Background
On October 8, 2013, I published a blog and white paper providing background and information on the Depository Trust Company (“DTC”) eligibility, chills and locks and the DTC’s then plans to propose new rules to specify procedures available to Issuers when the DTC imposes or intends to impose chills or locks. On December 5, 2013, DTC filed these proposed rules with the SEC and on December 18, 2013, the proposed rules were published and public comment invited thereon (“Rule Release”). For background on DTC basics such as eligibility and the evolving procedures in dealing with chills and locks, please see my prior blog here .
The Depository Trust Company (“DTC”) is a central securities depository in the U.S. which was originally created as a central holding and clearing system to handle the flow of trading securities and the problems with moving physical certificates among trading parties. The DTC is regulated by the SEC, the Federal Reserve System and the New York State Department of Financial Services. Today, and as noted by the SEC, the “… 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, the DTC processed 295,000,000 book entry transfers of securities worth $273.8 trillion.” If the DTC doesn’t process and settle trading in your securities, it just doesn’t happen.
The DTC is regulated by Section 17A of the Securities Exchange Act of 1934, as amended. As noted in the Rule Release, Section 17A requires that the DTC’s rules be “designed to promote the prompt and accurate clearance and settlement of securities transactions… and, in general, to protect investors and the public interest.”
A DTC Chill or Global Lock – General
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 (“Deposit Chill”) or withdrawal services. A chill can pertain to one or all of these services. In the case of a chill on all services, including book entry transfers, deposits, and withdrawals, the term of art is a “Global Lock.”
From the DTC’s perspective, a chill does not change the eligibility status of an Issuer’s securities, just what services the DTC will offer for those securities. For example, the DTC can refuse to allow further securities to be deposited into the DTC system or while an Issuer’s securities may still be in street name (a CEDE account), the DTC can refuse to allow the book entry trading and settlement of those securities.
On December 18, 2013, the SEC published the DTC’s proposed rule changes specifying procedures available to Issuers when the DTC imposes or intends to impose chills or locks. The entire rule release is available on the SEC website.
DTC Statement of the Purpose of the Proposed Rule Change
The DTC considers itself a critical part of the U.S. securities industry infrastructure and therefore responsible for ensuring that no illegal, improperly unrestricted securities enter the marketplace. Once a security is approved as eligible for DTC depository and book-entry services, banks and broker-dealers that are participants with the DTC (which is almost all such entities) may deposit securities into their DTC accounts on behalf of their respective clients. Securities deposited into the DTC may be transferred among brokerage accounts by book-entry (electronic) transfer, facilitating quick and easy transactions in the public marketplace.
Eligible securities are registered on the books of a Company in the DTC’s nominee name, Cede & Co. Securities of a Company deposited at DTC are maintained in “fungible bulk.” That is, each brokerage firm has a pro rata interest in the DTC’s entire inventory of such security. No single share could be identified as being “owned” by a particular brokerage firm or ultimately their depositing clients. By serving as the registered holder of trillions of dollars of securities, the DTC processes the enormous volume of daily transactions electronically, without the need to transfer physical certificates.
A basic premise to use of the DTC is that securities be freely tradable. Therefore, in order to be DTC eligible, an Issuer’s securities must (i) be issued in a transaction registered with the SEC under the Securities Act of 1933, as amended (“Securities Act”); (ii) be issued in a transaction exempt from registration under the Securities Act and that, at the time of seeking DTC eligibility, are no longer restricted; or (iii) be eligible for resale pursuant to Rule 144A or Regulation S under the Securities Act.
Since deposited securities are in fungible bulk, the deposit or existence of any illegally or improperly deposited securities (restricted securities) taints the bulk of all securities held by the DTC for that Company. As such, the DTC monitors enforcement actions, regulatory actions and pronouncements and red flags in the securities of DTC-eligible securities. A red flag includes unusually large deposits of thinly traded, low-priced securities. DTC Rule 6 allows the DTC to limit certain services to particular deposited securities. In addition, Section 1.B.2 of the DTC’s Operational Arrangements give the DTC the power to require Companies’ outside counsel to provide legal opinions in support of eligibility and free tradability of deposited securities.
In addition, the DTC looks for other red flags, including FINRA’s list of red flags such as the following:
A customer of the broker opens a new account and delivers physical certificates representing a large block of thinly traded or low-priced securities;
A customer of the broker deposits share certificates that are recently issued or represent a large percentage of the float of the security;
The company was a shell company when it issued the shares;
A customer of the broker with limited or no other assets under management at the firm receives an electronic transfer or journal transaction of large amounts of low-priced, unlisted securities;
The Issuer has been through several recent name changes, business combinations or recapitalizations, or the company’s officers are also officers of numerous similar companies;
The Issuer’s SEC filings are not current, or are incomplete or nonexistent.
Where the DTC’s monitoring raises concerns that securities held at the DTC have been distributed in violation of federal law, the DTC may impose a deposit chill or global lock. The two main scenarios when this occurs are as follows: (i) Where the DTC detects suspicious, unusually large deposits of a low-priced or thinly traded security, they may and often do impose a Deposit Chill until, in the words of the DTC, “the issuer convincingly demonstrates that the securities are freely transferable.” (ii) If the DTC determines that there is “definitive evidence” that restricted shares have been deposited, it will impose a Global Lock. According to the DTC, definitive evidence is established if the SEC or other regulatory agency has brought an enforcement action against any defendant that has deposited the Issuer’s securities into the DTC. The DTC may also impose a Global Lock where the Issuer fails to respond to or adequately resolve a Deposit Chill.
DTC Proposed Process for Issuers
The DTC has proposed rules (Rules 22(A) and 22(B)) such that Issuers will be notified in writing of chills and locks, have a set time frame in which to respond, and will have clear guidelines to be met to either prevent a chill or lock or remove same. The DTC will agree to respond within a set time frame. Moreover, and importantly, the DTC will agree to keep communication open between the Issuer and its counsel, and the DTC and its counsel, throughout the process.
A. Deposit Chills (Rule 22(A)) In general, proposed Rule 22(A) provides Companies with an opportunity to establish that they meet DTC’s eligibility requirements, including by submitting an opinion from independent legal counsel.
Notification of Deposit Chill. Pursuant to its Proposed Rule, the DTC will notify an Issuer of a deposit chill by overnight courier no later than 20 business days prior to imposition of the Deposit Chill, or if the chill has already been imposed, no later than three business days after the chill has been imposed. In either case, the Issuer has 20 days to respond. The notice will provide an explanation of the specific grounds upon which the restrictions are being or have been imposed. The notice will state the actions that the Issuer must take in order to prevent or remove the restrictions, including generally requiring a legal opinion from independent counsel. The DTC readily grants extensions to Issuers in providing responses.
The DTC will impose the chill prior to notice where “there is a threat of imminent harm or injury to DTC or the industry, including if circumstances suggest that advance notice might accelerate improper deposits.” In such a case, DTC must balance the identifiable need for emergency action with the Issuer’s right to fair procedures. Moreover, in such a case the DTC will need to provide expedited fair process to the affected Issuer. In particular, the DTC will provide notice of the action within three (3) business days from the imposition of the restriction. Following such notice, the Issuer will be subject to the same process and timing as a pre-chill notified Issuer.
It should be noted that the DTC considers it an emergency where “DTC’s monitoring suggests that marketplace actors are continuing to cause the deposit of eligible securities that are not freely tradable.” However, DTC has no way of knowing for sure that the shares are or are not freely tradable until the Issuer does or does not provide an acceptable opinion letter.
The Proposed Rules provide that the Issuer must support its response with a legal opinion, prepared by independent counsel, confirming that the Issuer’s securities deposited at the DTC satisfy the DTC’s eligibility requirements, including that they are freely tradable. The DTC will provide a template for the legal opinion to the Issuer. It is not anticipated that the legal opinion requirements will be different than as in effect today.
DTC Review of Issuer Response. The DTC may request further or additional information, in which case the Issuer will have at least ten (10) days to provide such additional information. The DTC will respond in writing to the Issuer’s submission and legal opinion within twenty business days for pre-chill notices and within ten business days if the chill has already been imposed.
Determination. An officer of the DTC who did not participate in the decision to impose the chill, together with outside counsel as appropriate, will decide whether the Issuer’s response is satisfactory. If the response from the Issuer is sufficient, the chill will either not be imposed or will be lifted. If the Issuer does not respond in a timely manner (including after extensions) or such response is not sufficient, the chill will remain and a lock may be imposed. In an adverse decision, prior to imposing a Global Lock, the DTC will give the Issuer a short period of time to demonstrate that the DTC’s determination was the result of the DTC’s clerical mistake or a mistake arising from an oversight or omission in reviewing the Issuer’s response. This added process will not include an added substantive review. Moreover, the Proposed Rules give the DTC full discretion to lift or modify a chill at any time it deems in the best interest of the DTC and its participants.
B. Global Locks.
Notification of Global Lock. Pursuant to its proposed rule, DTC will notify an Issuer of a Global Lock by overnight courier no later than 20 business days prior to imposition of the Global Lock, or if the lock has already been imposed, no later than three business days after the lock has been imposed. The notice will provide an explanation of the specific grounds upon which the restrictions are being or have been imposed. The DTC will impose the lock prior to notice where there is a threat of imminent harm or injury to the DTC or the industry, including where the SEC has alleged that defendants are in possession of additional unregistered securities that could be deposited into the system. In either case, the Issuer shall have twenty (20) days to respond.
The Proposed Rules differentiate in separate sections: Global Locks based on enforcement proceedings and Global Locks based on an Issuer’s failure to respond or adequately respond to a chill. The notice will provide the reason for the lock and identify the regulatory or enforcement proceeding upon which the lock is based, if applicable. The notice will give twenty days to respond with the ability to receive a twenty-day extension. The Issuer will have the opportunity to prove that the securities deposited at the DTC are not a part of the legal or enforcement proceeding or that the proceeding has been withdrawn, terminated, settled or otherwise resolved in favor of the defendant that deposited the securities at the DTC.
To be very clear, a DTC Global Lock may be imposed if an action is brought against any shareholder that has deposited the Issuer’s securities into the DTC and the DTC reasonably believes that the action relates to the Issuer’s securities. The Issuer itself does not have to be a party to the enforcement or legal proceeding.
The Proposed Rules provide Companies with an opportunity to establish that (i) the DTC has made a mistake in associating the Company’s securities with the specified enforcement proceeding or (ii) that the enforcement proceeding has been withdrawn or dismissed on the merits with prejudice or otherwise resolved in a final, non-appealable judgment in favor of the defendant(s). The DTC will not provide a forum for litigating or re-litigating the allegations or findings in the enforcement proceeding.
DTC Review of Issuer Response. The DTC will respond in writing to the Issuer’s submission and legal opinion within twenty business days for pre-lock notices and within ten business days if the lock has already been imposed. The DTC is cognizant of not providing an alternative forum for an Issuer to litigate enforcement proceedings. Accordingly, where there is a pending enforcement action, it is unlikely that a Global Lock will be lifted and the DTC’s review will be limited.
Determination. If the response from the Issuer is sufficient, the lock will either not be imposed or will be lifted. Otherwise, DTC will release the Global Lock within either one year or six months, as the case may be (depending on the company’s Rule 144 eligibility) after the final disposition of the enforcement proceeding or following imposition of a Global Lock for failing to respond to or satisfy the DTC’s concerns relating a Deposit Chill notice.
That is, the Proposed Rules include a provision whereby Global Locks can be lifted and removed after a holding period analogous to Rule 144. In particular, the DTC’s Proposed Rules include the lifting of a Global Lock after the following periods have elapsed:
- For non-reporting Issuers – one year after the latest date on which the outstanding litigation or administrative proceeding has been resolved with respect to any defendant that deposited securities at the DTC.
- For reporting issuers – six months after the latest date on which the outstanding litigation or administrative proceeding has been resolved with respect to any such defendant.
- Where the Global Lock was imposed for a failure to respond or properly respond to a Deposit Chill issue – for non-reporting issuers – one year after the date the Global Lock was imposed;
- Where the Global Lock was imposed for a failure to respond or properly respond to a Deposit Chill issue – for reporting issuers – six months after the date the Global Lock was imposed.
The release of the Global Lock as set forth above would only be available to Issuers that are not and have never been a “shell company” as defined by Securities Act Rule 144(i), unless the Issuer had ceased to be a shell company and filed Form 10 type information.
Moreover, the Proposed Rules give the DTC full discretion to lift or modify a Global Lock at any time it deems in the best interest of the DTC and its participants.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
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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