OTC Markets Makes Several Regulatory Recommendations

by Laura Anthony, Esq. on May 15, 2018 in OTC Market, OTC Markets Listing Requirements, OTCQB, OTCQX

On March 8, 2018, Cromwell Coulson, CEO of OTC Markets Group, made a presentation to the SEC’s Investor Advisory Committee (“IAC”) as part of a panel on “Discussion of Regulatory Approaches to Combat Retail Investor Fraud.” During the meeting, Mr. Coulson discussed the most serious market risks and presented a list of 14 OTC Market’s regulatory recommendations to improve disclosure and combat these market risks.

A review of OTC Markets website on April 24, 2018 shows 10,469 traded securities, $1.1 billion volume, 7.2 billion share volume and 174,268 trades. In his remarks to the IAC, Mr. Coulson points out that 98% of the traded dollar volume of companies on OTC Markets make current information available. Echoing the SEC’s “Main Street investor” focus, he states that “[W]e have many stocks on our markets that are completely appropriate to be part of a diversified, long term, investment portfolio, of a main street investor; we also have speculative securities that are only appropriate for risk tolerant trader.”

However, certainly the trading in all equity securities, and especially small-cap securities, has risk. Mr. Coulson identifies what he believes are the three biggest risks to retain investors. In particular: (i) manipulative online promotion, including fraudulent and misleading information; (ii) share dilution, including through equity line financings, toxic convertible instruments and illegal share distributions; and (iii) bad actors, with a suggestion to allow for a speedy trading freeze to prevent ongoing frauds. I note that in its recent comment letters to FINRA related to the 15c2-11 process, OTC Markets suggested that it be given the power to institute short-term trading halts in response to improper activity and/or a lack of proper disclosure (see HERE).

As part of OTC Markets’ recently adopted stock promotion policy and best practices guidelines to improve investor transparency (see HERE), OTC Markets conducted an investigative initiative to track promotion activities. Coulson indicates that data reveals that 70% of dollar volume of securities impacted by promotional activities are listed and trade on national exchanges. Moreover, promoted securities usually have significant share dilution and are rarely suspended by the SEC. Although OTC Markets stock promotion policies are helpful, Mr. Coulson suggests that regulatory modernization is also needed to require increased disclosure of online paid stock promotion and the people behind such promotions.

Coulson also addressed the issue of short selling. Internet-based forums, especially anonymous forums that are used for stock manipulation, misinformation and fraudulent promotions, proclaim that short selling in small-cap securities is rampant and the cause of downward pricing pressure. The reality is that short selling in small-cap securities is generally minimal due to the high cost of borrow interest and coverage requirements. Most short selling is small companies is completed by market makers with a requirement to close out within 2 days. Coulson actually suggests that in addition to greater transparency and reporting of short selling activity, regulatory changes should be made to encourage heathy short selling and price stabilization efforts by market makers.

Another topic of concern and interest involves the illegal issuance of securities and affiliate trading. Coulson suggests transparency and information can help this issue.  In particular, Coulson advocates for increasing the role of transfer agents as record keepers. I note that he did not use the words “gate keepers” and it is unclear from the transcript if that implication was there. On December 22, 2015, the SEC issued an advance notice of proposed rulemaking and concept release on proposed new requirements for transfer agents and requesting public comment. See HERE. No further action has been taken since that time, and rules related to transfer agents have been moved from the SEC short-term agenda to long-term actions.

Also to further transparency related to illegal issuances and affiliate trading, Coulson suggests ending anonymous Objecting Beneficial Owner (OBO) accounts for affiliates of issuers. Likewise, Coulson suggests adding a reporting requirement similar to Forms 3, 4 and 5 under Section 16 for non-SEC reporting companies. For more on Section 16, see HERE.

To help combat fraud and provide a deterrent to bad actors, Coulson supports increased cooperation and communication between market operators, such as OTC Markets, and regulators. Using the analogy of real-time monitoring for credit card fraud, Coulson suggests real-time monitoring and responses by market operators to red flags and indicia of fraud. In order to make preventative responses feasible, there would have to be a system to allow for a relatively quick investigation and re-onboarding of trading for affected companies.

Coulson notes that much of the fraud in smaller public company trading emanates from unregulated intermediaries that have acquired shares in the private financing markets and are seeking to stimulate investor buying interest, so they can sell their shares. Although Coulson does not talk about regulating finders as a response to this problem, he does talk about stimulating financing options for smaller companies. I am a champion of a workable regulatory regime for finders and, as such, cannot pass this opportunity to raise the issue. For more on the current state of the law and my views, see HERE.

To stimulate financing options, Coulson suggests allowing SEC reporting companies to utilize Regulation A+ and increasing shelf registration options. I’ve written many times about my support for an amendment to Regulation A+ to allow SEC reporting companies to complete offerings. For more on Regulation A+ in general, see HERE and particularly related to the OTC Markets comment letter and arguments for allowing reporting companies to be eligible to use the offering, see HERE.

Coulson completed his presentation by talking about another topic that has been oft debated and for which I have strong opinions, and that is venture exchanges. The OTC Markets has worked hard to position itself as a venture exchange, but unfortunately has not received legislative support. In fact, OTC Markets does not always receive due regard at all from the SEC and Wall Street. Back in December 2016, the SEC issued a white paper on penny stocks in which it inaccurately, albeit implicitly, lumped all OTC Markets securities together as penny stocks and as providing limited disclosure. See HERE. To the contrary, one of the requirements to trade on the OTCQX tier of OTC Markets is that the security not be a penny stock.  See HERE. Both the OTCQB and OTCQX require fairly robust disclosure, including audited financial statements. OTC Markets also has a flag which appears on a company’s quote page to identify if a particular security is exempt from the definition of a penny stock.

Mr. Coulson points out that in 2017, 61 companies graduated from the OTC Markets to a national exchange, illustrating the venture function of OTC Markets.  Furthermore, realizing the need for legislation, Coulson states that any venture legislation should follow the European SME growth market model, be disclosure-driven, and include exchanges and ATS’s that already serve smaller companies (such as OTC Markets). For more on the importance of venture exchanges and specifics on how they should operate, see HERE.

Coulson rightfully adds, “[E]xchange listing is not a clear solution to solving the problems at hand. We need a more holistic approach, focusing on better investor information, rather than the hard-and-fast assertion that every exchange-traded security is safe, while all other securities are risky.”

Complete List of OTC Markets Regulatory Recommendations

The following is the full list of the 14 regulatory recommendations by OTC Markets.

  1. Increase Paid Promoter Disclosure – OTC Markets recommends amending Securities Act Section 17(b) to require additional disclosures related to paid stock promotion and the people involved in such promotions. For more on stock promotion and Section 17(b), see HERE.
  2. Provide More Disclosures from Affiliates, Insiders and Institutions – As discussed above, OTC Markets suggests limiting anonymous Objecting Beneficial Owner accounts for affiliates. Moreover, insider and affiliate trading should be reported by all publicly traded companies and not just those subject to the Exchange Act reporting requirements.  The reporting requirements should be similar to those under Section 16 for reporting companies.  OTC Markets also suggests expanding Exchange Act Section 13(f) to OTC traded securities, requiring institutional investment managers to disclosure their holdings in all publicly traded securities, including short positions.
  3. Improve Share Issuance Compliance – OTC Markets suggest that transfer agent regulations be modernized to provide broker-dealers with reliable information on the issuance, ownership and transfer history of shares.

4, Enable More Real-time SEC Enforcement – Interdealer quotation systems (IDQS) (like OTC Markets) should monitor ongoing disclosure by companies and have the ability to monitor and label late or deficient disclosures (such as OTC Markets does now).  Furthermore, the SEC should work with these market operators to take quick action where there are indications of fraud, including with trading halts and suspensions.

  1. Short Sale Reform – Require the timely disclosure of short sale positions and of aggregate industry activity. Also, allow more market maker short selling activity by amending Regulation SHO to extend the close-out time for short positions in OTC equity securities to 6 days as is current allowed for exchange traded securities.
  2. Allow SEC Reporting Companies to Use Regulation A+ – See discussion above. In addition, in September 2017 the House passed the Improving Access to Capital Act, which would allow companies subject to the reporting requirements under the Exchange Act to use Regulation A.
  3. Allow Companies to Sell Shares Directly into the Market – Allow companies that trade on an exchange or an established public market to easily sell their shares directly in the market.
  4. Facilitate Competition in Venture Exchange Legislation – A monopoly venture exchange should be avoided. As discussed above, any venture legislation should follow the European SME growth market model, be disclosure-driven, and include exchanges and ATS’s that already serve smaller companies (such as OTC Markets).
  5. Adopt Investor Suitability Standards Based on Experience and Risk Tolerance – Broker-dealers should be allowed to establish risk profiles based on trading experience and overall risk tolerance. Similar to this suggestion, I would suggest a modification to the accredited investor definition in line with the SEC Advisory Committee on Small and Emerging Companies’ prior recommendations, including expanding the definition to take into account trading experience.  See HERE.
  6. Allow Payments for Market Making – FINRA Rule 5210 should be amended to allow broker-dealers to be compensated for out-of-pocket expenses associated with preparing and submitting a Form 211 to FINRA. For more, see HERE.
  7. Bring Back the Federal Reserve OTC Margin List – Non-penny stock OTC securities should be marginable. OTC Markets suggests two possible solutions: (i) give the SEC, rather than the Federal Reserve Board, oversight of margin eligibility, or (ii) the margin list that was historically published by the Federal Reserve under Regulation T should be reinstated to make margin-eligible all non-penny stocks that are actively traded on “established public markets.”
  8. Allow Small Companies to Effectively Provide Employee Stock Ownership Plans (ESOPs) – IRS regulations limit the ability for non-exchange traded companies to effectively offer ESOP’s to employees. The definition of an “established securities market” contained in IRS regulations should be updated to include securities quoted on OTC Markets Group’s OTCQX and OTCQB markets.
  9. Allow Trading Venues to Review and/or Submit FINRA Form 211 Filings – Currently only market makers may submit a Form 211 to FINRA. Trading venues registered with the SEC and FINRA should also be allowed to do so.  For more on this, see HERE.
  10. Update the SEC Definition of Penny Stocks (Exchange Act Rule 3a51-1) – Currently, biotech and other research-heavy companies may not meet the net tangible assets exemption (Subsection (g)(1)) from the definition of a penny stock. The review standard for net tangible assets (Subsection (g)(3)) should be updated to take into account interim capital raises for these types of companies. For more on the penny stock rules, see HERE.

The Author

Laura Anthony, Esq.
Founding Partner
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Corporate, Securities and Going Public Attorneys
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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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