DOOM Cragun: nytimes.com
SEC Plan for Better Policing by
Brokerage Firms Draws Heat
By GRETCHEN MORGENSON
n an attempt to combat securities fraud among small over-the-counter
stocks, the Securities and Exchange Commission has proposed that
brokerage firms do more of the policing.
The proposal, which is open for public comment until May 8, would
require a brokerage firm that makes markets in certain over-the-counter
stocks to review the issuing company's financial data periodically to try to
detect fraud. If the firm found evidence of malfeasance, it would have to
stop making markets in the company's shares. In addition, brokerage
firms would have to maintain records of their review procedures. Stocks
traded on the Bulletin Board and the pink sheets would be affected, but
not those on the Nasdaq National Market System or its Small
Capitalization Market.
Not surprisingly, the proposal has received a flood of criticism from
traders, investors and stock issuers who say that it would drive reputable
firms out of the business of trading these stocks. A trader's job is to set
prices on stocks based on supply and demand from investors, these
people say. By saddling firms with the responsibility for analyzing
companies' financial data and operations, regulators would increase the
firms' potential liability and the risk involved in trading these stocks.
Critics say that honest firms would probably stop trading the roughly
10,000 stocks on the Bulletin Board and pink sheets, leaving
stockholders unable to sell their shares and companies less able to raise
money.
"The proposal has serious flaws and is not going to be effective in
deterring microcap fraud," said George Kramer, associate general
counsel of the Securities Industry Association. "You make it harder on
the legitimate players, and at the end of the day you'll end up with fewer
of the legitimate players and more of the bad actors."
More than 200 letters have been submitted to the securities commission
regarding the proposal, the vast majority in opposition. As is customary,
regulators declined to speak publicly about the pending rule change while
it is in the comment period.
The National Association of Securities Dealers Regulation, which
oversees many of the firms that trade smaller, more obscure
over-the-counter stocks, supports the rule change. Michael Dorsey,
general counsel for Knight Trimark Group, a large market-making firm,
and a former lawyer at the commission, says that the group's support
may overpower industry opposition.
The proposal shows the securities commission's extreme frustration over
fighting fraud in shares of some tiny unknown companies peddled to
investors by unscrupulous brokers. According to the SEC, a market
maker should help fight such fraud because by facilitating trades, the
brokerage firm "raises the profile of the security even though the market
maker is not an active participant in the fraud."
The SEC has supplied a list of 28 warning signs that a market maker
could use to spot fraud at a company. These include a change of
accounting firms, inconsistent financial statements, altered certificates of
incorporation, extraordinary gains in year-to-year operations and unusual
activity in brokerage accounts of companies affiliated with the issuer. But
while market makers are good at measuring investor demand for the
stocks they trade, they are not now equipped to investigate a company's
activities to the degree the SEC would like.
"Maybe the SEC doesn't want there to be a secondary market for small
businesses," said R. Cromwell Coulson, chairman of National Quotation
Bureau LLC, publishers of the pink sheets. "If so, they should state it."
Critics of the proposed rule change say it reflects an increasing prejudice
against small business by securities regulators. Brad Smith, owner of
WBS&A Ltd., a consulting firm for small businesses in Austin, Texas,
said: "No one out here is for microcap fraud. Throw the suckers in jail;
they are the bane of our existence.
"The bulk of those people are legitimate salt-of-the-earth entrepreneurs,"
he added. "We just can't legislate them out of business."
The SEC is proposing to modify a rule that came into being in 1971
when the Nasdaq market was new and information was sparse about the
companies that traded on it. The idea behind the rule, according to
Dorsey, was that market makers should not quote prices in a security for
which there was no information available to investors. Brokerage firms
had to gather this information and make it part of their records, available
for any investor who requested it.
But this information is now readily available on the Internet at the SEC's
Web site. Rather than being expanded, the rule should be trimmed back,
Dorsey said.
The proposal would also require brokers who post investors' orders on
an electronic communications network, or ECN, to do the due diligence.
These networks bypass Nasdaq's traditional trading system, allowing
investors to meet without the market makers. By using an ECN, the
broker is acting solely as a conduit for the investor to meet another
investor interested in completing the trade.
While the SEC's concern about microcap fraud is shared by most on
Wall Street, the extent of the problem is difficult to measure. Alan
Davidson, president of Zeus Securities, a small brokerage firm in Jericho,
N.Y., and a member of the NASD board, asked an SEC staff member
at a February meeting how widespread fraud was at Bulletin Board and
pink sheet companies. "I asked them, 'Are you talking 10 percent?' and
they said, 'No,"' Davidson recalled. "Then I said, "Are you talking about
1 percent?" and they said, 'That's more like it."' With 10,000 companies
trading on the two venues, that would put those committing fraud at no
more than 100.
Even if fraud was found at a majority of these companies, pushing the
reputable brokerage firms away would leave only crooks who flout
securities regulations as a matter of course, market participants say.
History shows that when liquidity in a market is diminished, individual
investors get hurt. Consider what happened when the small secondary
market for real estate limited partnership holdings, many of which were
sold in the 1980s, disappeared a decade later. Investors were able to sell
their holdings only at steep discounts to net asset values, often to
professional investors taking advantage of individuals' needs for cash to
buy assets on the cheap.
Businesses will have a harder time raising capital if the proposal is
adopted, said Robert Wussler, the chief executive of United States
Digital Communications Inc., a reseller of satellite telephone equipment
and phone time in Chevy Chase, Md.; its shares are traded on the
Bulletin Board. "In order to start and expand small businesses you've got
to be able to raise capital," said Wussler, a former president of Turner
Broadcasting and CBS Television. "The Bulletin Board has been a
proven method of raising capital."
Companies as varied as Toys "R" Us, Xerox and the predecessor of
Blockbuster Video began their public trading in the pink sheets.
If market makers abandon trading in the 10,000 companies on the
Bulletin Board and the pink sheets, the shares will still change hands
somewhere. And they might be traded on venues that are completely out
of regulators' purview. "I find it incredible that they want the guys who
are regulated to take on more responsibilities, driving the market to
somewhere that it isn't regulated," Coulson said.
Preventing microcap fraud will not be easy without disrupting small
companies. Lewis Lowenfels, an expert in securities law at Tolins &
Lowenfels in New York, said, "The challenge for the regulators is to
address the cancer of microcap fraud in a way that does not destroy the
honest small broker-dealers, who provide sorely needed capital and
liquidity for smaller companies in today's marketplace." |
