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DTC Again Proposes Procedures For Issuers Subject To Chills And Locks

Posted by Securities Attorney Laura Anthony | August 30, 2016 Tags: DTC, dtc chill, dtc chills, DTC Eligibility, dtc global lock, dtc global locks, Finra

On June 3, 2016, the DTC filed a new set of proposed rules to specify procedures available to issuers when the DTC imposes or intends to impose chills or locks. The issue of persistent and increasing chills and global locks which once dominated many discussions related to the small- and micro-cap space has dwindled in the last year or two. The new proposed rule release explains the change in DTC procedures and mindset related to its function in combating the deposit and trading of ineligible securities.

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 (see my blog HERE). On December 5, 2013, the DTC filed these proposed rules with the SEC and on December 18, 2013, the proposed rules were published and public comment invited thereon. Following the receipt of comments on February 10, 2014, and again on March 10, 2014, the DTC amended its proposed rule changes (see my blog HERE).

Then on August 14, 2014, the DTC quietly withdrew its proposed rules and was silent until the release of new proposed rules on June 3, 2016.

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, it is called 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.

The proposed rule change would add new Rule 33 to address: (i) the circumstances under which the DTC would impose and release a restriction on deposits (“Deposit Chill”) or on book entry services (a “Global Lock”); and (ii) the fair procedures for notice and an opportunity for the company to challenge the Deposit Chill or Global Lock.

As stated in the rule release, the current proposed rules “specify procedures available to issuers of securities deposited at DTC when DTC blocks or intends to block the deposit of additional securities of a particular issue (‘Deposit Chill’) or prevents or intends to prevent deposits and restrict book-entry and related depository services of a particular issue (‘Global Lock’).”

Background and Purpose for the Rule

The DTC serves as the central securities depository in the U.S. facilitating the trading and operation of the country’s securities markets. I’ve written about the DTC on numerous occasions, including recently in this blog HERE – on the settlement and clearing process, which provides basic background and history on the role and function of the DTC in the clearing of trillions of dollars in securities on a daily basis.

Once a security is approved as eligible for DTC depository and book-entry services, banks and broker-dealersthat 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.

A basic premise to use of the DTC is that securities be fungible. To be fungible all deposited securities must be freely tradable and devoid of unique characteristics or features such as restrictions on transfer. 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.

Previously, upon detecting suspiciously large deposits of thinly traded securities, the DTC imposed or proposed to impose a Deposit Chill to maintain the status quo while it contacted the company and required such company to provide a legal opinion from independent counsel confirming that the securities met the eligibility requirements. As a reminder, the basic eligibility requirements that counsel confirmed were that the company’s securities were (i) issued in a transaction registered with the SEC under the Securities Act of 1933, as amended (“Securities Act”); (ii) 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) eligible for resale pursuant to Rule 144A, Regulation S or other applicable resale exemption under the Securities Act.

The Deposit Chill could, and often did, remain in place for years due to a company’s non-responsiveness, refusal or inability to submit the required legal opinion. As a practitioner that wrote such opinions, I can say that they were very expensive for a company. In order to satisfy the obligations as an attorney, we would be required to review each questionable deposit, including all paperwork, and satisfy ourselves that the securities qualified for deposit. In other words, for each deposit we would review the documents as if we were writing the initial opinion letter. Many times the company did not have all the records available and the shareholder that had made the deposit was not available, non-responsive or no longer had any supporting records. Sometimes the list of questionable deposits was in the hundreds and reviewing each and every one was extremely time-consuming. On more than one occasion, a company would spend significant funds attempting to comply only to realize that they fell short and no opinion could be rendered.

Regarding Global Locks, the DTC monitored enforcement actions, regulatory actions and pronouncements alleging Section 5 violations and would impose a Global Lock upon learning of such proceedings. At the time, the DTC had the policy to release the Global Lock when the action was withdrawn, dismissed on the merits with prejudice or otherwise resolved in favor of the company or shareholder defendants. However, over time this system was problematic as many enforcement proceedings are only resolved after several years and often without any definitive determination of wrongdoing.

On March 15, 2012, the Securities and Exchange Commission (SEC) issued an administrative opinion stating that an issuer is entitled to due process proceedings by the DTC as a result of a DTC chill placed on an issuer’s securities (In the Matter of the Application of International Power Group, Ltd. Admin. Proc. File No. 3-13687). The SEC stated, “DTC should adopt procedures that accord with the fairness requirements of Section 17A(b)(3)(H), which may be applied uniformly in any future such issuer cases”; “Those procedures must also comply with Section 17A(b)(5)(B) of the Exchange Act, which requires clearing agencies when prohibiting or limiting a person’s access to services, to (1) notify such person of the specific grounds for the prohibition or limitation, (2) give the person an opportunity to be heard upon the specific grounds for the prohibition or limitation, and (3) keep a record.”

At the time, the SEC confirmed that the DTC could still put a chill on an issuer’s security prior to giving notice and an opportunity to be heard to that issuer, in an emergency situation, stating, “[H]owever, in such circumstances, these processes should balance the identifiable need for emergency action with the issuer’s right to fair procedures under the Exchange Act. Under such procedures, DTC would be authorized to act to avert imminent harm, but it could not maintain such a suspension indefinitely without providing expedited fair process to the affected issuer.”

Following International Power, the DTC filed proposed rules on December 5, 2013, which were withdrawn on August 14, 2014.

In the time since International Power, the DTC has determined that its proposed procedures for imposing Deposit Chills and Global Locks are more appropriately directed to current trading halts or suspensions imposed by the SEC, FINRA or a court of competent jurisdiction. In fact, the DTC seems to think that the Deposit Chill and Global Lock process they were using only created more problems. In the proposed rule release, DTC states, “DTC believes that wrongdoers have seemingly taken into account DTC’s Restriction process, and have been avoiding it by shortening the timeframe in which they complete their scheme, dump their shares into the market and move on to another issue.”

Moreover, imposing Global Locks in response to an SEC enforcement action did nothing to curtail the behavior which had already occurred. As the DTC notes, “by the time of an enforcement action, the wrongdoers had long since transferred the subject securities.” Further, neither the Deposit Chill nor the Global Lock affected the trading in the security. In short, the DTC realized that its methods were not working.

New Proposed Rule 33

Imposing Chills and Locks

The proposed new Rule is dramatically simplified from the early 2014 proposals. Under the proposed new Rule 33, the DTC will establish the basis for the imposition of Deposit Chills and Global Locks premised directly on current judicial or regulatory intervention or the threat of imminent adverse consequences to the DTC or its participants.

In particular, if FINRA or the SEC halts or suspends trading in a security, the DTC will impose a Global Lock. The DTC will also impose a restriction (Chill or Lock) if ordered to do so by a court of competent jurisdiction. The DTC, however, recognizes that FINRA and the SEC may issue a trading halt or suspension for other reasons than fraud or wrongdoing, such as due to a technical glitch. Accordingly, if the DTC reasonably determines that a Global Lock will not further its regulatory purposes.

The DTC will also impose a Chill (or Lock) when it becomes aware of a need for immediate action to avert an imminent harm, injury, or other material adverse consequence to the DTC or its participants. It is expected that these circumstances will be rare, but an example would be if the DTC becomes aware that persons were about to deposit securities at the DTC in connection an ongoing corporate hijacking, market manipulation, or in violation of the law, or if a company notifies the DTC of stolen certificates. In support of its ability to impose such as Chill or Lock, the DTC quotes the SEC’s opinion in International Power, as discussed above.

Releasing Chills and Locks

New Rule 33 also address the release of Chills and Locks. From a high level, a Chill or Lock can be released if it was imposed in error in the first instance, such as based on clerical error.

Where a Global Lock has been imposed as a result of an SEC or FINRA trading suspension or halt, the Global Lock will be lifted when the suspension or halt is lifted. Where a Global Lock or Chill is imposed based on court order, the DTC will release it when also ordered to do so by a court.

Where a Chill or Lock is imposed as a result of imminent adverse consequences, it would be lifted when the DTC reasonably determines that lifting such Chill or Lock would not pose a threat of imminent adverse consequences such that the original basis for imposition has passed. Examples of when such a Chill or Lock could be lifted include: (i) the perceived harm as passed or is significantly remote; (ii) when the basis for the issue no longer exists (for example, lost certificates found); or (iii) there is a prior Global Lock based on an SEC enforcement action, but there is no current indication that illegally distributed securities are about to be deposited.

Proposed Fair Procedures

The DTC has established procedures to give a company timely notice of the imposition of a Chill or Lock, an opportunity to respond or object in writing, and a review and determination by an independent DTC officer. The DTC will also maintain complete records of all actions and proceedings. The DTC will send the initial written notice to the company’s last known business address and to the company’s transfer agents, if any, on record with the DTC.

The notice will be sent within 3 days of the imposition of the Chill or Lock. The company will have 20 business days to respond. An independent DTC officer will review the file. The independent DTC officer may request additional information from the company. Once the review is complete, a final written decision will be sent to the company. The company will then have 10 business days to submit a supplement; however, the supplement will only be reviewed if the objection is based on a clerical mistake or clear oversight or omission. If a supplement is submitted, the DTC must respond within 10 business days.

The Rule change will not modify of affect the DTC’s current ability to (i) lift or modify a Chill or Lock; (ii) restrict services in the ordinary course based on other rules not associated with Chills or Locks; (iii) communicate with the company, its transfer agent, or its representative as long as communications are memorialized in writing; or (iv) send out a restriction notice in advance of imposing a Chill or Lock.

Chart Summary of DTC Proposed Rules

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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The U.S. Capital Markets Clearance And Settlement Process

Posted by Securities Attorney Laura Anthony | April 19, 2016 Tags: Clearance And Settlement Process, DTC Eligibility, The U.S. Capital Markets Clearance And Settlement Process

Within the world of securities there are many sectors and facets to explore and understand. To be successful, a public company must have an active, liquid trading market. Accordingly, the trading markets themselves, including the settlement and clearing process in the US markets, is an important fundamental area of knowledge that every public company, potential public company, and advisor needs to comprehend. A basic understanding of the trading markets will help drive relationships with transfer agents, market makers, broker-dealers and financial public relations firms as well as provide the knowledge to improve relationships with shareholders. In addition, small pooled funds such as venture and hedge funds and family offices that invest in public markets will benefit from an understanding of the process.

This blog provides a historical foundation and summary of the clearance and settlement processes for US equities markets. In a future blog, I will drill down into specific trading, including short selling.

History and Background

The Paperwork Crisis

Prior to the advent of modern technology, securities were literally cleared and transferred by providing paper certificates to a company’s transfer agent, who would record the transfer on their books and records and issue new securities to the new holders. A transfer agent would receive a bundle of documents from a broker-dealer and physically process all of the paperwork and then send it to a separate registrar to record each of the transfers. In order to reduce time, most brokers, transfer agents and registrars were located in New York City in the Wall Street district. The broker would courier the documents to the transfer agent each day, who would process the paperwork and courier them to the registrar to process the transfers each after following a series of document checks, balances and audits, and then deliver the new certificates to the designated parties using a messenger or courier.

As the volume of transactions increased, numerous clearing brokers and clearing agencies emerged to help with the processing. However, the system was disjointed and as the physical certificate process remained the same, each of these clearing brokers and agencies maintained offices physically near each other to messenger paper back and forth. By the 1960s and early 1970s the sheer volume of paperwork crushed the system and caused what came to be known as the Paperwork Crisis.

At the time the Paperwork Crisis was the biggest crisis to face the securities industry since the Great Depression and to this day remains one of the most difficult and largest challenges the markets have faced. As a result of the Paperwork Crisis, the entire industry, including Congress, state and federal regulators, brokers, banks and security exchanges, all participated in a complete overhaul of the markets’ operational systems, which ultimately resulted in the current national clearing and settlement system. Years of expensive studies all came to the same basic conclusion regarding the Paperwork Crisis, which is that the securities industry needed a uniform, coordinated nationwide system for the clearance and settlement of securities transactions.

The birth of DTC

The current system did not pop up overnight, but rather took years and a series of changes and adjustments and then more changes and adjustments. In 1968 the NYSE created the Central Certificate Service as a division of the Stock Clearing Corporation to act as a clearing agency and depository service. In 1973, the Central Certificate Service (“CCS”) changed its name to the Depository Trust Company (DTC).

A clearing agency or depository typically compares member transactions, clears, nets and settles trades, and provides risk management services, such as trade guarantees. Depositories centralize securities by holding them on deposit for their participants and effect transfers of interests in those securities through book-entry credits and debits of participants’ accounts. Currently DTC, through its subsidiaries, is both the only central depository in the United States and the only one registered with the SEC as a clearing agency, but it wasn’t always. In the beginning CCS was only used by the NYSE and soon after by the American Stock Exchange.

In its early years, broker-dealers and banks would deposit their certificated securities with CCS, which would transfer them into the name of the CCS nominee and physically hold them in custody. That nominee account came to be referred to as “street name” and the nominee as CEDE. CCS maintained book accounts for all its members. When a member transferred securities, the transfer was recorded by book entry with a debit and credit between accounts rather than a physical transfer of securities. The securities themselves remained registered to CCS’s nominee account (today CEDE). Today DTC continues to hold physical custody of certificated securities held in street name. As an aside, the flooding from Hurricane Sandy destroyed massive amounts of paper certificates and records held by DTC in its New York storage, taking years to sort out and causing huge delays in the processing of transactions.

Around the same time that the NYSE created the CCS, the NASD formed the National Clearing Corporation (NCC) in an effort to develop and implement a nationwide system of interconnected regional clearinghouses for the clearance of all OTC and NASDAQ securities. In 1977 the NCC merged with CCS and formed the National Securities Clearing Corporation (“NSCC”). The NSCC in turn later merged with DTC. The NSCC net settles securities amongst all the participating broker participants, who in turn maintain records for each client account.

SEC gains regulatory power

It was quickly apparent to the thought leaders of the time that it was imperative to give the SEC the power to regulate the clearance and settlement process, including requiring clearing agencies to register with the SEC and to give the SEC the power to implement rules and regulations related to both the system and its participants. In 1975 Congress enacted the Securities Act Amendments of 1975, making sweeping changes to the federal laws and creating what is today the national market system and national clearance and settlement system.

The 1975 Amendments directed the SEC to “(i) facilitate the establishment of a national system for the prompt and accurate clearance and settlement of transactions in securities; (ii) end the physical movement of securities certificates in connection with the settlement among brokers and dealers of transactions in securities; and (iii) establish a system for reporting missing, lost, counterfeit, and stolen securities.” In addition, related to the national market system, the SEC was directed to establish a national market system to link together the multiple individual markets that trade securities to achieve the business objective of efficient, competitive, fair and orderly markets.

In the early ’70s the CCS and NCC were not the only clearing agencies; several others had popped up as well. However, using the power of the 1975 Amendments, the SEC required registration of and imposed regulations and compliance on these clearing agencies. In 1982 and 1983 the NASD (now FINRA) and the five major stock exchanges all amended their rules to require members to use an SEC registered clearing firm and depository. By the late ’90s DTC was the largest depository and NSCC was the largest clearing firm. In 1999 the two merged and DTC remained the only SEC registered clearing agency and depository.

DTC introduces FAST

By the mid to late ’70s, technological advancements were assisting in overall system advancements. In 1975 DTC created the Fast Automated Securities Transfer Program (“FAST”), which was approved by the SEC in 1976. Also, in 1977 Article 8 of the Uniform Commercial Code (UCC) was amended to allow for uncertificated book entry records of security ownership.

Prior to FAST, and today for those securities not eligible for the FAST program, when a security is being deposited into DTC, a broker-dealer physically sends the certificate to DTC, who in turn sends it to the transfer agent to register in CEDE. Again, CEDE is DTC’s nominee name for holding legal title to securities in the DTC system. Likewise for the withdrawal of these securities from the DTC system, DTC physically sends the certificate back to the transfer agent, who re-registers it and sends it back to DTC, who then sends it to the participating broker. If the participating broker is a clearing broker, that clearing broker then sends the certificate to the introducing broker, who then sends it to the account holder!

The FAST system allows transfer agents to act as custodians for all shares in the CEDE account. Each individual brokerage firm DTC participant maintains corresponding books representing their customers shareholder accounts for securities held in street name. When securities are deposited into or withdrawn from DTC, the FAST transfer agent makes an electronic adjustment which is electronically confirmed and balanced between DTC and the participating brokers on a daily basis.

Improving matters further, in 1996 the Direct Registration System (“DRS”) was implemented, which allowed investors to hold uncertificated securities in registered form directly on the books of the transfer agent. FAST eligibility is a prerequisite to using DRS. Using DRS and FAST together, a shareholder can electronically transfer shares to and from a brokerage account to facilitate their sale or transfer.

To become FAST, and therefore DRS eligible, a FAST approved transfer agent must apply to DTC on behalf of an issuer. The approval is not automatic. All FAST applications undergo a DTC review process. At a minimum, in order to be FAST eligible, an issuer must be eligible for DTC’s book-entry-only services, which requires a Blanket Letter of Representation (BLOR) in a form subscribed by DTC. DTC can ask for opinion letters to accompany an application. Beyond the BLOR and standard published DTC eligibility criteria, I was unable to find published criteria by DTC as to exactly what review requirements are included in a FAST application review process. I also spoke to several transfer agents that submit FAST issuer applications on a regular basis, and they likewise were unsure as to the review criteria used by DTC. However, it seems generally agreed that DTC conducts an issuer quality review looking at similar issues that would result in chills and locks, compliance with SEC reporting requirements, trading market price, volume and liquidity, and possibly bad actor reviews.

For further reading on DTC eligibility and chills and locks, see HERE; HERE; HERE; and HERE (Please note that DTC never implemented the rules discussed in that particular blog; however, the proposed process became a sort of industry practice. Also, note that the advent of chills and locks has dramatically decreased in recent years.)

Many OTC traded securities remain ineligible for the FAST program and DRS services today. The entire process of depositing securities into and removing securities from DTC is time-consuming for these non-FAST securities. The DTC, brokerage firms and transfer agents all charge for their part in the process—thus the current approximate $1,000 fee to deposit paper securities into DTC. This process, together with heightened regulatory scrutiny related to the deposit of all OTC traded securities and especially penny stocks, adds to the overall difficulty for OTC traded companies and the flow of their securities. See my blogHERE for a discussion on issues related to depositing penny stocks in today’s regulatory environment.

The Current Clearance and Settlement System

Today, DTC provides the depository and book entry settlement services for substantially all equity trading in the US. Over $600 billion in transactions are completed at DTC each day. Although all similar, the exact clearance and settlement process depends on the type of security being traded (stock, bond, etc.), how the security is owned (registered or beneficial), the market or exchange traded on (OTC Markets, NASDAQ…) and the entities and institutions involved.

The majority of shareholders of a public company are beneficial owners rather than record holders. Beneficial ownership refers to securities held in street name (i.e., legally titled in the name of DTC’s nominee, CEDE) which have been deposited with a brokerage firm and are in the DTC system. As discussed, these securities show up on the shareholder list in the CEDE account. Each brokerage firm maintains records and facilitates transfers for its beneficial owner account holders. Transfer agents process the restrictive legend removal for the initial deposit of securities into the brokerage firm but do not process transfers once in the system.

Where securities are held at DTC, the member brokerage firm will be identified on the books and records of DTC as having the entitlement to their pro rata share of all of the securities of that issuer held by DTC. The individual investor will then be identified on the books and records of the DTC member—i.e., the brokerage firm where the investors maintains an account and has deposited the securities. The specific rights of the individual investor are determined by rules and regulations, as well as by contract between the investor/shareholder and the particular brokerage firm.

Also, there may be two brokerage firms between DTC and the customer account holder. Brokerage firms that are direct members with DTC are referred to as “clearing brokers.” Many brokerage firms make arrangements with these DTC members (clearing brokers) to clear the securities on their behalf. Those firms are referred to as “introducing brokers.” A clearing broker will directly route an order through the national exchange or OTC Market, whereas an introducing broker will route the order to a clearing broker, who then routes the order through the exchange or OTC Market.

Only a limited number of clearing brokers will clear penny stocks and accordingly, only introducing brokers with clearing arrangements through those specific clearing brokers will, in turn, accept and clear penny stocks. COR Clearing, Alpine Securities and Wilson-Davis & Co. are the most widely known DTC member clearing brokers that will process penny stocks. Management of companies that issue penny stocks should communicate to their shareholders as to firms that will or will not clear their securities.

All securities trades involve a legally binding contract. In general the “clearing” of those trades involves implementing the terms of the contract, including ensuring processing to the correct buyer and seller in the correct security and correct amount and at the correct price and date. This process is effectuated electronically.

“Settlement” refers to the fulfillment of the contract through the exchanging of funds and delivery of the securities. In the US equities markets, settlement usually occurs three business days after the trade date, commonly referred to as “T+3.” As discussed, delivery occurs electronically by making an adjusting book entry as to entitlement. One brokerage account is debited and another is credited at the DTC level and a corresponding entry is made at each brokerage firm involved in the transaction. DTC only tracks the securities entitlement of its participating members, while the individual brokerage firms track the holdings in their customer accounts.

DTC’s clearing arm generally nets all brokerage transactions each day, making one adjusting entry per day. The net entry debits or credits the brokerage firm’s account as necessary. Likewise, a cash account is maintained for each brokerage firm, which is netted and debited and/or credited each day. This process is continuous. Moreover, brokerage firms can either settle each day or carry their open account forward until the next business day. Because all transactions are netted out, 99% of all trade obligations do not require the exchange of money.

The SEC concept release on transfer agent rules contained a good summary of this process. In particular, “…final settlement of the securities leg of the transaction will involve the following sequential steps: (i) the DTC securities account of the seller’s clearing broker will be debited with the securities being purchased; (ii) NSCC’s securities account at DTC will be credited with the securities purchased; (iii) the DTC securities account of the buyer’s clearing broker will also be credited; and (iv) each broker will credit or debit their respective customers’ securities accounts held with the broker. On the cash side, final settlement will involve the following sequential steps: (i) the Federal Reserve bank account of the buyer’s clearing broker will be debited for the sale price of the securities; (ii) DTC’s Federal Reserve bank account will credited for the sale price of the securities; (iii) DTC will transfer this cash to the Federal Reserve bank account of the seller’s Clearing Broker; and (iv) each broker will credit or debit its respective customers’ cash accounts held with the broker.”

This process is the same for all buy and sell transactions, whether the transaction involves a long or short sale. However, where the transaction involves a short sale, there are added “locate” and “close-out” requirements, generally governed by Regulation SHO. In a future blog, I will drill down on the short selling process and Regulation SHO.

Although the order flow is all electronic, certain fundamentals cannot be bypassed. For instance, for every sell order there must be a matching buyer, and for every buy order a matching seller. The ability to match a buyer and seller is often referred to as the liquidity of a company’s trading market.

Conclusion

It is important for high-level securities attorneys to go beyond the technical ability to draft a contract, 10-K or registration statement, but to also understand how trading markets work and thus be able to provide guidance and advice as to relationships with transfer agents, market makers and financial public relations firms.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Download our mobile app at iTunes.

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SEC Proposes Transfer Agent Rules

Posted by Securities Attorney Laura Anthony | February 23, 2016 Tags: DTC Eligibility, SEC, Transfer Agent Rules

On December 22, 2015, the SEC issued an advance notice of proposed rulemaking and concept release on proposed new requirements for transfer agents and requesting public comment. The transfer agent rules were adopted in 1977 and have remained essentially unchanged since that time. An advance notice of proposed rulemaking (ANPR) describes intended new and amended rules and seeks comments on same, but is not in fact that actual proposed rule release. The SEC indicates that following the comment process associated with this ANPR, it intends to propose actual new rules as soon as practicable.

To invoke thoughtful comment and response, the SEC summarized the history of the role of transfer agents within the securities clearing system as well as the current rules and proposed new rules. In addition, the SEC discusses and seeks comments on broader topics that may affect transfer agents and the securities system as a whole. This blog gives a high level review of the whole APNR and concept release with a more detailed focus on the proposed rules and discussions that will directly impact the transfer and deposit of restricted securities in the small-cap industry.

Introduction

As set out by the SEC, among other functions, transfer agents (i) track, record and maintain the official shareholders registrar and ownership records; (ii) cancel, issue and transfer securities, both in certificate and book entry form; (iii) communicate with shareholders on behalf of issuers; and (iv) process dividends and corporate actions such as reverse splits. In addition, from my own experience, transfer agents will act as mailing agent for proxy and other communications from the issuer, sometimes offer EDGAR agent services, and facilitate DTC eligibility applications with DTC member firms, obtain DWAC/FAST DTC eligibility for issuers and act as a front line where shareholders are attempting to remove a restrictive legend and deposit securities with brokerage firms.

Transfer agents are also seen as a gatekeeper in the prevention of fraud, and compliance with the registration and exemption provisions of the federal securities laws. In that regard, the SEC intends to impose obligations on a transfer agent in the processing and transfer of restricted securities. A major focus of the rulemaking is related to combatting microcap fraud. This is consistent with the recent SEC approach of increasing obligations and pressure on the gatekeepers, including brokerage firms related to the deposit of securities (see my blog HERE), attorneys and auditors, and transfer agents.

For the discussion of the proposed new rules related to the transfers of restricted securities, see the discussion below under the subheading “Restricted Securities and Compliance with Federal Securities Laws.”

History and Background

The SEC ANPR is lengthy and provides an in-depth discussion of the history of the clearing and settlement process and role of transfer agents in the process. Briefly, the ownership of securities represents certain property rights and the securities themselves are a negotiable instrument under state law allowing the owner to transfer such property to a third party. Where federal securities laws govern the registration and exemption provisions, the individual state’s Uniform Commercial Code (UCC) governs the transfer of certificates and securities as property. Accordingly, in addition to compliance with federal law, the daily activities of a transfer agent require knowledge of and compliance with the UCC.

Under the UCC, in order to obtain valid title to a security, the seller must voluntarily transfer possession of the security and the buyer must give value, not have notice of any adverse claim to the security and actually obtain control over the security. It is compliance with the UCC that requires that a certificate be endorsed, the signature guaranteed, instructions and authority from the seller, proof of payment/consideration from the buyer, proper cancellation of certificates and the proper registration and recording on the shareholder list. Moreover, it is the UCC that governs the process for replacing lost or stolen certificates and for an issuer or security holder to impose stop transfer restrictions.

Technology has helped streamline some of this process and for traded securities in DTC eliminated paper certificates altogether, but as all in the industry know, the paperwork is still extensive. Article 8 of the UCC governs the transfer of electronic or uncertificated securities. The SEC gives an interesting background discussion of the Paperwork Crisis beginning in the 1960s resulting from the massive volumes of paper needed to transfer securities associated with the growing and active trading markets. As a result of the Paperwork Crisis, the Depository Trust Company (DTC) and its securities holding arm, CEDE, were formed.

Moreover, for those interested, the APNR and concept release provides a thorough history of the creation and amendments to the national market system, national clearing and settlement system, SIPC, DTC the FAST program, and development of laws allowing for the holding and trading of book entry and electronic securities. Although this history is well beyond the scope of this blog, what I found particularly interesting is how recent many of these developments have been. For instance, it was only in 1996 that the Direct Registration System (DRS) was implemented that allowed investors to hold uncertificated securities in registered form on the books of the transfer agent and to utilize the FAST system to transfer shares to and from and brokerage account. It was during the late 1990s that DTC really flourished to become the largest depository and clearing house in the US. Today DTC provides the depository and book entry services for virtually all securities available for trading in the US.

Transfer Agent Role in Clearance and Settlement Processes

A transfer agent is an integral part of the National C&S System. The clearance and settlement process depends on the type of security being traded (stock, bond, etc.), how the security is owned (registered or beneficial), the market or exchange traded on (OTC Markets, NASDAQ…) and the entities and institutions involved. I will detail the clearing and settlement process in a future blog.

Security ownership can be either registered or beneficial. State corporate law conveys certain rights to registered owners that beneficial owners may not receive. For example, the right to examine a stockholder list at a meeting is limited to registered and not beneficial owners. Registered owners are listed on the stockholder list by name and are sometimes referred to as “holders of record.” In addition to state law rights, the holders of record is an important concept throughout the securities laws. For example, Section 12(g) of the Securities Exchange Act requires a company to register when it has 2,000 or more holders of record. Likewise, deregistration eligibility is determined in part by the number of holders of record.

A transfer agent often deals directly with a holder of record, including in the provision of transfer services, dividend payments and communications, such as the delivery of proxy forms. Record holders may hold their securities in either certificate or book entry form.

The majority of shareholders of a public company are beneficial owners rather than record holders. Beneficial ownership refers to securities held in street name which have been deposited with a brokerage firm and are in the DTC system. These securities usually show up on the shareholder list in the Cede account and sometimes in the name of the particular brokerage firm. Each brokerage and clearing firm maintains records and facilitates transfers for its beneficial owner account holders. Transfer agents process the restrictive legend removal for the initial deposit of securities into the brokerage firm but do not process transfers once in the system.

Current Transfer Agent Regulations

Transfer agents have been regulated by federal securities laws since 1975. A “transfer agent” is defined as any person who engages in the following activities on behalf of an issuer: (i) countersigning securities upon issuance; (ii) monitoring issuances and preventing unauthorized issuances; (iii) registering the transfer of securities; (iv) exchanging or converting securities; or (v) processing transfer and maintaining book entry ownership records. Public company transfer agents are required to be registered with the SEC.

The SEC currently regulates (i) registration and annual reporting requirements; (ii) timing and certain notice and reporting requirements (the “turnaround rules”); and (iii) recordkeeping and record retention rules and safeguarding requirements for securities and funds. The current transfer agent rules are extensive, and below is just a very high-level brief overview.

Current Registration and Annual Reporting Requirements

The current registration and annual reporting requirements are found in Exchange Act Rules 17Ac2-1 through 17Ac3-1. All transfer agents must register with the SEC on Form TA-1. The rules include eligibility prohibitions against certain “bad actors” similar to other bad actor rules within the securities laws. All transfer agents must file an annual report on Form TA-2, including information on compliance with turnaround rules, number of accounts, items received, funds distributed and lost securities. Both the application and the annual report can be viewed by the public on EDGAR. In addition to reviewing these forms, the SEC performs site visits and examinations of transfer agents.

Current Processing, Reporting, Recordkeeping and Exemptions

Exchange Act Rules 17Ad-1 through 17Ad-7 set forth performance standards for transfer agents. In relation to these rules, transfer agents must have written internal controls and procedures. The rules focus on establishing minimum performance and recordkeeping standards for routine transfers, cancellations and issuances. Routine items must be processed within 3 business days of receipt and non-routine items must receive “diligent and continuous attention” and be “turned around as soon as possible.” Routine items are defined in the negative such that all items are routine except items (i) requiring the issuance of a new certificate that the transfer agent does not have; (ii) subject to stop order, adverse claim or other restriction; (iii) requiring additional documentation to review and complete; (iv) are part of a corporate action (such as split or dividend); (v) are part of a public or private offering; or (vi) certain warrants, options or other convertible securities. The performance rules contain certain exemptions, such as for the processing of limited partnerships and redemptions for registered investment companies and for certain very small transfer agents.

The performance rules also require a transfer agent to respond to certain written inquiries within prescribed time periods and, in particular, within 5, 10 or 20 days depending on the person making the inquiry and the subject of the inquiry.

Transfer agents are required to keep detailed, defined records including minimum delineated information that allows for the prompt delivery of information related to shareholders, ownership positions and historical records related to same. Records, funds and securities in a transfer agent’s custody must be safeguarded to prevent theft, loss, destruction or misuse.

Transfer agents are required to notify DTC when terminating or assuming transfer agent services for an issuer.

SRO Rules and Requirements

In addition to federal securities laws, transfer agents are regulated by SRO’s including, for example, the NYSE and DTC. The NYSE requirements include further regulation on turnaround times and recordkeeping as well as capitalization and insurance requirements.

All transfer agents that include electronic or book entry services (which is really all of them) must comply with DTC rules including (i) being “Limited Participants” in DTC; (ii) participate in the FAST program and agree to DTC’s Operational Arrangements; (iii) link with DTC’s electronic communication system; and (iv) participate in DTC’s Profile Surety Program.

State Law

As briefly discussed above, transfer agents must comply with state corporate statutes related to recordkeeping and notice requirements as well as each state’s Uniform Commercial Code.

Proposed New Rules

The SEC has issued an advance notice of proposed rulemaking (ANPR) which describes intended new and amended rules and seeks comments on same, but is not in fact that actual proposed rule release. Following the receipt of public comment on the ANPR, the SEC will publish proposed rules. The ANPR reveals a thorough revamping of the transfer agent rules.

The ANPR proposes rules to (i) increase the scope of information on the registration application (Form TA-1) and annual report (Form TA-2) for transfer agents; (ii) require all contracts between a transfer agent and issuer to be in writing, which includes a fee schedule and termination provisions, including provisions for handing over information to a new transfer agent; (iii) enhance transfer agent requirements for the safeguarding of funds and securities; (iv) apply anti-fraud provisions to specific transfer agent activities; (v) require transfer agents to establish business continuity and disaster recovery plans; (vi) require transfer agents to establish basic procedures regarding the use of information, including safeguarding personal information; (vii) revise recordkeeping requirements; and (viii) conform and update various terms and definitions and eliminate those that are obsolete.

Restricted Securities and Compliance with Federal Securities Laws

All sales of securities, including the re-sale of restricted securities held by a current shareholder, must either be registered under the Securities Act or there must be an available exemption. The most common exemption for the resale of restricted securities is Section 4(a)(1) of the Securities Act and Rule 144, which is a safe harbor under Section 4(a)(1). Since transfer agents are responsible for affixing a restrictive legend on stock certificates or making a restrictive notation on book entry securities and for processing the transfer and legend removal from such securities, they are an important gatekeeper in the prevention of fraud and unregistered distributions.

Transfer agents are subject to aiding and abetting liability for violations of the registration requirements under Section 5 of the Securities Act. In addition, like any market participant, a transfer agent could be charged with fraud violations under Section 10(b) and Rule 10b-5 under the Exchange Act and Section 17(a) of the Securities Act.

Currently a transfer agent must determine whether any particular request is routine and thus requires a 3-day turnaround, and whether the state UCC requires the processing of a request. Neither federal nor state UCC regulations require the processing of a request that does not comply with the federal securities laws. Accordingly, the transfer agent must determine whether a particular request complies with federal (or state) securities laws and thus what their particular processing requirements are. It is this determination that has made it an industry practice to require an opinion letter from counsel with each request to transfer or remove a legend from restricted securities. The SEC is concerned that reliance on opinion letters from a shareholder’s or issuer’s counsel does not offer enough protection against improper transfers or fraud.

Accordingly, the SEC proposes new rules prohibiting any registered transfer agent or its officers, directors or employees from directly or indirectly taking any action to facilitate a transfer of securities if such person knows or has reason to know that an illegal distribution of securities would occur in connection with the transfer. Such knowledge qualifier carries a duty to make reasonable inquiry.

Moreover, the SEC proposes new rules prohibiting any registered transfer agent or its officers, directors or employees from making any materially false statements or omissions or engaging in any other fraudulent activity in connection with the performance of their duties.

In addition, the SEC proposes new rules requiring each transfer agent to adopt internal controls, policies and procedures reasonably designed to ensure compliance with securities laws and requiring that each transfer agent designate a chief compliance officer.

There is no proposal to adopt rules that would provide specificity to a transfer agent related to the removal of a restrictive legend or transfer of restricted securities. However, the SEC does seek comment on same and, in particular, whether there should be requirements related to (i) obtaining an attorney opinion letter; (ii) obtaining issuer approval; (iii) requiring evidence of a registration statement or available exemption; (iv) requiring evidence of beneficial ownership; (v) requiring representations related to affiliation; and/or (vi) conducting some level of due diligence. I would advocate for such guidelines.

As the SEC notes, there is a potential conflict between a transfer agent’s duties to process a transfer and to ensure compliance with federal securities laws. However, in my opinion, from a transfer agent’s perspective, there are certain rules (turnaround rules and the UCC) requiring processing and only a vague fear of being charged with aiding and abetting related to ensuring compliance with federal securities laws. The proposed new rule generally increasing the potential liability on the transfer agent is likewise vague in the APNR. Without specific guidelines and standards, transfer agents will have a hard time navigating the new regulatory environment and all market participants will pay the price.

In fact, fear of regulatory retribution has already created a very challenging environment in the small-and mid-cap marketplace. The deposit of penny stock securities has become extremely difficult and expensive, but the flow of information to the market participants as to what is and is not acceptable has been slow and disjointed. At the same time that the OTC Markets has created self-imposed quantitative and qualitative standards to improve the marketplace and has been attempting to support small and emerging growth business capital formation, the secondary trading becomes increasingly difficult.

Moreover, there is a contrarian reality among the legislature, the SEC’s public position, and again, the actual small-cap secondary trading market, including the ability to deposit securities. The JOBS Act, including Regulation Crowdfunding, and the FAST Act are designed to improve capital formation in the small and emerging growth sectors, including a specific focus on allowing companies easier access to public markets and facilitating going public transactions. The advent of Regulation A+ and 506(c), the creation of the emerging growth company category, the various provisions of the FAST Act including improvements to the Form S-1 filing process and the SEC initiatives to modernize and update disclosure obligations are all meant to ease capital formation and public filings for micro- and small-cap companies.

Further, the active SEC Advisory Committee on Small and Emerging Companies was organized by the SEC to provide advice on SEC rules, regulations and policies regarding “its mission of protecting investors, maintaining fair, orderly and efficient markets and facilitating capital formation” as related to “(i) capital raising by emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization; (ii) trading in the securities of such businesses and companies; and (iii) public reporting and corporate governance requirements to which such businesses and companies are subject.”

The contrary side to all of this is the extreme difficulty in depositing securities for small- and micro-cap public companies and in creating a vibrant trading market. Although not comprehensive on the issues, see my blogs HERE regarding broker duties in depositing stocks and HERE regarding the need for a venture exchange.

The small- and micro-cap marketplace needs more definitive standards that companies and practitioners can rely upon. The fact is, it is relatively easy for a company to pass a footnote 32 type vehicle through the SEC and obtain a ticker symbol from FINRA and then extremely difficult to do anything with it. See my blog HERE. The fact that it is easy to create the vehicles in the first place creates a sort of confusion and disconnect in the marketplace. I’d rather see the SEC and FINRA be more stringent in their review process on these obvious vehicles and require that they label themselves a shell such that brokers and transfer agents have some comfort that when a company has cleared the SEC and FINRA, it is as labeled, subject of course to post effectiveness changes.

Of course, brokers and transfer agents still need to be gatekeepers, but the standards they are relying upon and the issues they are facing in their own SEC investigations and reviews need to be articulated and communicated to the marketplace. New proposed transfer agent rules is a step in the right direction and a very good start, but if those rules include a vague requirement that the transfer agent follow the law, we will not have made the type of headway that is badly needed to support real and viable small businesses and their capital formation.

I note that as part of the SEC request for comment there are some extreme thoughts. For instance, the SEC requests comment on whether a transfer agent should be required to (i) confirm the existence and legitimacy of an issuer’s business by reviewing contracts and corporate records; (ii) conduct credit and criminal background checks for issuers and their officers and directors; (iii) obtain information on shareholders before processing requests for legend removal; and (iv) review public news and information on issuers and principals. My view is that this level of review by a transfer agent is too extreme. I strongly oppose giving a transfer agent that level of independent power over an issuer and its shareholders. In addition to the shutdown in the small and micro-cap markets that would entail, the re-tooling of current transfer agents to adequately be able to satisfy this level of responsibility would be cost-prohibitive both to the transfer agents and their clientele.

Some of the other comment requests of interest (and my view in parentheses) include: (i) should the SEC enumerate red flags that would trigger a duty of further inquiry by a transfer agent (yes); (ii) should there be a heightened review for securities of non-reporting issuers (yes, if no current information); (iii) should a transfer agent be required to deliver securities only to the registered shareholder and not third parties (yes, unless the third party is an attorney or other proper representative of the shareholder); and (iv) should transfer agents be prohibited from accepting stock as compensation (no).

Registration and Annual Reporting

The purpose of the registration and annual reporting requirements is to assist the regulators, issuers and investors in determining whether a transfer agent is performing its functions properly, determining the nature of a particular transfer agent’s business, assisting the SEC in making examination and investigation decisions, including areas of concern, monitoring the transfer agents activities and ensuring compliance with rules and regulations.

The SEC proposes to add information to the registration and annual reporting requirements, including financial information, potential conflicts of interest and details about the types of services being provided and the transfer agent’s clientele. For example, it is proposed that a transfer agent disclose any past or present affiliations with or ownership of issuers or broker-dealers serviced by or affiliated with a transfer agent. I note that several small-cap broker-dealers have sister transfer agencies and do not believe such vertical business investment is problematic nor should it be construed as nefarious. However, I do see benefit in the disclosure of same.

The SEC also proposed to require a transfer agent to designate a chief compliance officer with responsibilities to ensure compliance with written internal controls and procedures.

Written Agreements Between Transfer Agents and Issuers

The APNR proposed to require written agreements between transfer agents and issuers. Although it is not now a legal requirement, I think most transfer agents do have such agreements. I am hard-pressed to think of any issuer clients that do not have a written contract with their transfer agent, and most are quick to require the signing of an addendum or updated contract where there is a change of management or control of the issuer.

However, the SEC rightfully points out that where there is either no written agreement or the agreement does not cover certain questions, there is an increase of disputes with respect to (i) the duration of the arrangement; (ii) termination rights; (iii) the disposition of records and transfer of records to a new transfer agent; and (iv) fees. These issues are most prevalent in the small-cap world, especially where a transfer agent “holds records hostage” in exchange for a large termination fee. The APNR does not suggest that the transfer agent be limited in allowable termination fees, nor that a transfer agent be required to turn over records regardless of sums owed or the payment of a termination fee, though it does seek comment on such issues.

Safeguarding Funds and Securities

Transfer agents often provide administrative and processing services in relation to dividends, payouts associated with splits (paying agent services) and other transactional escrow services. The APNR proposes a more robust set of standards for transfer agents acting as a paying agent or providing escrow services. The APNR indicates the SEC will provide new rules such as (i) maintaining secure vaults; (ii) installing theft and fire alarms; (iii) having written procedures related to access and control over accounts and information; (iv) greater bookkeeping requirements; (v) and specific unclaimed property procedures. In addition, the SEC intends to impose rules similar to those for broker-dealers, requiring internal controls, annual reporting and independent audits related to these services.

Cybersecurity, Information Technology and Related Issues

Cybersecurity is a big concern for the SEC. In 2014 the SEC adopted Regulation Systems, Compliance and Integrity requiring covered entities to test their automated systems for vulnerabilities, test their business continuity and disaster recovery plans and notify the SEC of intrusions. In particular, the SEC intends to propose new or amended rules requiring registered transfer agents to, among other things: (i) create and maintain a written business continuity plan; (ii) create and maintain basic procedures and guidelines governing the transfer agent’s use of information technology, including methods of safeguarding data and personally identifiable information; and (iii) create and maintain appropriate procedures and guidelines related to a transfer agent’s operational capacity, such as IT governance and management.

Concept Release and Request for Additional Comment

The SEC concept release contains discussion and seeks comment from the public on issues outside of and in addition to the APNR. The SEC highlights different questions and issues such as whether brokerage firms should also be required to be registered as transfer agents when they hold securities in nominee accounts; specific issues affecting transfer agents for mutual funds and transfer agents that serve as administrators for employee stock option and similar plans. The concept release also seeks comment on a transfer agent’s role in a Regulation Crowdfunding offering (Title III Crowdfunding).

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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Once Again, DTC Amends Proposed Procedures For Issuers Affected By Chills And Proposes Subsequent Rule Change

Posted by Securities Attorney Laura Anthony | May 15, 2014 Tags: Deposit Chill, Deposit Chill Notice, DTC Depository, DTC Eligibility, Global Lock, Regulatory Filings, Rule 144 Eligibility, Rule 144A, Rule 22(a), SEC Rule 144(a)(3)

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, the DTC filed these proposed rules with the SEC and on December 18, 2013, the proposed rules were published and public comment invited thereon. Following the receipt of comments on February 10, 2014, and again on March 10, 2014, the DTC amended its proposed rule changes. This blog discusses those rule changes and the current status of the proposed rules.

The new rules provide significantly more clarity as to the rights of the DTC and issuers and the timing of the process. For a complete discussion on background and DTC basics such as eligibility and the evolving procedures in dealing with chills and locks, including a complete discussion of the proposed rules published December 18, 2013, please see my white paper here 12/18/13.

In the Matter of the Application of International Power Group, Ltd.

In September 2009, the DTC put a chill on the trading of International Power Group, Ltd. (IPWG) securities following the initiation by the SEC of an action against certain defendants, not IPWG, for improper issuance and trading in certain OTC securities, including IPWG and 3 other issuers. In May 2010, the SEC settled with the defendants related to IPWG for the usual penalties and permanent injunctions, which settlement did not address the already issued securities. As a result of this process, the DTC imposed a chill on the securities of IPWG. IPWG was unsuccessful in getting the DTC to be responsive to its inquiries, let alone determine a process for removing the chill. So, although IPWG was clearly and undeniably greatly impacted by the DTC chill, at the time the DTC took the position that it didn’t have any particular obligation to IPWG for its actions.

IPWG filed an administrative appeal with the SEC looking for assistance. In its opinion, the SEC held that an issuer, in this case IPWG, was an Interested Person for purposes of DTC Rule 22 and was impacted by the DTC chill such that they are entitled to due process and fair proceedings. The SEC did not tell the DTC what the criteria were for determining whether the chill was appropriate or not should be, but only that the issuer is entitled to “fair procedures.”

Moreover, the SEC stated, “DTC should adopt procedures that accord with the fairness requirements of Section 17A(b)(3)(H), which may be applied uniformly in any future such issuer cases”; “Those procedures must also comply with Section 17A(b)(5)(B) of the Exchange Act, which requires clearing agencies when prohibiting or limiting a person’s access to services, to (1) notify such person of the specific grounds for the prohibition or limitation, (2) give the person an opportunity to be heard upon the specific grounds for the prohibition or limitation, and (3) keep a record.”

Finally, the SEC confirmed that the DTC can still put a chill on an issuer’s security, prior to giving notice and an opportunity to be heard to that issuer, in an emergency situation, stating, “[H]owever, in such circumstances, these processes should balance the identifiable need for emergency action with the issuer’s right to fair procedures under the Exchange Act. Under such procedures, DTC would be authorized to act to avert imminent harm, but it could not maintain such a suspension indefinitely without providing expedited fair process to the affected issuer.”

A DTC Chill or Global Lock – General

DTC Statement of the Purpose of the Proposed Rule Changes

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.

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 newest amendments to the proposed rules clarify and narrow the DTC’s authority as a protector of the overall marketplace, to just a protector of the DTC system. Rather than give an explanation of each of the changes from the last version of the proposed rules, this blog explains the proposed rules as they exist today.

The DTC has proposed rules (new 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 the DTC’s eligibility requirements, including by submitting an opinion from independent legal counsel: “Proposed Rule 22(A) will not apply when DTC impose[s] operational restrictions on deposits or other services in connection with ordinary course of business processing of Eligible Securities. One example of ‘ordinary course of business processing’ is the processing of corporate actions, including name changes and stock splits.”

Notification of Deposit Chill. Pursuant to its Proposed Rule, the DTC will notify an issuer of a deposit chill 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.

The DTC will send the notice via overnight courier to the issuer’s address in its regulatory filings or where it is incorporated. If the DTC cannot locate the issuer with reasonable diligence, it will send it the notice to the issuer’s registered agent for service of process.

The DTC has narrowed and clarified when a deposit chill may be imposed prior to notice. In particular, the DTC may impose the chill prior to notice “in order to prevent imminent harm, injury or other such consequences to DTC or its Participants” or “if DTC reasonably determines that such action is necessary to protect the prompt and accurate clearance and settlement of securities transactions through DTC.”

The notice will provide an explanation of the specific grounds upon which the restrictions are being or have been imposed including the legal authority upon which DTC relies. 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. It will also provide the date the Deposit Chill was imposed or the date it will be imposed, should the issuer fail to respond to the Deposit Chill notice.

The issuer has 20 days to respond to the notice. The DTC may extend this deadline for up to an additional twenty business days if the issuer establishes “good cause.” If the issuer demonstrates to DTC’s “reasonable satisfaction” that the issue complies with the DTC’s eligibility requirements and the applicable procedures, the Deposit Chill will be lifted or will not be imposed.

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. In particular, the opinion letter must specify that the securities “(i) are not restricted securities under SEC Rule 144(a)(3), or (ii) are exempt from any restrictions on transferability under the Securities Act.” 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 a chill was imposed prior to the issuance of a Notice, the determination whether to lift such chill will be provided to the issuer within ten business days after receipt of the issuer’s response. In the event of a pre-chill notice, the determination will be provided to the issuer within twenty business days after receipt of the issuer’s response. This timing was not in the prior version of the proposed rules.

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 ten days in which to submit a supplemental response. The supplemental response will be limited to establishing that either (1) the issuer did timely respond to DTC previously, or (2) 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. The DTC will provide a determination within ten (10) days of receipt of the supplemental response.

The Record: The record of a proceeding, for purposes of use in an appeal to the SEC, shall include: (i) The Deposit Chill Notice, the Deposit Chill Response, the Deposit Chill Decision, the Supplemental Deposit Chill Response, the Supplemental Deposit Chill Response Decision, the Additional Information Request, and the Additional Information Response; (ii) all documents submitted in connection with (i) and (iii) any written communications created pursuant to the proposed rules as described herein.

DTC reserves authority to modify or lift a chill or to impose a chill after making a favorable determination, with a restart of the proposed procedures.

B.Global Locks. Global locks can be imposed either where (i) an issuer has failed to respond or failed to adequately respond to a deposit chill notice or (ii) the DTC becomes aware that the SEC or other state or federal agency has commenced a judicial or administrative proceeding alleging that DTC-eligible securities have been sold in violation of Section 5 of the Securities Act or other applicable law.

Notification of Global Lock. Pursuant to its proposed rule, the DTC will notify an issuer of a Global Lock 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 issuer shall have twenty (20) days to respond. The DTC may extend the deadline for up to an additional twenty (20) days if the issuer establishes “good cause.”

The notice will provide an explanation of the specific grounds upon which the restrictions are being or have been imposed including the legal authority upon which the DTC relies. The DTC will impose the lock prior to notice (i) to prevent imminent harm, injury or other such consequences to the DTC or its participants or (ii) if the DTC reasonably determines that such action is necessary to protect the prompt and accurate clearance and settlement of securities transactions through the DTC. It will also provide the date the Lock was imposed or the date it will be imposed, should the issuer fail to respond to the notice.

The proposed rules differentiate Global Locks based on enforcement proceedings and Global Locks based on an issuer’s failure to respond or adequately respond to a chill. Where the Lock is imposed as a result of an enforcement proceeding, the notice will provide that a “Global Lock will not be imposed, or, if already imposed, will be released if the issuer demonstrates either (1) that the Eligible Securities were not the intended subject of the Proceeding, or (2) that the Proceeding was withdrawn or dismissed on the merits with prejudice or otherwise resolved in a final, non-appealable judgment in favor of the Defendants.” The DTC will not provide a forum for litigating or re-litigating the allegations or findings in the enforcement proceeding. As noted above, the notice will give twenty days to respond, with the ability to receive a twenty-day extension.

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.

DTC Review of Issuer Response. The DTC will respond in writing to the issuer’s submission 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 DTC decision will be to either (i) not impose or release the Lock; or (ii) impose or not release the Lock. Otherwise, the DTC will release the Global Lock upon the eligible securities becoming eligible for free trading status pursuant to Rule 144 – that is, within either one year or six months, depending on whether the issuer is subject to the reporting requirements of the Exchange Act and depending on the company’s Rule 144 eligibility.

In particular, 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.

The record for purposes of an appeal to the SEC will consist of the Global Lock Notice, the Global Lock Response and the Global Lock Decision. Moreover, the proposed rules give the DTC full discretion to lift or modify a Global Lock on the same grounds for which a Lock can be imposed or lifted as set forth above.

The Author

Attorney Laura Anthony

LAnthony@LegalAndCompliance.com

Founding Partner, Legal & Compliance, LLC

Securities, Reverse Merger and Corporate Attorneys

Corporate and Securities Attorney Laura Anthony’s legal expertise includes but is not limited to registration statements, including Forms S-1, S-4, S-8 and Form 10, PIPE transactions, debt and equity financing transactions, private placements, reverse mergers, forward mergers, asset acquisitions, joint ventures, crowdfunding, and compliance with the reporting requirements of the Securities Exchange Act of 1934 including Forms 10-Q, 10-K and 8-K, the proxy requirements of Section 14, Section 16 filings and Sarbanes-Oxley mandated policies. Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including preparation of deal documents such as Merger Agreements, Share Exchange Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for corporate changes such as name changes, reverse and forward splits and change of domicile.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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How Does My Company Go Public?

Posted by Securities Attorney Laura Anthony | May 8, 2014 Tags: DPO, DTC Eligibility, Form 10, Public Shell, Public Shells, Reverse Merger, Rule 144, Rule 15C2-11, Small Cap Market

Introduction

For at least the last twelve months, I have received calls daily from companies wanting to go public. This interest in going public transactions signifies a big change from the few years prior.

Beginning in 2009, the small-cap and reverse merger, initial public offering (IPO) and direct public offering (DPO) markets diminished greatly. I can identify at least seven main reasons for the downfall of the going public transactions. Briefly, those reasons are: (1) the general state of the economy, plainly stated, was not good; (2) backlash from a series of fraud allegations, SEC enforcement actions, and trading suspensions of Chinese companies following reverse mergers; (3) the 2008 Rule 144 amendments including the prohibition of use of the rule for shell company and former shell company shareholders; (4) problems clearing penny stock with broker dealers and FINRA’s enforcement of broker-dealer and clearing house due diligence requirements related to penny stocks; (5) DTC scrutiny and difficulty in obtaining clearance following a reverse merger or other corporate restructuring and significantly DTC chills and locks; (6) increasing costs of reporting requirements, including the relatively new XBRL requirements; and (7) the updated listing requirements imposed by NYSE, AMEX and NASDAQ and twelve-month waiting period prior to qualifying for listing following a reverse merger.

However, despite these issues, the fact is that going public is and remains the best way to access capital markets. Public companies will always be able to attract a PIPE investor, equity line or similar financing (the costs and quality of these financing opportunities is beyond the scope of this blog). For cash-poor companies, the use of a trading valuable stock is the only alternative for short-term growth and acquisitions. At least in the USA, the stock market, day traders, public market activity and the interest in capital markets will never go away; they will just evolve to meet ever-changing demand and regulations.

What is a reverse merger? What is the process?

A reverse merger is the most common alternative to an initial public offering (IPO) or direct public offering (DPO) for a company seeking to go public. A “reverse merger” allows a privately held company to go public by acquiring a controlling interest in, and merging with, a public operating or public shell company. The SEC defines a “shell company” as a publically traded company with (1) no or nominal operations and (2) either no or nominal assets or assets consisting solely of any amount of cash and cash equivalents.

In a reverse merger process, the private operating company shareholders exchange their shares of the private company for either new or existing shares of the public company so that at the end of the transaction, the shareholders of the private operating company own a majority of the public company and the private operating company has become a wholly owned subsidiary of the public company. The public company assumes the operations of the private operating company. At the closing, the private operating company has gone public by acquiring a controlling interest in a public company and having the public company assume operations of the operating entity.

A reverse merger is often structured as a reverse triangular merger. In that case, the public shell forms a new subsidiary which the new subsidiary merges with the private operating business. At the closing the private company shareholders exchange their ownership for shares in the public company, and the private operating business becomes a wholly owned subsidiary of the public company. The primary benefit of the reverse triangular merger is the ease of shareholder consent. That is because the sole shareholder of the acquisition subsidiary is the public company; the directors of the public company can approve the transaction on behalf of the acquiring subsidiary, avoiding the necessity of meeting the proxy requirements of the Securities Exchange Act of 1934.

Like any transaction involving the sale of securities, the issuance of securities to the private company shareholders must either be registered under Section 5 of the Securities Act or use an available exemption from registration. Generally, shell companies rely on Section 4(a)(2) or Rule 506 of Regulation D under the Securities Act for such exemption.

The primary advantage of a reverse merger is that it can be completed very quickly. As long as the private entity has its “ducks in a row,” a reverse merger can be completed as quickly as the attorneys can complete the paperwork. Having your “ducks in a row” includes having completed audited financial statements for the prior two fiscal years and quarters up to date (or from inception if the company is less than two years old), and having the information that will be necessary to file with the SEC readily available. The SEC requires that a public company file Form 10 type information on the private entity within four days of completing the reverse merger transaction (a super 8-K). Upon completion of the reverse merger transaction and filing of the Form 10 information, the once private company is now public. The reverse merger transaction itself is not a capital-raising transaction, and accordingly, most private entities complete a capital-raising transaction (such as a PIPE) simultaneously with or immediately following the reverse merger, but it is certainly not required. In addition, many Companies engage in capital restructuring (such as a reverse split) and a name change either prior to or immediately following a reverse merger, but again, it is not required.

There are several disadvantages of a reverse merger. The primary disadvantage is the restriction on the use of Rule 144 where the public company is or ever has been a shell company. Rule 144 is unavailable for the use by shareholders of any company that is or was at any time previously a shell company unless certain conditions are met. In order to use Rule 144, a company must have ceased to be a shell company; be subject to the reporting requirements of section 13 or 15(d) of the Exchange Act; filed all reports and other materials required to be filed by section 13 or 15(d) of the Exchange Act, as applicable, during the preceding 12 months (or for such shorter period that the Issuer was required to file such reports and materials), other than Form 8-K reports; and have filed current “Form 10 information” with the Commission reflecting its status as an entity that is no longer a shell company, then those securities may be sold subject to the requirements of Rule 144 after one year has elapsed from the date that the Issuer filed “Form 10 information” with the SEC.

Rule 144 now affects any company who was ever in its history a shell company by subjecting them to additional restrictions when investors sell unregistered stock under Rule 144. The new language in Rule 144(i) has been dubbed the “evergreen requirement.” Under the so-called “evergreen requirement,” a company that ever reported as a shell must be current in its filings with the SEC and have been current for the preceding 12 months before investors can sell unregistered shares.

The second biggest disadvantage concerns undisclosed liabilities, lawsuits or other issues with the public shell. Accordingly, due diligence is an important aspect of the reverse merger process, even when dealing with a fully reporting current public shell. The third primary disadvantage is that the reverse merger is not a capital-raising transaction (whereas an IPO or DPO is). An entity in need of capital will still be in need of capital following a reverse merger, although generally, capital raising transactions are much easier to access once public. The fourth disadvantage is immediate cost. The private entity generally must pay for the public shell with cash, equity or a combination of both. However, it should be noted that an IPO or DPO is also costly.

Finally, whether an entity seeks to go public through a reverse merger or an IPO, they will be subject to several, and ongoing, time-sensitive filings with the SEC and will thereafter be subject to the disclosure and reporting requirements of the Securities Exchange Act of 1934, as amended.

What is a Direct Public Offering? What is the process?

One of the methods of going public is directly through a public offering. In today’s financial environment, many Issuers are choosing to self-underwrite their public offerings, commonly referred to as a Direct Public Offering (DPO). An IPO, on the other hand, is a public offering underwritten by a broker-dealer (underwriter). As a very first step, an Issuer and their counsel will need to complete a legal audit and any necessary corporate cleanup to prepare the company for a going public transaction. This step includes, but is not limited to, a review of all articles and amendments, the current capitalization and share structure and all outstanding securities; a review of all convertible instruments including options, warrants and debt; and the completion of any necessary amendments or changes to the current structure and instruments. All past issuances will need to be reviewed to ensure prior compliance with securities laws. Moreover, all existing contracts and obligations will need to be reviewed including employment agreements, internal structure agreements, and all third-party agreements.

Once the due diligence and corporate cleanup are complete, the Issuer is ready to move forward with an offering. Companies desiring to offer and sell securities to the public with the intention of creating a public market or going public must file with the SEC and provide prospective investors with a registration statement containing all material information concerning the company and the securities offered. Such registration statement is generally on Form S-1. For a detailed discussion of the S-1 contents, please see my white paper here. The average time to complete, file and clear comments on an S-1 registration statement is 90-120 days. Upon clearing comments, the S-1 will be declared effective by the SEC.

Following the effectiveness of the S-1, the Issuer is free to sell securities to the public. The method of completing a transaction is generally the same as in a private offering. (i) the Issuer delivers a copy of the effective S-1 to a potential investor, which delivery can be accomplished via a link to the effective registration statement on the SEC EDGAR website together with a subscription agreement; (ii) the investor completes the subscription agreement and returns it to the Issuer with the funds to purchase the securities; and (iii) the Issuer orders the shares from the transfer agent to be delivered directly to the investor. If the Issuer arranges in advances, shares can be delivered to the investors via electronic transfer or DWAC directly to the investors brokerage account.

Once the Issuer has completed the sale process under the S-1 – either because all registered shares have been sold, the time of effectiveness of the S-1 has elapsed, or the Issuer decides to close out the offering – a market maker files a 15c2-11 application on behalf of the Issuer to obtain a trading symbol and begin trading either on the over-the-counter market (such as OTCQB). The market maker will also assist the Issuer in applying for DTC eligibility.

A DPO can also be completed by completing a private offering prior to the filing of the S-1 registration statement and then filing the S-1 registration statement to register those shares for resale. In such case, the steps remain primarily the same except that the sales by the company are completing prior to the S-1 and a the 15c2-11 can be filed immediately following effectiveness of the S-1 registration statement.

Basic differences in DPO vs. Reverse Merger Process

Why DPO:

As opposed to a reverse merger, a company completing a DPO does not have to worry about potential carry-forward liability issues from the public shell.

A company completing a DPO does not have to wait 12 months to apply to the NASDAQ, NYSE MKT or other exchange and if qualified, may go public directly onto an exchange.

A DPO is a money-raising transaction (either pre S-1 in a private offering or as part of the S-1 process). A reverse merger does not raise money for the going public entity unless a separate money-raising transaction is concurrently completed.

As long as the company completing the DPO has more than nominal operations (i.e., it is not a very early-stage start-up with little more than a business plan), it will not be considered a shell company and will not be subject to the various rules affecting entities that are or ever have been a shell company. To the contrary, many public entities completing a reverse merger are or were shells.

A DPO is less expensive than a reverse merger. The total cost of a DPO is approximately and generally $100,000-$150,000 all in. The cost of a reverse merger includes the price of the public vehicle, which can range from $250,000-$500,000. Accordingly, the total cost of a reverse merger is approximately and generally $350,000-$650,000 all in. Deals can be made where the cost of the public shell is paid in equity in the post-reverse merger entity instead of or in addition to cash, but either way, the public vehicle is being paid for. NOTE: These are approximate costs. Many factors can change the cost of the transactions.

Why Reverse Merger

Raising money is difficult and much more so in the pre-public stages. In a reverse merger, the public company shareholders become shareholders of the operating business and no capital raising transaction needs to be completed to complete the process.

A reverse merger can be much quicker than a DPO.

Raising money in a public company is much easier than in a private company pre going public. A reverse merger can be completed quickly, and thereafter the now public company can raise money.

Reverse Mergers and DPO’s are both excellent methods for going public

As I see it, the evolution in the markets and regulations have created new opportunities, including the opportunity for a revived, better reverse merger market and a revived, better DPO market. A reverse merger remains the quickest way for a company to go public, and a DPO remains the cleanest way for a company to go public. Both have advantages and disadvantages, and either may be the right choice for a going public transaction depending on the facts, circumstances and business needs.

The increased difficulties in general and scrutiny by regulators may be just what the industry needed to weed out the unscrupulous players and invigorate this business model. Shell companies necessarily require greater due diligence up front, if for no other reasons than to ensure DTC eligibility and broker dealer tradability, prevent future regulatory issues, and ensure that no “bad boys” are part of the deal or were ever involved in the shell. Increased due diligence will result in fewer post-merger issues.

The over-the-counter market has regained credibility and supports higher stock prices, especially since exchanges are forcing companies to trade there for a longer period of time before becoming eligible to move up. Resale registration statements, and thus disclosure, may increase to combat the Rule 144 prohibitions. We have already seen greater disclosure by non-reporting entities trading on otcmarkets.com.

The bottom line is that issues and setbacks for going public transactions since 2008 have primed the pump and created the perfect conditions for a revitalized, better reverse merger and DPO market beginning in 2014.

The Author

Attorney Laura Anthony

Founding Partner, Legal & Compliance, LLC

Securities, Reverse Merger and Corporate Attorneys

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Ms. Anthony has structured her securities law practice as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms.

Ms. Anthony’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony 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 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.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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Small-Cap Reverse Mergers Poised for a Comeback

Posted by Securities Attorney Laura Anthony | December 27, 2011 Tags: DTC Eligibility, Form 10, OTC Market, Private Placement, Reverse Merger, Reverse Merger Process | Reverse Merger Attorneys, Rule 419 SPAC’s, S-1 Registration, Securities Attorney, Shell Company

The good news about reaching bottom is that the only place to go from there is up. As I have blogged about recently, since 2009, the small cap and reverse merger market has diminished greatly. According to industry statistics, 2011 was the slowest year for reverse mergers since 2004.

The Perfect Storm of Reverse Merger Stagnation

To reiterate my previous blogs, I can identify at least seven main reasons for the downfall of the reverse merger market. Briefly, those reasons are: (1) the general state of the economy, plainly stated, it’s not good; (2) backlash from a series of fraud allegations, SEC enforcement actions, and trading suspensions of Chinese company’s following reverse mergers; (3) the 2008 Rule 144 amendments including the prohibition of use of the rule for shell company and former shell company shareholders; (4) problems clearing penny stock with broker dealers and FINRA enforcement of broker dealer due diligence on penny stocks; (5) DTC scrutiny and difficulty in obtaining clearance following a reverse merger or other corporate restructuring; (6) increasing costs of reporting requirements, including the new XBRL requirements; and (7) the new listing requirements imposed by NYSE, AMEX and NASDAQ and prohibition against immediate listing following a reverse merger.

The Need for Reverse Mergers Still Remains

However, despite these issues and the chill in the reverse merger market, the fact is that going public is and remains the best way to access capital markets. Public companies will always be able to attract a PIPE investor. For cash poor companies, the use of a trading valuable stock is the only alternative for short term growth and acquisitions. At least in the USA, the stock market, day traders, public market activity and the interest in capital markets will never go away; it will just evolve to meet ever changing demand and regulations.

That very evolution has created new opportunities, including the opportunity for a revived, better, reverse merger market. Certainly there are alternatives to a reverse merger, for instance a company can go public directly either through a private placement followed by S-1 registration statement; a direct public offering (DPO) or especially for those in the internet or tech business, trading on a private company market place (PCMP).

Reverse Merger Alternatives Are Unreliable

However, each of these alternatives can be difficult and time consuming. Many companies abandon DPO’s or private offerings prior to completion. Raising money for a trading public company is difficult, for a non-trading pre-public company, it can be impossible. Unscrupulous unregistered companies and individuals prey on these entities, taking their time and money and leaving a mess that can take years and more money to clean up.

A reverse merger remains the quickest and cleanest way for a company to go public. The increased difficulties in general and scrutiny by regulators may be just what the industry needed to weed out the unscrupulous players and invigorate this business model. Shell companies will necessarily require greater due diligence up front, if for no other reason than to ensure DTC eligibility and broker dealer tradability. Increased due diligence will result in fewer post merger issues.

A Higher Quality OTC Market

The over the counter market should regain credibility and support higher stock prices, since exchanges are forcing companies to trade there for a longer period of time before becoming eligible to move up. Rule 419 SPAC’s may increase providing clean new entities to complete reverse mergers. Resale registration statements, and thus disclosure, may increase to combat the Rule 144 prohibitions. We have already seen greater disclosure by non-reporting entities trading on otcmarkets.com.

In summary, we believe that the issues and setbacks of the reverse merger market since 2008 have primed the pump and created the perfect conditions for a revitalized, better reverse merger market beginning in mid to late 2012.

The Author

Attorney Laura Anthony,
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions

Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public Companies as well as private Companies intending to go public on the Over the Counter Bulletin Board (OTCBB), now known as the OTCQB. For more than a decade Ms. Anthony has dedicated her securities law practice towards being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.

Ms. Anthony’s focus includes but is not limited to compliance with the reporting requirements of the Securities Exchange Act of 1934, as amended, (“Exchange Act”) including Forms 10-Q, 10-K and 8-K and the proxy requirements of Section 14. In addition, Ms. Anthony prepares private placement memorandums, registration statements under both the Exchange Act and Securities Act of 1933, as amended (“Securities Act”). Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of the Exchange Act, state law and FINRA for corporate changes such as name changes, reverse and forward splits and change of domicile.

Contact Legal & Compliance LLC for a free initial consultation or second opinion on an existing matter.

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