...CONTINUED....
Congress also has previously worked to address micro cap fraud. In 1990,
the Subcommittee on Telecommunications and
Finance of the House Commerce Committee took up the issue of penny stock
fraud, 9 and ultimately Congress enacted the
Penny Stock Reform Act of 1990 (,,Penny Stock Act ") as part of the
Securities Enforcement Remedies Act ( "Remedies Act
"). 10 The Penny Stock Act expanded the Commission's authority over such
previously unregulated persons as promoters who
associate with broker-dealers to sell penny stocks, and it required the
creation of a toll-free hotline investors could call to
obtain the disciplinary history of brokers. The Act also placed
significant restrictions on so-called "blank check " offerings and
required broker-dealers to disclose more information to customers when
selling penny stocks. Finally, the Act called for the
creation of an automated quotation system for OTC stocks, which the NASD
and Commission already had underway with the
OTC Bulletin Board. 9 Penny Stock Market Fraud: Hearings on H.R. 4497
Before the Subcommittee on Telecommunications
and Finance of the House Committee on Energy and Commerce, 101st Cong.
27 (1990) (Statement of Richard C. Breeden,
Chairman of the Commission). 10 Securities Enforcement Remedies and
Penny Stock Reform Act of 1990, Pub. L. No.
101-429, 104 Stat. 931.
After the enactment of the Penny Stock Act, the Commission adopted new
rules to implement the statute. 11 Among the
requirements are rules requiring brokers to give customers specific
information before the sale about the market for penny
stocks and the broker's compensation. After the sale, the broker must
provide clients with monthly statements reporting the
market value of the client's penny stocks. The goal of these rules is to
provide information to investors and provide prospective
investors with an opportunity to consider whether to make a purchase
without the pressure of boiler room tactics. 11 Penny
Stock Rule Release, surpa, at fn. 1.
In 1993, the Commission amended Exchange Act Rule 15c2-1 1. That rule
requires a broker-dealer to review financial and
other issuer information before publishing a quotation in the issuer's
stock in a quotation media such as the OTC Bulletin Board
or the Pink Sheets. The rule also requires brokers to have a reasonable
basis for believing the information is accurate. Finally,
the amended rule requires broker- dealers to obtain a copy of any
trading suspension order in the issuer's Stock for the
previous twelve months. 12 12 Exchange Act Release No. 29094 (Apr. 17,
1991), 56 Fed. Reg. 19,148 (Apr. 25, 1991).
In 1993, the Commission conducted an extensive examination sweep with
the NASD and state regulators to determine
whether firms were complying with the Penny Stock Rules. The sweep found
widespread adherence to the Penny Stock
Rules, along with generally diminished activity in stocks covered by the
Penny Stock Rules. 13 13 Joint Regulatory Penny
Stock Examination Sweep (June 1994). Only 14 of the 129 broker-dealer
examinations disclosed violations serious enough to
warrant consideration of enforcement or disciplinary action.
C. How Micro Cap Fraud Has Changed
Although the Penny Stock Act and Rules and the creation of the OTC
Bulletin Board have by and large curbed certain abuses
in the market for securities priced under $5, we are now finding that
promoters and broker-dealers have adjusted their
schemes so that the securities fall outside these measures. The simplest
way around the Penny Stock Rules, for example, is to
offer or sell securities that do not meet the technical definition of
"penny stocks ". The Commission today sees more fraud in
mostly lower- priced Nasdaq-listed securities and in securities valued
at $5 or more.
In addition, the Internet is being used as a new vehicle to perpetrate
securities fraud, especially in the micro cap market
(including touting in "chat rooms ", bulletin boards and on e- mail).
The Commission has already brought enforcement actions
involving fraudulent securities offerings, stock manipulations, 14 and
investment advisers fraud through Internet newsletters. 15
The fraudulent securities offerings often promise unreal returns and
include everything from interests in an eel farm, 16 an
ethanol plant, 17 gold and diamond mining enterprises 19 and a coconut
chip enterprise, 19 to more sophisticated offerings of
sham promissory notes 20 and bonds purportedly issued by a nonexistent
offshore company. 21 The Internet can be used for
scams because it provides anonymity, broad circulation and the
appearance of legitimacy at low cost. Accordingly, the
Commission has been developing an effective surveillance strategy for
the Internet. 22 However, the Commission is committed
to the legitimate use of the Internet by honest market participants. 14
SEC v. Huttoe, Litigation Release No. 15237 (Jan. 31,
1997), 63 SEC Docket 2383 (Mar. 4, 1997). 15 SEC v. Chelekis, Litigation
Release No. 15264 (Feb. 2.5, 1997), 63 SEC
Docket 2900 (Mar. 25, 1997). 16 SEC v. Odulo, Litigation Release Nos.
14591 (Aug. 7, 1995), 59 SEC Docket 3105
(Sept. 5, 1995), and 14616 (Aug. 24, 1995), 60 SEC Docket 122 (Sept. 19,
1995). 17 SEC v, Spencer, Litigation Release
Nos. 14856 (Mar. 29, 1996), 61 SEC Docket 1960 (Apr. 30, 1996), and
15042 (Sept. 12, 1996), 62 SEC Docket 2409
(Oct. 8, 1996). 18 SEC v. Wye Resources, Inc., Litigation Release No.
15073 (Sept. 26, 1996), 62 SEC Docket 2762
(Oct. 22, 1996). 19 SEC v. Frye, Litigation Release Nos. 14720 (Nov. 15,
1995), 60 SEC Docket 2123 (Dec. 12, 1995),
15139 (Oct. 29, 1996), 63 SEC Docket 422 (Nov. 26, 1996). 20 SEC v.
Sellin, Litigation Release No. 15012 (Aug. 12,
1996), 62 SEC Docket 1749 (Sept. 10, 1996). 21 SEC v.Octagon Tech.
Group. Inc., Litigation Release No. 14942 (June
11, 1996), 62 SEC Docket 377 (July 9, 1996). 22 See discussion at pp.
14-15.
III. The Commission's Program to Prevent
Fraud in the Micro Cap Markets
The Commission's program to prevent fraud in the micro cap market
involves:
- early detection and intervention; and
- investor education.
A. Early Detection and Intervention
The Commission's program of early detection and intervention includes:
(1) regular examination of broker-dealers; (2)
surveillance of the Internet and the markets; (3) imposition of trading
suspensions; and ( 4) an increasing resort to emergency
litigation to stop active and on-going frauds.
The Commission's Office of Compliance Inspections and Examinations (
"OCIE ") examines broker-dealers and oversees the
examinations which the Self Regulatory Organizations ( "SROs ") -- the
national securities exchanges and the NASD --
conduct of their members. Over the past several years, OCIE has focused
its review of broker-dealers on their sales and
trading practices. About 20% of examinations lead to referrals to the
Commission's Division of Enforcement. OCIE is currently
working closely with the NASD to focus on micro cap fraud through
intense examination of broker-dealers.
The examination staff also periodically conducts "sweeps " to determine
if particular violations are widespread and then it
issues recommendations and reports. For instance, in 1994 the Commission
staff with the NYSE and NASD conducted a
review of the hiring, retention and supervisory practices of nine of the
largest brokerage firms. Two years later, the
Commission, together with the NASD, NYSE and the North American
Securities Administrators Association, Inc. ( "NASAA
") conducted a joint sweep to review the sales practices of selected
registered representatives employed by small and
medium-sized firms as well as the hiring, retention and supervisory
practices of the brokerage firms that employ them.
The second sweep revealed that some firms employ registered
representatives with a history of disciplinary actions and
customer complaints, use only minimal hiring procedures, and have
supervisors in branch offices who fail to review customer
transactions adequately to detect sales abuses. We also found that
almost one-half of the branches that engage in cold calling
violated federal cold-calling rules. 23 As a result of the sweep, the
Commission, NYSE, NASD and NASAA prepared a
public report making specific recommendations designed to correct these
problems. 24 For example, the report recommends
more stringent hiring procedures for registered representatives;
heightened supervision of registered representatives with a
history of customer complaints, disciplinary actions or arbitrations;
and training and supervision of cold-calling techniques. 23
In 1991, Congress passed the Telephone Consumer Protection Act, Pub. L.
No. 102243, 105 Stat. 2394 (1991), codified at
47 U.S.C. 227. The Federal Communications Commission enacted rules
which, among other things, restrict the hours
unsolicited calls can be made and require telemarketing firms to have
"do-not-call " lists. 47 C.F.R. 64.1200. 24 Joint
Regulatory Sales Practice Sweep, A Review of the Sales Practice
Activities of Selected Registered Representatives and the
Hiring, Retention, and Supervisory Practices of the Brokerage Finns
Employing Them (Mar. 1996).
These joint sweeps have resulted in greater coordination among the
regulatory authorities. The Commission's compliance staff
meets quarterly with the NASD and NYSE to discuss how to improve our
combined examination procedures. In addition, the
Commission's regional examination staff meet regularly with their state
counterparts and local NASD offices to determine how
to better craft regulatory solutions.
To combat securities fraud on the Internet, the Commission's Division of
Enforcement, with the assistance of other Commission
staff, has assembled a group of professionals who devote more and more
resources to Internet surveillance. These
professionals use the latest browsing software to monitor the Internet,
including such message areas as newsgroups and bulletin
boards. The on-line Division of Enforcement Complaint Center also
provides an easy means for investors to send complaints
to the Commission staff. Currently, the Commission receives between 50
and 70 on-line investor complaints a day. Suspicious
activities are investigated, with enforcement action initiated where
appropriate. In addition, the Commission staff has helped
states develop their own Internet surveillance programs and meets
regularly with the states, both individually and as part of
regional and national conferences, to coordinate our surveillance and
investigations.
The Commission recently implemented a pilot program in our Florida
regional office to intervene as soon as a potential sham
micro cap offering is identified, which has already resulted in six
trading suspensions. 25 The staff reviews regulatory filings for
irregularities, or "red flags ", that suggest the company may not be
legitimate. After determining that the public interest and
protection of investors require it, the Commission can suspend trading
in the stock. Trading suspensions can be a very potent
remedy because: 25 In the Matter of Amquest International, Ltd..
Exchange Act Release No. 38695 (May 30, 1997), 64
SEC Docket 1862 (July 1, 1997); In the Matter of Green Oasis
Environmental, Inc., Exchange Act Release No. 38588 (May
9, 1997), 64 SEC Docket 1395 (June 10, 1997); In the Matter of Genesis
International Financial Services, Inc., Exchange
Act Release No. 38565 (May 1, 1997), 64 SEC Docket 1259 (May 27, 1997);
In the Matter of Historic Hotel Holdings,
Inc., Exchange Act Release No. 38492 (Apr. 10, 1997), 64 SEC Docket 761
(May 6, 1997); In the Matter of OmniGene
Diagnostics, Inc., Exchange Act Release No. 37966 (Nov. 19, 1996), 63
SEC Docket 709 (Dec. 17, 1996); In the Matter of
Home Link Corp., Inc., Exchange Act Release No. 37292 (June 10, 1996),
62 SEC Docket 288 (July 9, 1996).
- Investors are put on notice of a potential fraud, hopefully
encouraging more informed decision- making; and
- Promoters and brokers are hit where it hurts most: in the pocketbook.
The financial reward of a micro cap scheme depends
on selling all the stock at the height of the manipulation. A trading
suspension often leaves the promoters holding worthless
stock before they are able to dump it on unsuspecting investors.
Although a trading suspension only halts trading for a ten- day period,
the suspension triggers application of Exchange Act Rule
150-11, which requires a market maker to have current and accurate
financial information about the issuer before trading
resumes. In other words, it is difficult for a broker-dealer to lawfully
resume trading.
B. Investor Education
The Commission continually works to educate investors about how to avoid
and report securities fraud through its Office of
Investor Education and Assistance (OIEA). A well-educated investor is
one of the most important defenses against securities
fraud. Through Investor Alerts, an Internet Web Site 26 and a toll-free
information line, 27 OIEA provides investors with
practical tips on how to spot securities fraud. Numerous pamphlets and
brochures have been developed to warn investors
about scams, stating in "plain English " what every investor should know
about investing. All of our publications are available
free of charge on the Commission's website as well as through our toll
free number. 26 sec.gov 27 ( 800)
SEC-0330
To educate investors and listen to their concerns, the Commission has
coordinated -and will continue to hold -- Investors'
Town Meetings throughout the country. The town meetings are typically
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