Shifting Capital Markets; Bank of America’s Merrill Lynch Exits the Penny Stock Business

Posted by on October 30, 2018

Shifting Capital Markets; Bank of America’s Merrill Lynch Exits the Penny Stock Business- Today is the continuation of a LawCast series talking about changes in capital markets related to low priced securities. In June 2017, the SEC filed a complaint in the United States District of New York against Alpine Securities Corporation, claiming a violation of the same activity in the COR matter that I discussed in the last LawCast in this series. In particular the failure to file suspicious activity reports (SARs) for penny stock transactions. The SEC is seeking $20,000,000 in fines and penalties, including injunctive relief. Unlike COR, Alpine decided to fight the SEC action and proceed with litigation. In April 2018, the SEC won a partial summary judgment against Alpine on all but one of their claims, and Alpine appealed. Litigation continues with Alpine’s survival at stake – literally – if the SEC wins, it is likely Alpine will no longer be able to continue in business.

In April, around the time the SEC won its partial summary judgment, Alpine lost its X-clearing arrangement with Merrill Lynch. Trades in securities are deemed “X-Clearing” when they are settled outside of the DTCC FAST system. DTC’s subsidiary, the National Securities Clearing Corp (NSCC), charges large “illiquid fees” for the clearing of securities that are low-priced and not traded on a national exchange. To manage these charges, small clearinghouses such as Alpine can enter into arrangements with larger clearinghouses that can clear the securities for them outside of the DTC system. As a result of losing its x-clearing arrangement, Alpine no longer processes transactions for securities priced below $0.10.

In an effort to assist Alpine Securities with its twofold predicaments, a special purpose vehicle has been set up to raise funds privately, which funds will be used to invest in SCA Clearing, LLC, the holding company for Alpine Securities. The purpose of the investment will be to increase Alpine’s net capital so that it can reduce its NSCC illiquid charges and for other operational purposes. Although I have no direct knowledge of the status of the private offering, I find it difficult to imagine that investors will invest in light of the risk imposed by the SEC litigation.

I’ve written a lot on blockchain, cryptocurrencies and my belief that a change in capital markets is inevitable. I believe that the sale of digital assets as a security is here to stay and that several of the companies that claim to be seeking proper registration and licensing to operate a secondary marketplace for the trading of these digital assets, will succeed. FINRA is actively working with broker-dealers and licensed ATSs to figure out the operations, compliance and regulatory aspects of an operational exchange. Furthermore, the SEC has proven that it will take enforcement action against those that operate without such appropriate licenses.

However, the vast majority of the companies that are issuing crypto and securities tokens are very early-stage with valuations that, even if inflated today, will adjust to reasonable levels. That is, the vast majority of crypto and securities tokens, are and will be, just another form of a penny stock. As quickly as clearing firms exit the penny stock marketplace, a new platform is building to provide an alternative. The race is on for the first entrant with T-Zero, Coinbase, Templum, SharesPost and others all vying for the prize.

I don’t know which clearing firms will be involved in the trading and clearing of securities tokens on individual ATSs, but I believe it will be new players that are working with individual ATSs as I film this. Also, it could be that the trading on a particular ATS will be siloed such that the trading of a security token on one ATS will be independent from the trading of that same token on another ATS. A clearing firm could be tied to a particular ATS, which in turn is run by a single broker-dealer, creating multiple individual marketplaces. That is how it works on crypto-exchanges today, which is why, for example, bitcoin can be a slightly different price or rise and fall in different patterns on different exchanges.

During an industry life cycle, it is normal to see the rise and fall of key participants; Lehman Brothers and others have once been too big to fail and plenty of smaller players have closed their doors along the way. Likely, this is a similar scenario for clearing firms and new players will see the opportunity and enter the penny stock marketplace. OTC Markets is invariably working hard to help its customers, and their stockholders, have the ability to gain liquidity. With the rise of alternative markets, it will be interesting to see the changes that take place over the next few years.