Ran across this and although it is mostly off-topic, I thought it might still be interesting reading...
National Quotation Bureau, LLC
11 Penn Plaza, 15th Floor
New York, NY 10001
(212) 896-4476
April 27, 1998
Jonathon G. Katz
Secretary
Securities and Exchange Commission
Mail Stop 6-9
450 Fifth Street NW
Washington, D.C. 20549
Re: File No. S7-3-98
Dear Mr. Katz,
As Chairman of the National Quotation Bureau, LLC (the "NQB"), I am pleased that the Securities and Exchange Commission (the "Commission") is taking an initiative to review their rules and regulations surrounding the over-the-counter ("OTC") markets. A competitive and transparent market should be available for all securities and regulators should be given the tools to punish any entity that attempts to manipulate that market or defraud investors. I would like to offer my comments, which represent the views of the NQB, on the proposed changes to the Rule 15c2-11 and the regulatory structure for secondary trading of OTC securities. I view the intentions and goals of the proposed rules favorably, although I think that, improperly implemented, they may cause terrible unintended consequences. The following comments relate to the proposed rule and its potential effects on the marketplace for securities covered by the proposed rule.
The NQB is a publisher of financial information for the securities market. Our core business has been publishing quotations of competitive market makers in OTC securities. The National Quotation Service (the "NQS") is a quotation medium composed of sections: the Pink Sheets_ the Yellow Sheets+ and the Partnership Sheets.
I have put substantial thought on how to identify and offer solutions to various regulatory concerns in the OTC markets. It has been an interesting learning experience as I have had the opportunity to discuss the issues with investors, issuers, market makers and regulators from the Commission, self regulatory organizations and state securities departments. The first part of this letter will be to seek to provide helpful information to the Commission about the OTC market and various regulatory approaches. Since the majority of the Commission's contact with participants in these markets is when the Commission brings enforcement actions against the bad guys, we fear that the staff and the Commission tend to see only the problems. I also think that is what the media tend to see and sensationalize. I hope that the Commission takes this opportunity to better understand the inner workings of and functions that this marketplace and brings forward some innovative solutions to its problems.
While "micro-cap stocks" are currently in the public spotlight, fraud occurs across all markets. Employee fraud at New York Stock Exchange listed Cendant Corporation cost investors over $14,000,000,000. Stratton Oakmont was lead managers in twenty-seven stock offerings according to Securities Data Company; all of which were listed on the Nasdaq Stock Market, Inc._ (the "Nasdaq"). On February 26th, an officer of A.R. Baron & Co. was convicted of twenty-five charges including enterprise corruption, scheming to defraud, falsifying business records, perjury, and manipulating prices of eight Nasdaq listed companies.
Forcing issuers to provide financial disclosure does not prevent fraud. Comparator Systems Corp. (IDID) and Systems of Excellence Inc. (SEXI) both filed with the Commission.
There are two primary routes that shady operators use to prey upon investors: (1) traditional hard sell boiler rooms and (2) fraudulent touts of securities through radio, television and print media and now the Internet or other "new" media. Investors will send their orders through legitimate brokers based on an Internet tout. The globalization of stock markets means that the stock touted may trade overseas. Thus, the first problem is long-standing and demands fine-tuning of existing rules and regulations. I was mildly surprised by my research on the well known boiler rooms, Stratton Oakmont, A.R. Baron & Co., Duke & Co., etc., that virtually all of the stocks they underwrote or were convicted of manipulating were listed on Nasdaq. I might venture to guess that the Penny Stock Rule (Rule 15g-9) has been successful in removing such firms from the non-Nasdaq OTC market.
I believe that the best protection is a knowledgeable investor. The current "micro-cap" and "penny stock" initiatives should be used to protect investors through increased investor education and enforcement of suitability standards. Unsophisticated, inexperienced investors must be kept out of this sector of the market. The issuers, promoters and retail brokerages who commit micro-cap fraud are criminals who violate and ignore existing securities laws. While there will always be criminals, we must increase the consequences and lessen the profitability of rule breaking. The Commission's review of rules and regulations should be designed to increase investor education, close loopholes, enforce responsibility for one's actions and give enforcement better tools to stop frauds.
What Purpose does a Quotation Medium Serve?
Secondary markets for securities are an integral part of the capital raising process. Issuers need capital to operate their businesses. Investors provide capital through the purchase of securities. Investors purchase securities with the assurance that they can sell those securities or buy more based upon changes in their investment outlook, tax situation or the underlying company's financial performance and prospects. The exchanges and Nasdaq provide trading facilities for larger issuers to list their securities. However, there are issuers who do not meet the standards required for listing on the larger markets or do not want to be listed. These are smaller companies with limited operating histories, troubled companies or closely held companies with less than 500 shareholders. But many of them are real, viable companies with capital needs. For many reasons, the issuers may or may not want a public market in their securities. Some of those issuers can, some can't and some won't provide financial information to minority shareholders or the public. However, all of those issuers have securities outstanding, and as long as the securities exist, minority shareholders and investors will want or need to buy or sell those securities.
Quotation media such as the Pink Sheets serve the needs of minority investors' seeking to efficiently buy and sell securities of companies that can't or won't list on an exchange or Nasdaq.
Unlisted securities have traditionally been traded by broker-dealer market makers in a quotation medium. A market's role is to find a price point where supply equals demand. Supply does not always equal demand in unlisted securities, so competitive market makers provide liquidity for buyers and sellers. Without market makers, markets are less liquid and easier to manipulate. Multiple dealers competing in a transparent medium have proven over time to be the best way to trade small-cap stocks.
Numerous attempts to recreate the structure of an exchange for small-cap stocks have met with failure. The American Stock Exchange's Emerging Company Marketplace was host to numerous dubious issuers and was finally dissolved with great embarrassment. The Pacific Stock Exchange SCOR marketplace initiative has just been shuttered due to the failure to attract any suitable listings. Every other attempt to recreate an exchange for small company securities has been started with great fanfare but always ended in failure. The exchange listing has either been overly burdensome for legitimate, small companies or abused by fraudulent issuers to give false legitimacy and respectability to their securities.
The only successful services for small-cap equities have been the National Association of Securities Dealers, Inc. (the "NASD") OTC Bulletin Board (the "OTCBB") and the Pink Sheets. They have served the public's demand for the centralization of competitive buyers and sellers of unlisted securities. There are approximately 8,300 issuers whose equities are quoted on the OTCBB or in the Pink Sheets. We estimate the market capitalization of those companies is over $400,000,000,000. The companies employ millions of workers and have millions of public shareholders. Quotation media also serve the limited partnership and bond markets. There are over 900 limited partnerships quoted in the Partnership Sheets and over 2,500 corporate bonds are quoted in the Yellow Sheets. There is an average of 4.5 market makers for the 11,700 securities quoted in the NASD and the NQB quotation media.
Possible Regulatory Solutions to the Unlisted Markets
The regulatory approaches that have been fantastically successful in creating the greatest exchange markets in the world do not work in the unlisted markets. The Commission primarily regulates three parts of securities markets; the issuance of securities by companies (the primary markets), the listing of securities on exchanges or Nasdaq and the secondary trading of securities. The two most successful tools of the Commission in creating the worlds greatest listed markets have been financial disclosure by issuers and listing standards. Companies that issue securities and list on exchanges all want access to capital and a public market for their securities so they are willing to supply information and comply with rules.
The securities traded in unlisted markets are more problematic. Unlisted issuers either want access to capital and a public market, but don't meet the listing standards of an exchange or Nasdaq or don't want access to capital or a public market for their securities. For that reason, unlisted markets have always troubled regulators. How can regulators control issuers who can't or won't list on an exchange or Nasdaq? What good are listing standards if an issuer can't meet them? You can't impose higher standards. How do you obtain financial disclosure from issuers who don't need access to capital or don't want their minority shareholders to have the benefit of a public market? Especially, when some of the issuers are small businesses that are specifically exempt from the burdens of reporting to the Commission. The truth is you can't.
One regulatory solution would be to not allow these securities to trade. Once a security did not meet certain standards or stops providing financial disclosure, shares would become frozen and disappear. If an issuer doesn't supply financial information, no broker could buy or sell that security. The issuers who don't want a public market for their minority shareholders would approve. Management could then buy back the shares at substantial discounts because there would be no competing offer away from the company. Investors would probably be less willing to provide capital to legitimate small companies if they were never able to sell their stock or only at such discounts. Stopping trading in companies that can't meet listing standards or won't provide full disclosure will not work because it would hurt small companies access to capital and seriously harm minority shareholder's rights. Millions of workers and shareholders would be harmed.
Since the securities quoted in the Pink Sheets and the OTC Bulletin Board already exist and regulators can't make them disappear without causing irreparable harm to thousands of legitimate small companies and millions of shareholders, what can they do? Throw them out of the system and make them trade only in private transactions? No. The Commission does not want to create an underground and unregulated black market. The securities exist and investors need to buy or sell them. That demand will not disappear. Transactions should take place where regulators can oversee them.
Many of these securities are for small banks, companies in bankruptcy or liquidation, and closely held companies that won't disclose financial information to the public. If legitimate on-shore markets become unavailable, the danger is that the legitimate securities that don't have current financials available or won't supply current financials to shareholders are forced to less regulated offshore markets or the Internet. Ten years ago, the trading of a non-Nasdaq OTC security would stop if it weren't quoted in the Pink Sheets. That is not the case today. Individuals buy and sell used computers, beanie babies and baseball cards on the Internet today (see www.ebay.com, www.firstauction.com, www.bid.com and www.onsale.com ). They can and will trade securities. If the legitimate securities owned by legitimate investors are thrown out of the regulated markets, a black market of unregulated entities will develop to fill the need.
The Commission could smother the unlisted marketplace in regulation. Make the marketplace opaque and inefficient. Increase costs, burden participants and the activity will definitely slow down. However, it is a strategy that is doomed to failure. If regulation increases the cost of quoting securities in the Pink Sheets and the OTCBB, market makers will pass on the cost to investors in the form of wider spreads and less liquidity for all non-Nasdaq OTC securities. Legitimate investors will lose out. Legitimate issuers and investors will then seek lower cost trading forums with less regulatory overhead such as issuer web sites or offshore market makers. Under the cover of those legitimate securities, fraudulent ones will find added credibility. It is terrible that issuers and promoters tell lies on the Internet and the trading takes place through legitimate broker-dealers, on the exchanges, and in the OTC markets. However, the public would be worse served and the opportunities for fraud and manipulation increased if the securities were traded on an issuer or promoter web site that briefly appears and then disappears.
In short, I rapidly conclude that the only answer in is to make markets so competitive, transparent, efficient and inclusive that there is never the need for other trading forums. Every legitimate security with minority shareholders should be traded through a regulated and supervised broker-dealer. Rather than resist technology, markets should exploit technology to reach these goals.
What Should the Commission do?
The securities covered by the rule proposal are like children, some are good, some are bad, but all need to be supervised and disciplined when they get out of line. The Commission cannot control the children all the time but they must impose and enforce rules to protect the good children and the community from the bad children. Just because there are some bad children, the Commission shouldn't throw all the children out into the street. The bad children would run rampant through the community and the good children would suffer from neglect. Nor can they ask others to take on the Commission's responsibilities to supervise the children.
Therefore, the most important emphasis should be on a comprehensive review of market rules and regulations to increase the professional standards of the securities industry to protect retail customers and increase oversight of issuers. Since the Commission cannot impose listing standards or require financial disclosure from issuers, they must limit unsophisticated investors access to the securities. OTC securities are a dangerous asset class. Investors must be educated with respect to and sophisticated enough to understand the risks of the securities. Rules must protect the public from being lied to by a dishonest salesman or unwittingly buying stock from or selling stock to an insider.
The Commission should clearly limit insiders access to OTC markets if there is no current information available in the marketplace. Many of the problems in this marketplace were created by the Commission's easing of restrictions on insider sales of stock through Regulation D and Regulation S. Insiders should not be free to trade stock if there is no information in the marketplace. Issuers must be current in their filings with the Commission if they are reporting companies.
If they are not, there should be information repository for issuers, officers, directors, affiliates, promoters and significant shareholders to post needed information before insiders are able to buy from or sell into the public markets. If insiders want to sell any stock covered by Rule 15c2-11 they must make a filing with the Commission or appropriate state regulator in advance. The repository should include that information. State banking and insurance filings should also be available.
Insiders should be limited to private transactions if there is not current information in the marketplace, and their stock should be restricted so that any stock sold in a private transaction does not become "washed" and find its way into the public markets.
Minority shareholding outsiders are entitled to buy and sell their interests in as transparent and competitive media as possible, however insiders should not be able to prey them upon. The public would be protected from insiders dumping securities on an unsuspecting public. However, insiders would not be able to limit minority shareholders liquidity options by restricting information when insiders try to repurchase securities. In short, public securities markets should be strictly limited to outsiders if insiders won't or can't supply current information in the form of 15c211, bank or insurance regulatory, or other filings with the repository.
Registered transfer Agents obligations under Section 17A should be expanded to support the repository. The transfer agents should be required to report to any exchange, inter-dealer quotation system or quotation medium, information regarding the issuers and securities listed or quoted. The transfer agent should be required to report to such organization on their request and at least on an annual basis the issuer address, officers, state of incorporation and shares of the security outstanding. The transfer agent should be required to report significant intervening events such as significant securities offerings, splits, name changes, moves and other events that the Commission deems important. While the Commission only has power over registered transfer agents for securities issued under 12(A) the majority of non-reporting issuers use registered transfer agents. If unregistered transfer agents became a significant problem, the Commission could work with state securities commissioners to gain access to the information. The transfer agent has a contractual relationship with the issuer and thus is in a position to collect factual information. The exchange, inter-dealer quotation system or quotation medium can distribute the information to market participants through the repository.
I believe that responsibility for customer protection should lie with the firm who holds the customer's account. Regulation must walk the fine line of protecting a customer while not unduly restricting or limiting their opportunities. Therefore, I am in favor of the NASD proposed Rules 2315 and 2350. The proposed rules would require members to review current issuer financial statements prior to recommending a transaction to a customer in a OTC equity security and to deliver a disclosure statement to a customer prior to an initial purchase of an OTC equity security. I believe that the NASD should go further and replicate their rules regarding options accounts. Options are an asset class that involves a high degree of risk for investors. The only difference between options and OTC equity securities is that the big firms want to sell options to their customers and probably deals with non-Nasdaq equities only when forced by the customer. The industry has developed rules and procedures to adequately inform investors of the risks and keep unsuitable customers from trading options. Why shouldn't we impose those same protections for non-Nasdaq OTC equities? Rules which mimic NASD Rule 2860 (sections: (11) Delivery of disclosure documents, (16) Opening of accounts, (18) Discretionary accounts, (19) Suitability and (20) Supervision of accounts) should be written for non-Nasdaq OTC equities.
NASDR should consider sales practice rules that warn the customer of what primary market center a security is listed on or quoted in at the time they place an order, and that information should be repeated on their confirmation. Properly identifying primary market centers would help differentiate securities for customers and reinforce the prestige of Nasdaq and the exchanges and the risks of the non-Nasdaq market. The public would no longer view all securities with symbols as having the same risk characteristics.
NASDR's and other SRO's regulatory divisions should have the ability to stop member firms and associated persons from transacting in any non-Nasdaq security for ten out of twenty working days for practically no reason at all. This rule would allow market surveillance to instantly stop trading in a security simply as a precaution on suspicion of manipulation or questionable information in the marketplace. The restriction that it only is allowed for ten out of twenty days would limit it from being used capriciously and provide a window in which to initiate more formal suspension for cause shown. The halt in transactions should not effect quotations under 15c2-11. The Commission would have ten days to research whether a trading suspension pursuant to 12(k) is warranted. The rule would have many benefits. Investors would be instantly stopped from buying or selling a security based on potentially false information. Fraudulent promoters and manipulators would lose the ability to continue profiting as NASDR and the Commission researched whether a trading suspension was justified. Investors and market makers would be much more wary of owning speculative issues that could halt trading with no warning (unlike a 12(k) suspension that the market place is always warned of days in advance by the Commission's subpoenas of documents).
We support the Commission's recent initiative of imposing an increasing number of trading suspensions pursuant to 12(k). The Commission ordered 12 suspensions in fiscal year 1997, 8 in 1996, 4 in 1995 and 1 in 1994. See SEC Increasingly Using Trading Suspensions to Combat Fraud, Dow Jones Newswire, Paul Beckett (2/4/98). However, a faster response is now required. The best way to limit fraud is to cut down on the potential for fraudulent profit.
The NASD is presently developing the Order Audit Trail System (the "OATS"), to track customer orders in NASDAQ equities. OATS should be expanded to include all non-NASDAQ OTC equities, be they OTCBB, Pink Sheets, unlisted or foreign, i.e. any order from a domestic customer for an equity security and any order by a foreign customer for a domestic equity security. OATS should include information if the order was solicited or unsolicited, the registered representative's CRD# and the branch office. The ability to easily track solicited orders will aid NASDR in identifying cornered or controlled markets. OATS will give NASDR market surveillance a valuable tool in tracking where orders are coming from in times of unusual volume or price change. NASDR will be able to recognize what firms are soliciting orders in active securities and trace the reason for such activity. The NASDR surveillance systems will be able to easily identify firms that may be soliciting business in securities and not recording the orders as solicited.
I would hope that the Commission and the NASD form a permanent joint task force on micro-cap fraud. The task force would be in charge of market surveillance, enforcement and investor education for non-Nasdaq OTC equities. The task force would be able to quickly stop and prosecute fraud in the OTC markets. The joint powers of the Commission and the NASD should increase the ease of prosecution. Publicity of enforcement actions would serve to deter potential wrongdoers and educate the public regarding the risks in non-Nasdaq OTC markets. The Section 31(a) fees that the Commission has been receiving from the OTC markets could fund the task force. The task force would design industry wide programs to educate the public on smart investing.
Increase Transparency and Efficiency
Since the Commission cannot turn back the clocks on technology, they must embrace technology to identify and stop frauds quickly. The best first defense against fraud is an efficient, competitive and transparent marketplace that is well policed. In response to the proposed changes to the OTCBB, the NQB has initiated plans to provide quotation transparency for securities quoted OTC through an electronic bulletin board and messaging facility. The OTCBB has provided a transparent and efficient medium for issuers and investors, however it's association with Nasdaq has given the securities an implied legitimacy. The quoting of securities in the Pink Sheets does not give the same respectability or visibility as a system sponsored by a SRO.
Subject to discussions with the Commission, the NQB would become a centralized information clearinghouse, accepting prices from market makers and other information from issuers and market makers. I realize that there is potential for misinformation within that role, but believe that misinformation circulates today and that in collecting it we are making a record that benefit's the markets and regulators well beyond any incremental damage that its centralized availability may introduce.
NQB would have an information repository for issuers that aren't required to register with the Commission. The NQB believes for a repository to be successful, it must be driven issuers supplying the information. No matter how respected the market maker firm is that supplies information to a Repository, any other market maker would have to obtain source documents from the issuer to be certain they are from reliable sources. Thus, NQB would have to establish private contracts with issuers, advising them that anti-fraud provisions covered the information supplied. The contract would require the issuers to supply financial information on a timely schedule that NQB would store in an electronic repository. The issuers would be contractually obligated to notify NQB of important intervening events such as mergers, acquisitions, name changes, resignation of accountants, bankruptcy and significant offerings. NQB would make all information in the repository available to our broker-dealer subscribers. The public could access the information through their broker-dealer. NQB would place identifiers on the securities quoted in our service identifying whether the issuer's filings were current with the Commission, current with our repository or not current. Customers would be warned that securities in the latter category would be "buyer beware". I believe that if current information is not available in the marketplace, issuers, insiders and promoters should not be able to access the marketplace to buy or sell. However, outsiders should still be able to buy or sell their securities with other outsiders in an efficient, competitive and transparent medium.
The NQB disagrees with the viewpoint that the public is more easily defrauded by widespread dissemination of quotation information. The public is hurt by information that does not come with education and risk warnings. The de-listing of the securities from the Pink Sheets or the OTCBB will not have an effect on the uneducated investor who still will see volume, high, low and last trades through the widely available Nasdaq ticker. It will not matter if there is no bid or ask. The NQB would only distribute our quotation information to customers who have been suitably warned and educated of the dangers and differences the various OTC markets. We would like to incorporate the proposed NASD Rule 2350-disclosure document into our subscriber agreement. The NQB will require quote vendors to clearly identify securities quoted on the NQS as different from exchange and Nasdaq issues. The quotes would be distributed with the current information availability or "buyer beware" identifier. The public is always benefited by increased information if they are properly educated.
Rule 15c2-11
Rule 15c2-11 regulates the publication of quotations in a quotation medium. I will first briefly describe the features of the proposal I like. I like the increased disclosure for non-reporting companies. I like the fact that court confirmed bankruptcy reorganization plans would be an acceptable document. I like the fact that significant relationship information has been expanded to all covered securities. I think that the significant relationship information should be provided when market makers start trading any equity security.
The rest of the rule proposal I totally, unequivocally disagree with. I disagree with the Commission's reasoning, logic and supporting basis for the proposal. I expect the results will be that competition, transparency and liquidity will be significantly diminished and opportunities for manipulation will be increased. The potential liability from an implied right of action by investors will drive legitimate firms from making markets in all non-Nasdaq OTC securities and give an incentive for the remaining market makers to refrain from publishing prices. Transparency and liquidity will disappear from the secondary market for small companies; harming legitimate issuers access to capital. It is much easier to manipulate markets when there is no competition or transparency. The crooks will have free reign as the honest players exit the business.
Rule 15c2-11 presently requires that market maker which introduces a security into an inter-dealer quotation medium, must obtain, review, and believe certain information for the security. After thirty days, any market maker can quote the security without having to perform the review process. Thus, once a security is in the system, competition and ease of entry are promoted. The new rule proposal will drastically change the market structure.
The rule proposal requires every market maker to review and vouch for a security when they initiate quotations and on annual basis if they publish a price. The proposed rule requires market makers to have a reasonable basis under the circumstances for believing the issuer information is accurate and current in all material respects, and that it is obtained from reliable sources. According to the proposal, the review process will help market makers ascertain if there are indications of whether potential or actual fraud or manipulation may be present. The review process will apply to both reporting and non-reporting issuers. Not only does the rule cover quotations in the Pink Sheets and on the OTC Bulletin Board but OTC markets in corporate bonds and foreign securities.
A Good Idea with Bad Consequences
The rule proposal is based on a simple idea; "Market makers should know the securities they trade." The NQB agrees that all market participants should be as informed as possible so the market price reflects all available information. The best way to achieve that goal is to make the market structure so competitive that participants need information to give them a maximum advantage.
The consequences of the rule are worrisome. If a market maker uncovers indications of fraud or manipulation, is the firm supposed to stop trading the security? Why not adjust its quote to more accurately reflect its suspicions. The rule proposal states "responsible broker-dealers should refrain from publishing quotations in questionable securities." What is a questionable security? According to the rule proposal it is one where "potential or actual fraud or manipulation may be present." What are a market maker's obligations if third parties are trying to manipulate a security they trade? Salomon Brothers was convicted of manipulating the treasury market and Morgan Stanley has just been fined by NASDR $1,000,000 for manipulating ten securities in the Nasdaq 100 Index. When those manipulations occurred, should all of the legitimate firms have stopped trading those securities? Won't it be easier to manipulate securities when any market maker that disagrees with the trading valuation is forced to stop quoting the security? The market maker should have their viewpoint reflected in the market by adjusting their quotations. The market maker has no power |
