens of a national exchange listing, but is also stifled by the inability to properly access liquidity for its investors on IDQS’s such as OTC Markets due to antiquated and improperly administered rules such as Rule 6432.
In fact, as of today OTC Markets is the only viable operating secondary marketplace for the trading of non-exchange traded public securities. OTC Markets is comprised of three tiers: the OTCQX; the OTCQB and the Pink Open Market. For a review of the OTCQX standards, see HERE. For a review of the OTCQB standards, see HERE. For more information on the Pink Open Market, see HERE.
By implementing OTC Markets suggested changes to Rule 6432 and its implementation and administration, more small companies would access public markets, better information would be made available to investors and the marketplace, and secondary market liquidity would improve.
The OTC Markets Comment Letter on Rule 5250
On February 8, 2018, OTC Markets group submitted a second comment letter to FINRA related to Exchange Act 15c2-11 and its implementation by FINRA. The second letter directly addresses Rule 5250, which prohibits a market maker from accepting any payments or other consideration, directly or indirectly, in association or connection with publishing a quotation, acting as a market maker or submitting an application in connection therewith.
As discussed above, a Form 211 goes through an extensive review, comment and response process similar to an SEC review of a filing. The comment and review process is completed when FINRA either clears the Form 211 or refuses to clear the Form. The market maker is required to provide FINRA with a copy of all information and documents in their possession, and FINRA reviews the information for completeness but also the merits of the information using undisclosed subjective standards. In response to comments, a market maker must work with a company to provide information, which can often involve material non-public information that is not, and may never be, made public. The process takes weeks at a minimum and oftentimes much longer.
As a basic premise for the market maker, it must conduct adequate due diligence on the company and properly gather and analyze information prior to submittal to FINRA. The process can be labor-intensive for the market maker.
Furthermore, part of the process involves the market maker’s analysis and backup for the requested pricing of the security in its initial quotation. When a company goes public on a national exchange, a market maker is not restricted from charging for its investment banking services, including the part of the service that involves a valuation and determination of initial offering price. The process of determination valuation for an initial quote on the OTC Markets is substantially similar. The inability to charge for such service acts as a disincentive for a market maker to give adequate thought and attention to the process.
Since a market maker cannot even cover their internal costs for this labor-intensive process, fewer market makers are willing to engage in the process at all. Moreover, market makers have no incentive to engage with issuers in completing due diligence or creating on ongoing relationship which ensures access to information, that is made public to the investing community. In addition to assisting investors and the market place in making informed decisions, market maker/company engagement will help detect red flags and indicia of fraud, facilitating the purpose of the rules and benefiting the markets as a whole.
A responsible rule could be put into place that allows a market maker to charge for their services and encourages productive engagement and communication between a market maker and their client company. The rule should require public disclosure of a market makers fee (as well as the application itself as discussed above). In addition, market makers should be allowed to receive reimbursements for actual out-of-pocket expenses associated with preparing and filing a Form 211. Again, this amount should be fully disclosed to the investment community.
Laura Anthony, Esq.
Legal & Compliance, LLC
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Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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