SEC Proposes Amendments To 15c2-11

by Laura Anthony, Esq. on October 08, 2019 in Uncategorized

As anticipated, on September 26, 2019, the SEC published proposed amendments to Securities Exchange Act (“Exchange Act”) Rule 15c2-11.  The purpose of the rule amendment is to enhance retail protection where there is little or no current and publicly available information about a company and as such, it is difficult for an investor or other market participant to evaluate the company and the risks involved in purchasing or selling its securities.  The SEC release also includes a concept release regarding information repositories and a possible regulatory structure for such entities.  The SEC believes the proposed amendments will preserve the integrity of the OTC market, and promote capital formation for issuers that provide current and publicly available information to investors.

The proposed rules entail a complete overhaul of the rule and its exceptions are complicated and, if enacted, will require the development of a new infrastructure, compliance procedures and written supervisory procedures at OTC Markets, new compliance procedures and written supervisory procedures at broker-dealers that quote OTC Markets securities, and similar changes within FINRA to adapt to and accommodate the new system.  I expect a period of somewhat chaos in the beginning with rapid execution adjustments to work out the kinks.

Background

Rule 15c2-11 was enacted in 1970 to ensure that proper information was available prior to quoting a security in an effort to prevent micro-cap fraud.  The last substantive amendment was in 1991.  At the time of enactment of the rule, the Internet was not available for access to information.  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 the 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.

I’ve written about 15c2-11 many times, including HERE and HERE.  In the former blog I discussed OTC Markets’ comment letter to FINRA related to Rule 6432 and the operation of 15c2-11.  FINRA 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.

The specific information required to be maintained by the broker-dealer is delineated in Exchange 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, a broker-dealer must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source.

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 for 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 SEC’s proposed rule release discusses the OTC Markets in general, noting that the majority of fraud enforcement actions involve either non-reporting or delinquent companies.  However, the SEC also notes that the OTC Markets provides benefits for investors (a welcome acknowledgment after a period of open negativity).  Many foreign companies trade on the OTC Markets and importantly, the OTC Markets provides a starting point for small growth companies to access capital and learn how to operate as a public company.

The proposed rules: (i) require that information about the company and the security be current and publicly available; (ii) limit certain exceptions to the rule including the piggyback exception where a company’s information becomes unavailable to the public or is no longer current; (iii) reduce regulatory burdens to quote securities that may be less susceptible to potential fraud and manipulation; and (iv) streamline the rule and eliminate obsolete provisions.

The proposed rule release adds the ability for new “market participants” to conduct the review process and allows broker-dealers to rely on that review process and the determination from certain third parties that an exception is available for a security.  The release uses the terms “qualified IDQS that meets the definition of an ATS” and “national securities association” throughout.  In reality, the only relevant qualified IDQS is OTC Markets itself and the only national securities association in the United States is FINRA.

Proposed Amendments

Current Public Information Requirements

The proposed rule changes will (i) require that the documents and information that a broker-dealer must have to quote an OTC security be current and publicly available; (ii) permit additional market participants to perform the required review (i.e., OTC Markets); and (iii) expand some categories of information required to be reviewed.  In addition, the amendment will restructure and renumber paragraphs and subparagraphs.

The existing rule only requires that SEC filings for reporting or Regulation A companies be publicly available and in practice, there is often a deep-dive of due diligence information that is not, and is never made, publicly available.  Under the proposed rule, all information other than some limited exceptions, and the basis for any exemption, will need to be current and publicly available.  The information required to be current and publicly available will also include supplemental information that the broker-dealer, or other market participant, has reviewed about the company and its officer, directors, shareholders, and related parties.

The information that needs to be reviewed depends on the category of company and in particular (i) a company subject to the Exchange Act reporting requirements; (i) a company with a registration statement that became effective less than 90 days prior to the date the broker-dealer publishes a quotation; (iii) a company with a Regulation A offering circular that goes effective less than 40 days prior to the date the broker-dealer publishes a quotation; (iv) an exempt foreign private issuer and (v) all others (catch-all category).

Regardless of the category of company, the broker-dealer, and OTC Markets if they are doing the review, must have a reasonable basis under the circumstances to believe that the information is accurate in all material respects and from a reliable source.  In order to satisfy this obligation, the information and its sources must be reviewed and if any red flags are present such as material inconsistencies in the public information or between the public information and information the reviewer has knowledge of, the reviewer should request supplemental information.  Other red flags could include a qualified audit opinion resulting from failure to provide financial information, companies that list the principal component of its net worth an asset wholly unrelated to the issuer’s lines of business, or companies with bad-actor disclosures or disqualifications.

Interestingly, the SEC release specifies that a deep-dive due diligence is not necessary in the absence of red flags and that OTC Markets or a broker-dealer can rely solely on the publicly available information, again, unless a red flag is present.  Currently, the only broker-dealer that actively submits Form 211 applications does complete a deep-dive due diligence, and FINRA then does so as well upon submittal of the application.  If the execution of the new rule matches its language, it will benefit the process greatly and possibly encourage more broker-dealers to offer OTC Markets’ quotations.

Information will be deemed publicly available if it is on the EDGAR database or posted on the OTC Markets (or other qualified IDQS), a national securities association (i.e., FINRA), or the company’s or a registered broker-dealer’s website.  The posted information must not be password-protected or otherwise user-restricted.  A broker-dealer will have the requirement to either provide the information to an investor that requests it or direct them to the electronic publicly available information.

Information will be current if it is filed, published or disclosed in accordance with each subparagraph’s listed time frame. The rule will have a catch-all whereby unless otherwise specified information is current if it is dated within 12 months of a quotation.  A broker-dealer must continue to obtain current information through 3 days prior to the quotation of a security.

The proposed rule will add specifics as to the date of financial statements.  A balance sheet must be less than 16 months from the date of quotation and a profit and loss statement and retained earnings statement must cover the 12 months prior to the balance sheet.  However, if the balance sheet is not dated within 6 months of quotation, it will need to be accompanied by a profit-and-loss and retained-earnings statement for a period from the date of the balance sheet to a date less than six months before the publication of a quotation.

The categories of information required to be reviewed will also expand.  For instance, a broker-dealer or the OTC Markets will be required to identify additional company officers, 10%-or-greater shareholders and related parties to the company, its officer and directors.  In addition, records must be reviewed and disclosure made if the person for whom quotation is being published is the company, CEO, member of the board of directors, or 10%-or-greater shareholder.

The rule will not require that the qualified IDQS – i.e., OTC Markets – separately review the information to publish the quote of a broker-dealer on its system, unless the broker-dealer is relying on the new exception allowing it to quote securities after a 211 information review has been completed by OTC Markets.  In other words, if a broker-dealer completes the 211 review and clears a Form 211 with FINRA, OTC Markets can allow the broker-dealer to quote on its system.  If OTC Markets completes the 211 review and clears a Form 211 with FINRA, the broker-dealer, upon confirming that the 211 information is current and publicly available, is accepted from performing a separate review and can proceed to quote that security.

Piggyback and Unsolicited Quote Exception Changes

There are two main current exceptions to Rule 15c2-11: the piggyback exception and the unsolicited quotation exception.  The proposed rule will amend the piggyback exception to: (i) require that information be current and publicly available; (ii) limit the piggyback exception to priced bid and ask (two-way) quotations; (iii) eliminate the piggyback exception during the first 60 calendar days after the termination of a SEC trading suspension under Section 12(k) of the Exchange Act; (iv) eliminate the piggyback exception for shell companies; and (v) revise the frequency of quotation requirement.  To reduce some of the added burdens of the rule change, the SEC would allow a broker-dealer to rely on either OTC Markets or FINRA’s publicly announced determination that the requirements of an exception have been met.

As discussed above, currently 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.  Moreover, as the SEC notes, by continuing to quote securities with no available information, that are being manipulated or part of a pump-and-dump scheme, a broker is perpetuating the scheme.  The SEC proposes to only allow reliance on the piggyback exception when current public information is available.  I think this will have a significant impact on micro-cap fraud.

The elimination of the piggyback exception for shell companies will likewise have a huge effect on the microcap space and instances of micro-cap fraud.  The SEC intends this amendment to prevent shell companies from maintaining a quoted market.  A broker-dealer will be prohibited from relying on the piggyback exception to publish or submit a quotation for a security of a company that meets the definition of a shell company.  The proposed amendments will include a definition of a shell company which is the same as the definition in Rule 144: “any issuer, other than a business combination related shell company as defined in Rule 405 of Regulation C, or an asset-backed issuer, as defined in Item 1101(b) of Regulation AB, that has (1) no or nominal operations and (2) either (i) no or nominal assets, (ii) assets consisting solely of cash and cash equivalents, or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets.”

The SEC notes that there are perfectly legal and valid reverse-merger transactions.  My firm has worked on many reverse-merger transactions over the years.  Obviously if passed, this rule change will have a significant effect on the reverse-merger market.  I think the rule change sounds good on paper, and that a business engaged in a going public transaction should not bulk at either a Super 8-K or a 15c2-11 process.  I do have concerns about the process and FINRA’s lengthy merit review of Form 211 filings, but perhaps these rule changes would give FINRA more confidence in its broker-dealer members and OTC Markets when they perform the review, making the process less arduous once submitted to FINRA.

A company would not be considered a shell simply because it is a start-up or has limited operating history.  However, the onus will be on the broker-dealer to remain vigilant regarding whether they may rely on the piggyback exception if the company becomes a shell or falls into shell status.  To help reduce the obvious burden on broker-dealers imposed by this proposed rule change, the rules will allow a broker-dealer to rely on a publicly available determination by a qualified IDQS (OTC Markets) or a national securities association (FINRA) that the securities are eligible for the piggyback exception.  When up and running, I would hope that OTC Markets would add “piggyback qualified” or not, to each company’s quote page.  I would hope the same for FINRA but do not foresee that occurring.

The SEC’s proposed rule only requires that companies that fall within the “catch-all” category have current public information for reliance on the piggyback exemption, since other categories of issuers have current public information by definition and thus adding the requirement to those categories would be redundant.

The requirement limiting the piggyback exception for the first 60 calendar days after a trading suspension will not likely have a market impact.  A trading suspension over 5 days currently results in the loss of the piggyback exception and requirement to file a new Form 211.  In practice, the SEC issues ten-day trading suspensions on OTC securities, and there is no broker-dealer willing to file a new 15c2-11 within 60 days thereafter in any event.  In fact, in reality, it is a rarity for a company to regain an active Form 211 after a trading suspension.  Perhaps that will change with implementation of the new rules.

The proposal would eliminate the 12-day requirement in the piggyback exception.  Currently if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted for at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may rely on the piggyback exception.  As proposed, for a broker-dealer to rely on the piggyback exception, the quoted OTC security would need to be the subject of two-way priced quotations within the previous 30 calendar days, with no more than four business days in succession without a quotation.

The existing rule excepts from the information review requirement the publication or submission of quotations by a broker-dealer where the quotations represent unsolicited customer orders.  Under the proposed rule, a broker-dealer would need to determine that there is current publicly available information.  If no current available information exists, the unsolicited quotation exception is not available for company insiders including officers, directors and 10%-or-greater shareholders.

The proposed rule requires that documentation be maintained that supports a broker-dealer’s reliance on any exception to the rule, including reliance on third-party determinations that an exception applies.

Lower Risk Securities; New Exceptions

The proposed rule amendments also add new exceptions that will reduce regulatory burdens: (i) for securities of well-capitalized companies whose securities are actively traded; (ii) if the broker-dealer publishing the quotation was named as an underwriter in the security’s registration statement or offering circular; (iii) where a qualified IDQS that meets the definition of an ATS (OTC Markets) complies with the rule’s required review and makes known to others the quotation of a broker-dealer relying on the exception (see discussion under current information above); and (iv) in reliance on publicly available determinations by a qualified IDQS that meets the definition of an ATS (i.e., OTC Markets) or a national securities association (i.e., FINRA) that the requirements of certain exceptions have been met.

The proposed rule provides an exception for companies that are well capitalized and whose securities are actively traded.  In order to rely on this exception, the OTC security must satisfy a two-pronged test involving (i) the security’s average daily trading volume (“ADTV”) value during a specified measuring period (the “ADTV test”); and (ii) the company’s total assets and unaffiliated shareholders’ equity (the “asset test”). The company must also have current public information to rely on the exception.

The ADTV test requires that the security have a worldwide ADTV value of at least $100,000 during the 60 calendar days immediately prior to the date of publishing a quotation.  To satisfy the proposed ADTV test, a broker-dealer would be able to determine the value of a security’s ADTV from information that is publicly available and that the broker-dealer has a reasonable basis for believing is reliable. Generally, any reasonable and verifiable method may be used (e.g., ADTV value could be derived from multiplying the number of shares by the price in each trade).

The asset test requires that the company have at least $50 million in total assets and unaffiliated stockholders’ equity of at least $10 million as reflected on the company’s publicly available audited balance sheet issued within six months of the end of its most recent fiscal year-end.  This would cover both domestic and foreign issuers.

The proposal would add an exception to the rule to allow a broker-dealer to publish a quotation of a security without conducting the required information review, for an issuer with an offering that was underwritten by that broker-dealer and only if (i) the registration statement for the offering became effective less than 90 days prior to the date the broker-dealer publishes a quotation; or (iii) the Regulation A offering circular became qualified less than 40 days prior to the date the broker-dealer publishes a quotation. This proposal may potentially expedite the availability of securities to retail investors in the OTC market following an underwritten offering, which may facilitate capital formation.

This exception requires that the broker-dealer have the 211 current information in its possession and has a reasonable basis for believing the information is accurate and the sources of information are reliable.  Since FINRA issues a ticker symbol, this new exception will still require the filing of a Form 211 (or new form generated by FINRA to facilitate the exception).  Whether the process for an exception review is quicker or less arduous will remain to be seen.

The proposed rule will also add a provision excepting broker-dealers from the 211 information review requirement where a qualified IDQS (OTC Markets) complies with the information review requirements and the broker-dealer relies on that review.  The broker-dealer would need to publish a quotation within 3 business days after the qualified IDQS makes its determination of compliance publicly available.  The proposed exception, however, would not be available if the issuer of the security to be quoted is a shell company, or 30 calendar days after a broker-dealer first publishes or submits such quotation, on OTC Markets, in reliance on this exception.

Once OTC Markets has complied with the rule’s information review requirement and made a publicly available determination that the requirements have been met, any broker-dealer could quote the security in the 30-day window.  If the stock becomes frequently quoted during that 30-day window, the piggyback exception could then become available for continued quotation; otherwise, a new review or exception would need to be complied with.  This is a win for OTC Markets, which included this as one of its suggestions in its comment letter to the SEC on the subject in January of 2018.

The SEC amendments also propose to allow a broker-dealer to rely on a determination by a qualified IDQS (OTC Markets) or national securities association (FINRA) that an exception to the rule is available as long as the broker-dealer determines that current public information is available or that they rely on OTC Markets’ or FINRA’s determination that such information is available.  To facilitate a broker-dealer’s reliance, OTC Markets or FINRA must represent in a publicly available determination that it has reasonably designed written policies and procedures to determine whether information is current and publicly available, and that the conditions of an exception are met.

The proposed amendments require that the broker-dealer, OTC Markets and FINRA keep records regarding the basis of its reliance on, or determination of availability of, any exception to the rule.

Miscellaneous Amendments to Streamline

The SEC has also proposed numerous miscellaneous changes to streamline the rule and eliminate obsolete provisions.  The miscellaneous changes include: (i) allowing a broker-dealer to provide an investor that requests company information with instructions on how to obtain the information electronically through publicly available information; (ii) updated definitions; and (iii) the elimination of historical provisions that are no longer applicable or relevant.

Conclusion

I’m happy that the SEC is reviewing the 211 process and attempting to improve the system, especially allowing the OTC Markets itself to conduct a review, submit a Form 211 directly to FINRA and determine the availability of an exception; however, I would like to see additional changes.  In particular, the proposing release did not address the prohibition on broker-dealers, or now, OTC Markets, charging a fee for reviewing current information, confirming the existence of an exemption and otherwise meeting the requirements of Rule 15c2-11.  The process of reviewing the information is time-consuming and the FINRA review process is arduous.  Although not in the rule, FINRA in effect conducts a merit review of the information that is submitted with the Form 211 application and routinely drills down into due diligence by asking the basis for a reasonable belief that the information is accurate and from a reliable source.   Most brokerage firms are unwilling to go through the internal time and expense to submit a Form 211 application.  In fact, in reality, there is really only one that does so consistently.  I believe the SEC needs to allow broker-dealers and OTC Markets to be reimbursed for the expense associated with the rule’s compliance.