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FINRA Issues New Guidance On Communications With The Public, Including Social Media

Posted by Securities Attorney Laura Anthony | August 22, 2017 Tags: Finra, FINRA Rule 2210, Regulatory Notice 17-18

In April 2017 FINRA issued Regulatory Notice 17-18 providing additional guidance on the use of social media and digital communications by member firms and persons associated with member firms. The guidance specifically relates to FINRA Rule 2210 – Communications with the Public, and supplements previously issued guidance in Regulatory Notices 10-06 and 11-39, published in 2011. The new guidance is in the form of FAQ’s and concentrates on the areas of recordkeeping, third-party posts and hyperlinks to third-party sites.

I have previously written about the SEC’s guidance on social media use by companies, including as a method for communications with investors and the public. The most recent blog is HERE and includes hyperlinks to prior blogs, including a three-part summary of the SEC Guidance on Social Media and Websites for Company Announcements and Communications.

Brief Overview of Rule 2210

FINRA Rule 2210 governs communications by FINRA member firms and associated persons, including: (i) institutional communications – including any written or electronic communication, distributed or made available only to institutional investors such as banks, insurance companies and investment companies; (ii) retail communications – including any written or electronic communication distributed or made available to more than 25 retail investors within any 30-calendar-day period; and (iii) correspondence. The Rule also sets forth requirements related to approval, review and recordkeeping of communications; filing requirements and review procedures and content standards.

The Rule’s general content standards apply to all communications and are meant to ensure that communications are fair, balanced and not misleading. Communications to retail customers or potential customers have the highest standards. The communication rules focus on the recipient and not the type of product (IPO, private, debt, etc.) that might be being discussed.

Retail Communications

Subject to certain exemptions, an appropriately qualified registered principal of the member firm must approve each and every retail communication before the earlier of its first use, or its filing with FINRA’s Advertising Regulation Department. However, this requirement does not apply where another member firm has used the same communication and received approval from FINRA as to its content. In other words, member firms can piggyback on each other’s advertising and communication approvals.

The requirement also does not apply to: (i) certain communications excepted from the definition of a research report or debt research report unless the communication makes a financial or investment recommendation; (ii) any retail communication that is posted on an online interactive electronic forum; and (iii) retail communication that does not make any financial or investment recommendation or otherwise promote a product or service of the member firm.

Correspondence

All correspondence must be subject to general supervision and review requirements.

Institutional Communications

Members must establish written procedures that are appropriate to their business, size, structure, and customers for the review by an appropriately qualified registered principal of institutional communications used by the member and its associated persons. The procedures must be reasonably designed to ensure that institutional communications comply with applicable standards. When the procedures do not require review of all institutional communications prior to first use or distribution, they must include provisions for the education and training of associated persons as to the firm’s procedures, documentation of the education and training, and surveillance and follow-up to ensure that the procedures are implemented and adhered to.

Recordkeeping

As required by Securities Exchange Act Rule 17a-4(b), member firms must maintain all records, including all digital communications related to their business. Records must be maintained for a minimum of three years. Determining whether a communication must be retained depends on its content and not upon the type of device or technology used to transmit the communication. Firms also have an obligation to train and educate their associated persons regarding the differences between business and personal (non-business) communications and must have procedures in place to ensure that any business communications made by associated persons are retained, retrievable and supervised.

Records must include: (i) a copy of the communication and the dates of first and last use; (ii) the name of any principal who approved the communication and the date of approval; (iii) if the communication was not approved, the name of the person who prepared or distributed it; (iv) information on the source of any statistical table, chart, graph or other illustration; (v) where the firm or representative is relying on another member’s approval, the name of the member and a copy of the review letter and approval from FINRA; and (vi) for any retail communication that includes or incorporates a performance ranking or performance comparison of a registered investment company, a copy of the ranking or performance used in the retail communication.

Filing Requirements and Review Procedures

For the first year as a licensed broker-dealer, a firm must file all retail communications with FINRA’s Advertising Regulation Department at least 10 days prior to its first use. If a communication is a free writing prospectus that has been filed with the SEC, it can be filed with FINRA within 10 days of its first use, instead of prior. FINRA can also impose a filing requirement on any firm at any time if it determines that the firm has departed from the standards in Rule 2210.

Retail communications concerning registered investment companies, which include or incorporate performance rankings or comparisons, must always be filed at least 10 business days prior to use. Likewise, retail communications recommending a specific registered investment company, concerning a direct participation program, concerning collateralized mortgages or concerning derivatives or indexes must all be filed with FINRA at least 10 business days prior to their first use.

If a member has filed a draft version or “storyboard” of a television or video retail communication pursuant to a filing requirement, then the member also must file the final filmed version within 10 business days of first use or broadcast.

Certain retail communications are excluded from the filing requirements, including: (i) communications based on a template that has previously been filed with FINRA and approved for use either without material change, or changes limited to updated statistical and other information; (ii) retail communications that do not make any financial or investment recommendation or otherwise promote a product or service of the member; (iii) retail communications that do no more than identify a national securities exchange symbol of the member or identify a security for which the member is a registered market maker; (iv) retail communications that do no more than identify the member or offer a specific security at a stated price; (v) offering documents, reports or free writing prospectus that have been filed with the SEC or a state or offering documents for exempt offerings; (vi) tombstone communications identifying a firm’s participation in an offering; (vii) press releases that are made available only to members of the media; (viii) republications of unaffiliated third-party articles or reports that the firm has neither adopted nor become entangled with; (ix) correspondence; (x) institutional communications; (xi) communications that refer to types of investments solely as part of a listing of products or services offered by the member; (xii) retail communications that are posted on an online interactive electronic forum; (xiii) press releases issued by closed-end investment companies that are listed on the New York Stock Exchange; (xiv) research reports on exchange traded securities.

FINRA may grant exemptions to the filing requirements for good cause. All filings must be approved by a registered principal within the firm prior to submitting to FINRA.

Content Standards

Rule 2210 focuses on antifraud issues. In particular, the Rule provides that “All member communications must be based on principles of fair dealing and good faith, must be fair and balanced, and must provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry, or service. No member may omit any material fact or qualification if the omission, in light of the context of the material presented, would cause the communications to be misleading.” The next section continues: “No member may make any false, exaggerated, unwarranted, promissory or misleading statement or claim in any communication. No member may publish, circulate or distribute any communication that the member knows or has reason to know contains any untrue statement of a material fact or is otherwise false or misleading.”

Information may only be placed in a footnote if it is still clear. Members must ensure that statements are not misleading and that they provide balanced treatment of risks and potential benefits. FINRA requires that firms consider their audience in creating content, and such content must be audience-appropriate. Communications cannot exaggerate and may not predict or project performance.

There are specific requirements for content in communications. For example, a member firm must prominently include the name of the member firm, fictional names, and relationships between parties listed in the communication. There are specific requirements regarding communications related to tax-free or tax-exempt products and disclosures of fees and expenses for investment management companies and pooled funds.

Testimonials and Recommendations

Rule 2210 governs the use of testimonials about a member firm and the use of recommendations by a member firm. Each requires a reasonable basis and must be rendered by a person with the knowledge and experience to form a valid opinion. Retail communications involving recommendations about a product or service by a member firm have additional technical requirements.

BrokerCheck

All communications must contain a prominent reference and hyperlink to BrokerCheck.

New Guidance

FINRA Regulatory Notice 17-18 provides additional guidance on the use of social media and digital communications by member firms and associated persons through FAQ’s designed to supplement previously issued guidance on the areas of recordkeeping, third-party posts and hyperlinks to third-party sites.

Recordkeeping

As noted above, and as required by Securities Exchange Act Rule 17a-4(b), member firms must maintain all records, including all digital communications related to their business. Records must be maintained for a minimum of three years. Determining whether a communication must be retained depends on its content and not upon the type of device or technology used to transmit the communication. Firms also have an obligation to train and educate their associated persons regarding the differences between business and personal (non-business) communications and must have procedures in place to ensure that any business communications made by associated persons are retained, retrievable and supervised.

The new guidance confirms that the record retention requirements apply to communications made through text messaging or a chat service or app. Prior to allowing text or chat communications, a firm must ensure that it has the ability to retain the content of the communications.

Third-party Posts; Adoption or Entanglement

Generally speaking, posts by customers or other third parties on social media or any website established by a firm or its personnel do not constitute communications with the public by the firm or its associated persons under Rule 2210. Accordingly, these posts do not require pre-use approval by a principal in the firm, and as a practical matter, a firm could not require third parties to seek such approval. However, if the firm or associated person paid for the preparation of the content or otherwise caused it to be prepared and posted, the firm would be responsible for its content under FINRA’s “entanglement” theory. Moreover, if the firm or associated person explicitly or implicitly endorses or approves the third-party content, it would also be responsible for its content under FINRA’s theory of “adoption” of content. Where a firm or associated person is responsible for the content, it must comply with all the requirements of Rule 2210.

The new guidance clarifies that a firm or registered representative can contact a third party to correct factual information, such as the spelling of a name, an incorrect address or website, where the firm was completely unaffiliated with the publisher and not involved in the publications content, without such correction resulting in entanglement or endorsement.

Hyperlinks to Third-party Sites

A firm is responsible for links to a third-party site if that firm has adopted or become entangled with the content. A firm would be deemed to have adopted content that it explicitly or implicitly endorses or approved and would be deemed to be entangled in content where it has participated in the development of such content. A member firm may not establish a link to any third-party site that the firm knows or has reason to know contains false or misleading content and may not include a link on its website if there are any red flags that indicate the linked site contains false or misleading content.

The new guidance clarifies that by sharing or linking to third-party content, the member firm has adopted that content and is responsible for its content to the same extent it is for firm-generated communications. Where the shared or linked content itself has additional links to other content, the firm must do a facts-and-circumstances analysis to determine if it would also be responsible for that additional content. The firm would not be deemed to have adopted the content in the links in the shared content, solely by sharing or linking.

In general, if a firm shares or links to content that in turn links to other content over which the firm has no influence or control, the firm would not have adopted the other content. On the other hand, if a firm shares or links to content that in turn links to other content over which the firm has influence or control, the firm would then have adopted that other content. In addition, if the firm shares or links to content that itself serves primarily as a vehicle for links, the firm would be responsible for the content in the links.

The new guidance also clarifies that whether a firm has adopted the content of an independent third-party website or any section of the website through the use of a link is fact dependent. Two factors are critical to the analysis: (i) whether the link is “ongoing” and (ii) whether the firm has influence or control over the content of the third-party site.

Where the link is “ongoing” the firm would not have adopted the content. “Ongoing” means that: (i) the link is continuously available to investors who visit the firm’s site; (ii) investors have access to the linked site whether or not it contains favorable material about the firm; and (iii) the linked site could be updated or changed by the independent third party and investors would still be able to use the link. As an example, some firms link to regulatory agencies such as FINRA or the SEC.

However, if the firm has influence or control over the third-party site, the firm would be entangled with its content and thus responsible under Rule 2210.

Personal Communications

Personal communications are not subject to Rule 2210. Moreover, if an associated person shares or links to content that the member firm made available, which is not related to its products or services, the communication is likewise not subject to Rule 2210. Examples given in the FINRA notice include information about the firm’s sponsorship of a charitable event, a human interest article, or an employment opportunity.

Native Advertising

Native advertising is defined as content that bears a similarity to the news feature articles, product reviews, entertainment and other material that surrounds it online. Native advertising can appear to be a genuine news article or product review at first glance. FINRA clarifies that native advertising is not inherently misleading and can be used as long as it complies with Rule 2210, including that the firm ensures that the communication is fair, balanced and not misleading. Native advertising must prominently disclose the firm’s name, accurately reflect any relationship with the firm and any other entity or individual named in the advertisement, and state whether mentioned products or services are offered by the firm.

Where a member firm arranges for or pays for third-party native advertising, such as content in a blog or posts by an influencer, the firm would be responsible for its content under the entanglement theory. As provided in an earlier Regulatory Notice, if a firm or representative has paid for the publication, production or distribution of any communication that appears to be a magazine, article or interview, then the communication must be clearly identified as an advertisement. Firms should clearly identify as advertisements any communications that take the form of comments or posts by influencers and include the broker-dealer’s name as well as any other information required for compliance with Rule 2210.

Testimonials and Endorsements

Many social networking sites, such as LinkedIn, allow individuals to post opinions or provide comments regarding a person’s professional capabilities. FINRA allows registered representatives and associated persons to utilize social networking platforms for business-related purposes as long as the account is supervised and retained by the member firm. FINRA does not include unsolicited third-party opinions or comments posted on a social network to be communications of the firm or representative for purposes of Rule 2210. However, if the firm or representative likes or shares content, they have adopted the content and become subject to the communication rules, including prohibitions on misleading or incomplete statements or claims, the testimonial requirements, and the supervision and recordkeeping rules.

Testimonials are governed by Rule 2210 and in particular:

(A) If any testimonial in a communication concerns a technical aspect of investing, the person making the testimonial must have the knowledge and experience to form a valid opinion.

(B) Retail communications or correspondence providing any testimonial concerning the investment advice or investment performance of a member or its products must prominently disclose the following: (i) the fact that the testimonial may not be representative of the experience of other customers; (ii) the fact that the testimonial is no guarantee of future performance or success; and (iii) if more than $100 in value is paid for the testimonial, the fact that it is a paid testimonial.

Testimonials are subject to the general Rule 2210 standards as well, including that they not be false, misleading, exaggerated or promissory. The disclosures that must be required can be included via a clearly marked and labeled hyperlink. Also, investment advisors are prohibited from directly or indirectly publishing, circulating or distributing testimonials.

BrokerCheck

Effective June 6, 2016, Rule 2210 requires each of a firm’s websites to include a readily apparent reference and hyperlink to BrokerCheck on (i) the initial web page that the firm intends to be viewed by retail investors, and (ii) any other web page that includes a professional profile of one or more registered persons who conduct business with retail investors. The reference and hyperlink are not required to be included in communications appearing on a third-party website, including social media sites, or in email or text messages.

The new guidance clarifies that the reference and hyperlink to BrokerCheck would not need to be included in an app created by a firm. However, if the app accesses and displays the firm’s website, the link must be readily apparent when the page is displayed through the app.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.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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SEC Chair Jay Clayton Discusses Direction Of SEC

Posted by Securities Attorney Laura Anthony | August 1, 2017 Tags: Chair Jay Clayton, Finra, SEC, SEC Chair Jay Clayton, SEC Chair Jay Clayton Discusses Direction Of SEC

In a much talked about speech to the Economic Club of New York on July 12, 2017, SEC Chairman Jay Clayton set forth his thoughts on SEC policy, including a list of guiding principles for his tenure. Chair Clayton’s underlying theme is the furtherance of opportunities and protection of Main Street investors, a welcome viewpoint from the securities markets’ top regulator. This was Chair Clayton’s first public speech in his new role and follows Commissioner Michael Piwowar’s recent remarks to the SEC-NYU Dialogue on Securities Market Regulation largely related to the U.S. IPO market. For a summary of Commissioner Piwowar’s speech, read HERE.

Guiding Principles

Chair Clayton outlined a list of eight guiding principles for the SEC.

#1: The SEC’s Mission is its touchstone

As described by Chair Clayton, the SEC has a three part mission: (i) to protect investors; (ii) to maintain fair, orderly and efficient markets, and (iii) to facilitate capital formation. Chair Clayton stresses that it is important to give each part of the three-part mission equal priority. For more information on the role and purpose of the SEC, see HERE.

#2: SEC Analysis Starts and ends with the long-term interests of the Main Street investor

According to Clayton, an assessment of whether the SEC is being true to its three-part mission requires an analysis of the long-term interests of the Main Street investors, including individual retirement accounts. This involves reviewing actions in light of the impact on investment opportunities, benefits and disclosure information for “Mr. and Mrs. 401(k).”

#3: The SEC’s historic approach to regulation is sound

As I’ve written about many times, disclosure and materiality have been at the center of the SEC’s historic regulatory approach. Chair Clayton reiterates that point. The SEC does not conduct merit reviews of filings and registration statements but rather focuses on whether the disclosures provided by a company provide potential investors and the marketplace with the information necessary to make an informed investment decision. For more information on disclosure requirements and recent initiatives, see HERE and HERE.

In addition to disclosure rules, the SEC places heightened responsibility on the individuals and people that actively participate in the securities markets. The SEC has made it a priority to review and pursue enforcement actions, where appropriate, against securities exchanges, clearing agencies, broker-dealers and investment advisors. In that regard, the SEC has historically and will continue to enforce antifraud provisions. Clayton states that “wholesale changes to the Commissions’ fundamental regulatory approach would not make sense.”

#4: Regulatory actions drive change, and change can have lasting effects

Under the fourth principle, Clayton continues to speak of the benefits of the disclosure-based system for public company capital markets. However, he does note that over time, new disclosure rules have been added on to the old, based on determinations beyond materiality, and that the SEC now needs to conduct a cumulative and not just incremental view of the disclosure rules and regulations.

Clayton specifically points to the much talked about decline in the number of IPO’s over the last two decades. He also points out that the median word count for SEC filings has more than doubled in over the same period, and that reports lack readability. Clayton points out, and I agree, that fewer small and medium-sized public companies affects the liquidity and trading for all public companies in that size range. A reduction of U.S. listed public companies is a serious issue for the U.S. economy and an improvement in this regard is a clear priority to the SEC.

For more on the SEC’s ongoing Disclosure Effectiveness program, see the further reading section at the end of this blog.

#5: As markets evolve, so must the SEC

Technology and innovation are constantly disrupting the way in which markets work and investors transact. Chair Clayton is well aware that the SEC must keep up with these changes and “strive to ensure that our rules and operations reflect the realities of our capital markets.” Clayton sees this as an opportunity to make improvements and efficiencies.

The SEC itself has utilized technology to improve its own systems, including through the use of algorithms and analytics to detect companies and individuals engaged in suspicious behavior. The SEC is adapting machine learning and artificial intelligence to new functions, including analyzing regulatory filings. On the other side, the SEC has to be aware of the costs involved with implementing these changes, versus the benefits derived.

#6: Effective rulemaking does not end with rule adoption

The SEC has developed robust processes for obtaining public input (comments) and performing economic analysis related to its rulemaking. Clayton is committed to ensuring that the SEC perform rigorous economic analysis in both the proposed and adoption stages of new rules. Clayton is aware of the principle of unintended consequences in rulemaking and is committed to ensuring that rules be reviewed retrospectively as well. Clayton states, “[W]e should listen to investors and others about where rules are, or are not, functioning as intended.”

Although Clayton does not get into specifics, certainly changes are necessary in the disclosure requirements, fiduciary rule, Dodd-Frank rollbacks (see HERE on the Financial Choice Act 2.0); finders’ fees (see HERE for more), eligibility for Regulation A+ (see HERE for more), and small business-venture capital marketplace.

#7: The costs of a rule now often include the cost of demonstrating compliance

Clayton states, “[R]ules are meant to be followed, and the public depends on regulators to make sure that happens. It is incumbent on the Commission to write rules so that those subject to them can ascertain how to comply and — now more than ever — how to demonstrate that compliance.” Vaguely worded rules end up with subpar compliance and enforcement. Clayton refers to the officer and director certifications required by the Sarbanes-Oxley Act and the need to create a system of internal controls to support the ultimate words on the paper – which system can be hugely expensive.

I note that understanding rules and their application is one of the biggest hurdles in the small-cap industry, including where responsibility lies vis-à-vis different participants in the marketplace. For example, the responsibility of a company, transfer agent, introducing broker, and clearing broker in the chain of the issuance and ultimate trading of a security, continues to provide challenges for all participants. Often participants are left with an education and interpretation by enforcement process, rather than what would be a much more efficient system providing participants with the knowledge and tools to create compliance systems that prevent fraud and related issues and reduce the need for retrospective enforcement.

#8: Coordination is key

Clayton notes that “the SEC shares the financial services space with many other regulatory players charged with overseeing related or overlapping industries and market participants.” There are more than 15 U.S. federal regulatory bodies and over 50 state and territory regulators, plus the Department of Justice, state attorneys general, self-regulatory organizations (SRO – such as FINRA) and non-SRO standard-setting entities (for example, DTC) in the financial services sector. In addition, the SEC works with international regulators and markets cooperating with over 115 foreign jurisdictions.

Clayton specifically points to the regulations of over-the-counter derivatives – including security-based swaps for which the SEC shares regulatory functions with the CFTC (for more on this, see HERE). Clayton is committed to working with the CFTC to improve this particular area of financial regulation and reduce unnecessary complexity and costs.

In addition, cybersecurity is an important area requiring regulatory coordination. Information sharing is essential to address potential and respond to actual cyber threats.

Putting Principles into Practice

After laying out his eight principles for the SEC, Chair Clayton addressed some specific areas of SEC policy.

Enforcement and Examinations

Clayton is committed to deploying significant resources to enforcement against fraud and shady practices in areas where Main Street investors are most exposed, including affinity and micro-cap fraud. He indicates that the SEC is taking further steps to find and eliminate pump-and-dump scammers, those that victimize retirees, and cyber criminals. As a practitioner in the small- and micro-cap market space, I welcome and look forward to initiatives that work to reduce fraud, while still supporting the honest participants and the necessary small-business ecosystem.

Clayton also recognizes that the markets also have more sophisticated issues requiring enforcement attention related to market participants. The SEC is “committed to making our markets s fair, orderly, and efficient – and as liquid – as possible.” Although prior Commissioners and Chairs have made similar statements, the addition of “and as liquid” by this regime continues to illustrate a commitment to supporting business growth and not just enforcement.

Finally on this topic, Clayton stresses the importance of cybersecurity in today’s marketplace. Public companies have an obligation to disclose material information about cyber risks and cyber events (see HERE for more on this topic). However, cyber criminals, including entire nations, can have resources far beyond a single company, and companies should not be punished for being a victim where they are being responsible in face of cyber threats. To bring proportionality to the topic, Clayton points out that cyber threats go beyond capital markets but affect national security as well.

Capital Formation

Consistent with his pro-business attitude, Jay Clayton advocates enhancing the ability of “every American to participate in investment opportunities, including through public markets.” Of course, the flip side is the ability for businesses to raise money to grow and create jobs. Clayton is also consistent with the message that he and other Commissioners have been relaying that the U.S. public markets need to grow and become more attractive to businesses (without damaging the private marketplace).

As a first step, the SEC recently expanded the ability to file confidential registration statements for all Section 12(b) Exchange Act registration statements, initial public offerings (IPO’s) and for secondary or follow-on offerings made in the first year after a company becomes publicly reporting, to all companies. Previously only emerging growth companies (EGC’s) were allowed to file registration statements confidentially. For more on this, see my blog HERE. Clayton believes that allowing companies to submit sensitive information on a non-public basis for initial staff review, will make the going public process more attractive to earlier-stage entities.

As a last point on capital formation, Chair Clayton encourages companies to request waivers or modifications to the financial reporting requirements under Regulation S-X, where the particular disclosure or reporting is overly burdensome and not material to the total mix of information presented to investors.

Market Structure

Clayton suggests shifting the focus of the conversation on market structure to actions. He recommends proceeding with a pilot program to test how adjustments to the access fee cap under Rule 610 of the Securities Exchange Act of 1934 would affect equities trading. The pilot would provide the SEC with more data to assess the effects of access fees and rebates on market makers, pricing and liquidity. Clayton is open to that and further suggestions from the SEC’s Equity Market Structure Advisory Committee.

Clayton believes the SEC should broaden its review of market structure to also include the fixed-income markets, to provide stable investment options for retirees. In that regard the SEC is creating a Fixed Income Market Structure Advisory Committee.

Investment Advice and Disclosure to Investors

Chair Clayton addresses both the fiduciary rule and improving disclosures to investors. Related to the fiduciary rule, Clayton states that it is important for the SEC to bring clarity and consistency to the area. In that regard, in June the SEC issued a statement seeking public input and comment on standards of conduct for investment advisers and broker-dealers.

Related to disclosures, as with all other areas of disclosure, investment advisors must provide potential investors with easily accessible and meaningful information. Clayton refers to the SEC’s ongoing Disclosure Effectiveness initiative, the progress in which is summarized at the end of this blog.

Resources to Educate Investors

A priority for the SEC is to provide more information to investors through technology and other means.

Further Reading on Disclosure Effectiveness Initiative

I have been keeping an ongoing summary of the SEC’s ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. I note that we have not seen any regulatory changes since the election and new regime at the SEC, but certainly significant changes are expected in light of Chair Clayton’s, and the Commissioners’, publicly disclosed priorities.

On August 31, 2016, the SEC issued proposed amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The proposed amendments would require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the proposed amendment would also require that all exhibits be filed in HTML format. See my blog HERE on the Item 601 proposed changes.

On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE.

On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE.

That proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.

As part of the same initiative, on June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE.

As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the reporting requirements in general, see my blog HERE.

In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.

In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE.

The Author

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FINRA Proposes New Registration And Examination Rules

Posted by Securities Attorney Laura Anthony | May 30, 2017 Tags: Finra, FINRA Exam Registration, FINRA Examination Rules, FINRA New Registration, FINRA Proposes New Registration And Examination Rules, SIE Exam

On March 8, 2017, the Financial Industry Regulatory Authority (FINRA) filed a proposed rule change with the SEC to adopt amended registration rules and restructure the entry-level qualification examination for registered representatives. The new rules would also eliminate certain examination categories. FINRA is planning to implement the changes in two phases, with full implementation completed during the first half of 2017.

Securities Industry Essentials Exam

As part of the proposed amendments, FINRA introduced a new beginning-level examination called the Security Industry Essentials (SIE), which can be taken by individuals without sponsorship by a broker-dealer. The SIE would be a general-knowledge examination including fundamentals such as basic product knowledge, structure and functioning of the securities industry markets, regulatory agencies and their functions, and regulated and prohibited practices.

Under the proposed new rules, anyone desiring to work in the securities industry for a member firm would need to take the SIE. The SIE would also be open to anyone who desires to take it. When becoming employed by a member firm, a person would then need to take an additional exam associated with their particular job function (for example, series 7, 79 or 24). The new SIE exam would not change the requirement to pass tests associated with those additional licenses, or that such licenses expire if a person is not associated with a member firm for a two-year period. However, as discussed below, the proposed new rules add the ability to extend this two-year period in certain instances.

Currently, in order to qualify to take a registered representative examination to become licensed in the securities industry, a person must be employed and sponsored by a FINRA member broker-dealer. The intent of the SIE is to prequalify potential job applicants, saving member firms time and expense on vetting registered representatives and putting them through the examination process. A member firm will be able to view the SIE passing status and score on FINRA’s CRD system.

The proposed SIE is broken down into four categories: (i) “Knowledge of Capital Markets,” which focuses on topics such as types of markets and offerings, broker-dealers and depositories, and economic cycles; (ii) “Understanding Products and Their Risks,” which covers securities products at a high level as well as associated investment risks; (iii) “Understanding Trading, Customer Accounts and Prohibited Activities,” which focuses on accounts, orders, settlement and prohibited activities; and (iv) “Overview of the Regulatory Framework,” which encompasses topics such as SRO’s, registration requirements and specified conduct rules.

Individuals that have passed the SIE but not yet taken a specialized knowledge examination, would not be subject to continuing education requirements.

Individuals that are already licensed as of the effective date of the new SIE, will not need to take the exam and will be deemed to have passed such exam. The SIE qualification will remain valid for four years without the person being registered with a firm. However, other licenses, such as a Series 7, may lapse if a person is not associated with a member firm for a two-year period.

Although not discussed by FINRA, I see an opportunity to use the SIE for multiple purposes going forward as the securities laws and regulations continue to evolve. In particular, the SIE could be a factor in considering whether a person is accredited. The SIE could also be a factor in considering exemptions from the registration requirements for finders, a topic that continues to be at the forefront for regulators and practitioners alike. I will be writing about the subject of finders again very soon. In my view this is a topic that needs immediate attention. The fact is that regulators do not have the resources to police the finders industry, which has indeed become a full industry. Thousands of people operate as unlicensed finders, and their use has become accepted and commonplace in the small- and micro-cap industries. Clearly, the simple “it is not allowed” approach of regulators is not working. Unfortunately, without some parameters and workable regulation around this function, bad actors, inexperienced and completely unknowledgeable individuals hold themselves out as finders together with those that can abide by basic disclosure and antifraud provisions in the offer and sale of securities. Perhaps the SIE or a variation thereof could be used as part of a workable regulatory regime related to finders.

Extension of Time Prior to License Termination

Currently, if a registered person is not employed with a member firm for a period of two years, their securities license will lapse (except for the SIE) and they will need to retake a particular examination if they become re-employed by a member firm. The new rules allow this two-year period to be extended for up to seven years where a person is working for a non-FINRA member financial services affiliate.

That is, a person can maintain licensing for up to seven years while working for a non-FINRA member financial services affiliate of the member firm (such as a parent company) if the following conditions are met: (i) the person has been registered with a FINRA member for a total of five out of the past ten years, the most recent of which must be their current employer; (ii) when the person transitions to the affiliate, a Form U-5 must be filed notifying FINRA of the transition; (iii) the person must continue to satisfy continuing education requirements and have no pending or adverse regulatory matters; and (iv) the person must continuously work for the financial services affiliate.

If each of these qualifications is met, the person can re-register with a member firm for up to seven years without retaking a licensing examination.

Consolidated Examination Structure; Elimination of Exam Levels

Over time, the number of exams and licensing levels has expanded such that as of today, there are 16 exams with a considerable amount of content overlap and requirements for individuals to pass multiple exams to work in a given job function. There are 11 FINRA exams alone for a registered representative engaging in sales activities with investors, most of which focus on specific products, such as options or private securities.

The proposed consolidation and simplification of the examination process is the result of an effort to reduce redundancies and simplify the process, resulting in cost savings for all parties including FINRA, the member firm and representatives, and eliminating outdated examinations and materials.

A part of the consolidation and simplification is the introduction of the SIE discussed above, which will test on general securities knowledge, eliminating that portion of testing for specific specialized functions and duties of the registered representative. Under the proposed rules, a person would need to take the SIE as a precondition to taking a specialized knowledge examination. The SIE remains valid for a four-year period. Moreover, although a person is not required to be associated with a member firm to take the SIE, they will be required to be associated with and sponsored by a member firm to take the specialized knowledge exam.

The new specialized knowledge exams would eliminate questions on basic industry knowledge covered in the SIE. In addition, FINRA is proposing to reduce the current 16 exams to new exams covering: (i) investment company and variable contracts products representative (current Series 6); (ii) general securities representative (current Series 7); (iii) direct participation programs representative (current Series 22); (iv) equity trader (current Series 55); (v) investment banking representative (current Series 79); (vi) private securities offerings representative (current Series 82); (vii) research analyst (current Series 86 and 87); and (viii) operations professional (current Series 99).

In addition to consolidating certain exam levels, FINRA is proposing to eliminate the following exams: (i) option representative (Series 42); (ii) corporate securities representative and government securities representative and associated exams (Series 62 and 72); and (iii) order processing assistant (Series 11). FINRA is also considering eliminating the Series 17, 37 and 38, which deal with representatives who conduct cross-border foreign business with the U.K. and Canada.

Registration Amendments

Under current rules, FINRA limits individuals that can obtain a securities license, to those working in certain functions. Currently a person must be actively engaged in the securities or investment banking business of a firm in order to be licensed, subject to certain exceptions. Those exceptions include, for example, persons performing legal, compliance, internal-audit, back-office or similar functions and persons performing administrative functions for registered persons.

The new rules would eliminate the restrictions on these permissive registrations, and allow any employee of a member firm to take examinations and be licensed in any capacity which that firm’s membership with FINRA encompasses. For example, a person not actively engaged in investment banking could nevertheless take the Series 79, or a person not actively engaged in retail client management could take the Series 7. The new rules add supervisory responsibilities for the member firm related to persons holding licenses in areas for which they are not actively engaged.

Among other benefits, the intent of the new rules is to simplify the registration requirements and encourage individuals to cross-train within a member firm’s organization.

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Recommendations Of SEC Government-Business Forum On Small Business Capital Formation

Posted by Securities Attorney Laura Anthony | May 23, 2017 Tags: ATS Registration, Blue Sky Pre-Emption, Finra, Form S-3, NASAA, Non-GAAP Accounting Standards, OTC Markets, Regulation A, Regulation CF, Regulation S-K, Rule 144, Rule 147, Rule 147A, Rule 15C2-11, Rule 504, Rule 506(b) Offerings, SEC, SEC Advisory Committee, SEC Office of Small Business Policy, SEC Rule 15c2-11, Section 4(a)(2), Small Business Capital Formation, Smaller Reporting Companies

In early April, the SEC Office of Small Business Policy published the 2016 Final Report on the SEC Government-Business Forum on Small Business Capital Formation, a forum I had the honor of attending and participating in. As required by the Small Business Investment Incentive Act of 1980, each year the SEC holds a forum focused on small business capital formation. The goal of the forum is to develop recommendations for government and private action to eliminate or reduce impediments to small business capital formation.

The forum is taken seriously by the SEC and its participants, including the NASAA, and leading small business and professional organizations. The forum began with short speeches by each of the SEC commissioners and a panel discussion, following which attendees, including myself, worked in breakout sessions to drill down on specific issues and suggest changes to rules and regulations to help support small business capital formation, as well as the related, secondary trading markets. In particular, the three breakout groups were on exempt securities offerings; smaller reporting companies; and the secondary market for securities of small businesses.

Each breakout group is given the opportunity to make recommendations. The recommendations were refined and voted upon by the forum participants in the few months following the forum and have now been released by the SEC in a report containing all 15 final recommendations. In the process, the participants ranked the recommendations by whether it is likely the SEC will give high, medium, low or no priority to each recommendation.

Recommendations often gain traction. For example, the forum first recommended reducing the Rule 144 holding period for Exchange Act reporting companies to six months, a rule which was passed in 2008. Last year the forum recommended increasing the financial thresholds for the smaller reporting company definition, and the SEC did indeed propose a change following that recommendation. See my blog HERE for more information on the proposed change. Also last year the forum recommended changes to Rule 147 and 504, which recommendations were considered in the SEC’s rule changes that followed. See my blog HERE for information on the new Rule 147A and Rule 147 and 504 changes.

Forum Recommendations

The following is a list of the recommendations listed in order or priority. The priority was determined by a poll of all participants and is intended to provide guidance to the SEC as to the importance and urgency assigned to each recommendation. I have included my comments and commentary with the recommendations.

As recommended by the SEC Advisory Committee on Small and Emerging Companies, the SEC should (a) maintain the monetary thresholds for accredited investors; and (b) expand the categories of qualification for accredited investor status based on various types of sophistication, such as education, experience or training, including, but not limited to, persons with FINRA licenses, CPA or CFA designations, or management positions with issuers. My blog on the Advisory Committee on Small and Emerging Companies’ recommendations can be read HERE. Also, to read on the SEC’s report on the accredited investor definition, see HERE.
The definition of smaller reporting company and non-accelerated filer should be revised to include an issuer with a public float of less than $250 million or with annual revenues of less than $100 million, excluding large accelerated filers; and to extend the period of exemption from Sarbanes 404(b) for an additional five years for pre- or low-revenue companies after they cease to be emerging-growth companies. See my blog HERE for more information on the current proposed change to the definition of smaller reporting company and HERE related to the distinctions between a smaller reporting company and an emerging-growth company.
Lead a joint effort with NASAA and FINRA to implement a private placement broker category including developing a workable timeline and plan to regulate and allow for “finders” and limited intermediary registration, regulation and exemptions. I think this topic is vitally important. The issue of finders has been at the forefront of small business capital formation during the 20+ years I have been practicing securities law. The topic is often explored by regulators; see, for example, the SEC Advisory Committee on Small and Emerging Companies recommendations HERE and a more comprehensive review of the topic HERE which includes a summary of the American Bar Association’s recommendations.

Despite all these efforts, it has been very hard to gain any traction in this area. Part of the reason is that it would take a joint effort by FINRA, the NASAA and both the Divisions of Corporation Finance and Trading and Markets within the SEC. This area needs attention. The fact is that thousands of people act as unlicensed finders—an activity that, although it remains illegal, is commonplace in the industry. In other words, by failing to address and regulate finders in a workable and meaningful fashion, the SEC and regulators perpetuate an unregulated fringe industry that attracts bad actors equally with the good and results in improper activity such as misrepresentations in the fundraising process equally with the honest efforts. However, practitioners, including myself, remain committed to affecting changes, including by providing regulators with reasoned recommendations.

The SEC should adopt rules that pre-empt state registration for all primary and secondary trading of securities qualified under Regulation A/Tier 2, and all other securities registered with the SEC. I have been a vocal proponent of state blue sky pre-emption, including related to the secondary trading of securities. Currently, such secondary trading is usually achieved through the Manual’s Exemption, which is not recognized by all states. There is a lack of uniformity in the secondary trading market that continues to negatively impact small business issuers. For more on this topic, see my two-part blog HERE and HERE.
Regulation A should be amended to: (i) pre-empt state blue sky regulation for all secondary sales of Tier 2 securities (included in the 4th recommendation above); (ii) allow companies registered under the Exchange Act, including at least business development companies, emerging-growth companies and smaller reporting companies, to utilize Regulation A (see my blog on this topic, including a discussion of a proposed rule change submitted by OTC Markets, HERE ); and (iii) provide a clearer definition of what constitutes “testing-the-waters materials” and permissible media activities.
Simplify disclosure requirements and costs for smaller reporting companies and emerging-growth companies with a principles-based approach to Regulation S-K, eliminating information that is not material, reducing or eliminating non-securities-related disclosures with a political or social purpose (such as pay ratio, conflict minerals, etc.), making XBRL compliance optional and harmonizing rules for emerging-growth companies with smaller reporting companies. For more on the ongoing efforts to revise Regulation S-K, including in manners addressed in this recommendation, see HERE and for more information on the differences between emerging-growth companies and smaller reporting companies, see HERE.
Mandate comparable disclosure by short sellers or market makers holding short positions that apply to long investors, such as through the use of a short selling report on Schedule 13D.
The SEC should provide scaled public disclosure requirements, including the use of non-GAAP accounting standards that would constitute adequate current information for entities whose securities will be traded on secondary markets. This recommendation came from the secondary market for securities of small businesses breakout group. I was part of the smaller reporting companies breakout group, so I did not hear the specific discussion on this recommendation. However, I do note that Rule 144 does provide for a definition of adequate current public information for companies that are not subject to the Exchange Act reporting requirements. In particular, Rule 144 provides that adequate current public information would include the information required by SEC Rule 15c2-11 and OTC Markets specifically models its alternative reporting disclosure requirements to satisfy the disclosures required by Rule 15c2-11.
The eligibility requirements for the use of Form S-3 should be revised to include all reporting companies. For more on the use of Form S-3, see my blog HERE.
The SEC should clarify the relationship of exempt offerings in which general solicitation is not permitted, such as in Section 4(a)(2) and Rule 506(b) offerings, with Rule 506(c) offerings involving general solicitation in the following ways: (i) the facts and circumstances analysis regarding whether general solicitation is attributable to purchasers in an exempt offering should apply equally to offerings that allow general solicitation as to those that do not (such that even if an offering is labeled 506(c), if in fact no general solicitation is used, it can be treated as a 506(b); and (ii) to clarify that Rule 152 applies to Rule 506(c) so that an issuer using Rule 506(c) may subsequently engage in a registered public offering without adversely affecting the Rule 506(c) exemption. I note that within days of the forum, the SEC did indeed issue guidance on the use of Rule 152 as applies to Rule 506(c) offerings, at least as relates to an lternative trading systemintegration analysis between 506(b) and 506(c) offerings. See my blog HERE.
The SEC should amend Regulation ATS to allow for the resale of unregistered securities including those traded pursuant to Rule 144 and 144A and issued pursuant to Sections 4(a)(2), 4(a)(6) and 4(a)(7) and Rules 504 and 506.
The SEC should permit an ATS to file a 15c2-11 with FINRA and review the FINRA process to make sure that there is no undue burden on applicants and issuers. An ATS is an “alternative trading system.” The OTC Markets’ trading platform is an ATS. This recommendation would allow OTC Markets to directly file 15c2-11 applications on behalf of companies. A 15c2-11 application is the application submitted to FINRA to obtain a trading symbol and allow market makers to quote the securities of companies that trade on an ATS, such as the OTC Markets. Today, only market makers seeking to quote the trading in securities can submit the application. Also today, the application process can be difficult and lack clear guidance or timelines for the market makers and companies involved. This process definitely needs attention and this recommendation would be an excellent start.
Regulation CF should be amended to (i) permit the usage of special-purpose vehicles so that many small investors may be grouped together into one entity which then makes a single investment in a company raising capital under Regulation CF; and (ii) harmonize the Regulation CF advertising rules to avoid traps in situations where an issuer advertises or engages in general solicitations under Regulation A or Rule 506(c) and then converts to or from a Regulation CF offering.
The SEC should provide greater clarity on when trading activities require ATS registration, and when an entity or technology platform needs to a funding portal, broker-dealer, ATS and/or exchange in order to “be engaged in the business” of secondary trading transactions.
Reduce the Rule 144 holding period to 3 months for reporting companies. I fully support this recommendation.

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FinCEN Updates Due Diligence Rules

Posted by Securities Attorney Laura Anthony | September 6, 2016 Tags: AML Procedures, AML Programs, AML Rules, CIP Rule, CIP Rules, Due Diligence Rules, FinCEN, Finra, FINRA Rule 3310, The Bank Secrecy Act, The USA Patriot Act

On May 11, 2016, the Financial Crimes Enforcement Network (“FinCEN”) issued new final rules under the Bank Secrecy Act requiring financing institutions, including brokerage firms, to adopt additional anti-money laundering (AML) procedures that include specific due diligence and ongoing monitoring requirements related to customer risk profiles and customer information. In addition, the new rules require financial institutions to collect and verify information about beneficial owners and control person of legal entity customers.

The Securities Exchange Act of 1934 (“Exchange Act”) specifically requires brokerage firms to comply with the Bank Secrecy Act. FinCEN provides minimum rules. Brokerage firms are also required to comply with AML rules established by FINRA, including FINRA Rule 3310. The purpose of the AML rules is to help detect and report suspicious activity including the predicate offenses to money laundering and terrorist financing, such as securities fraud and market manipulation. FINRA also provides a template to assist small firms in establishing and complying with AML procedures. As of the date of this blog, FINRA has not updated Rule 3310 or its form template.

The new rules will make the difficult process of opening brokerage accounts even more difficult, especially for foreign individuals and entities and U.S. individuals and entities operating through offshore entities. The new rules could impact the ongoing process of depositing and trading in penny stocks, even for existing brokerage firm clients. FinCEN initially issued advance notice of proposed rulemaking in March 2012 and issued proposed rules in August 2014. A push to issue final rules gained momentum following the release of the Panama Papers. The new rules become effective for new customer accounts opened on or after May 11, 2018; however, as discussed below, where appropriate it may have retroactive application.

FinCEN requires that financial institutions address the following four key elements in all of their AML programs: (i) customer identification and verification; (ii) beneficial ownership identification and verification; (iii) understanding the nature and purpose of customer relationships to develop risk profiles; and (iv) ongoing monitoring for reporting suspicious transactions and maintaining and updating customer information.

Obligation to identify and verify beneficial ownership

The USA Patriot Act grants authority to FinCEN to establish rules for financial institutions to identify and verify customer information and establish AML procedures in general. All financial institutions are required to have minimum AML procedures, and the application of these procedures has been the subject of many enforcement proceedings. The initial customer identification program rule (CIP Rule) was enacted in 2003 and required financial institutions to identify any individual or entity that opened an account but did not require identification of beneficial ownership.

A “legal entity” is defined as a corporation, limited liability company, partnership or other entity that is created by the filing of a public document with a U.S. state or foreign governmental body. Under the new rules, the financial institution will need to identify beneficial owners of a legal entity that own (i) 25% or more of the equity of the legal entity; and (ii) any control persons over the legal entity, including officers, directors and senior management. Certain entities are excluded from the definition of an “entity” for purposes of the CIP rules, including financial institutions, banks, bank holding companies, certain pooled investment funds, state regulated insurance companies and foreign financial institutions.

Subject to certain exclusions, the new rule requires financial institutions to identify and verify the beneficial owners of their legal entity customers. The rulemaking process included numerous comments on this requirement. As a concession, the final rule generally does not contain a requirement that the financial institution verify that a listed beneficial owner in fact holds the disclosed ownership interest or exerts actual control over the entity.

As with most such rules, the financial institution can establish written processes and procedures tailored to that institution and its operations. Such processes and procedures must include a consideration of both the ownership test and control test of beneficial ownership. A financial institution must collect information on all individuals who either directly or indirectly own 25% or more of the equity of an entity. Where a financial institution has questions or determines there are risk factors, they may collect identifying information on owners with a lower percentage as well. In addition, the financial institution must collect information on all individuals that have the ability to control, manage or direct the entity, including officers, directors and key management.

The terms “direct and indirect” and “control” remain undefined and are to be broadly construed based on facts and circumstances to encompass all forms of potential ownership and control. Likewise, when making risk and knowledge assessments, the financial institution must consider all facts and circumstances and is held to a “reasonableness” standard.

Financial institutions must verify the collected information. The original CIP Rule established verification requirements based on risk. The same risk-based verification processes remain in place, with some modifications. In essence, the financial institution must gather due diligence, including corporate records, ownership records and the like, and continue such process until it is satisfied it has enough information on the beneficial owners of that particular entity, considering the risk imposed by that entity.

There are two significant modifications from the CIP Rule. In particular, a financial institution may rely on photocopies of documents rather than originals, and the institution may rely on disclosures of ownership from the entity itself except where it has knowledge of facts that would call into question the reliability or veracity of such information.

The risk assessment in the CIP Rule includes a consideration of all relevant facts and circumstances, including, but not limited to: (i) type of account; (ii) method of opening account; (iii) size of account and trading activity; (iv) type of identifying customer information; (v) relationship with the customer, including other accounts with the same beneficial owners, length of relationship, personal knowledge, and account activity; (vi) whether the customer has a physical address or physical business location; (vii) whether the customer has a U.S. tax identification number; and (viii) historical activity, including a suspicious activity.

Although the rule sets a firm requirement that financial institutions complete written procedures and apply them to all accounts opened on or after May 11, 2018, FinCEN is clear that a financial institution has a broad requirement to monitor and know its customers. Where risks are identified, additional procedures as outlined in the new rules should be applied to accounts, effective immediately. In addition, financial institutions should have ongoing monitoring procedures and may, where appropriate, go back and ask for information on existing accounts, as well as require updated information for accounts on a continuing basis. For instance, if an account has suspicious activity or contradictory ownership or control information is brought to the financial institution’s attention, there would be an obligation to conduct further due diligence and update and verify ownership and control information.

Basic AML Procedure Requirements

The USA Patriot Act sets out the basic requirements for effective AML policies and procedures. In particular, an effective AML program requires: (i) written policies and procedures; (ii) a designated compliance officer; (iii) an ongoing training program; (iv) an independent audit; and (v) customer due diligence. The new rules are focused on the fifth element: customer due diligence.

An effective customer due diligence process must have procedures for effectively understanding a customer relationship and establishing a customer risk profile, and for ongoing monitoring and compliance procedures, including those related to detecting and reporting suspicious activities and updated customer beneficial ownership and control information.

The Bank Secrecy Act imposes an obligation on broker-dealers to file a SAR with FinCEN to report any transaction (or a pattern of transactions) involving $5,000 or more, in which it “knows, suspects, or has reason to suspect” that it “(1) involves funds derived from illegal activity or is conducted to disguise funds derived from illegal activities; (2) is designed to evade any requirements of the Bank Secrecy Act; (3) has no business or apparent lawful purpose and the broker-dealer knows of no reasonable explanation for the transaction after examining the available facts; or (4) involves use of the broker-dealer to facilitate criminal activity.”

SEC guidance points out red flags that should cause a broker to conduct further investigation as to whether a SAR needs to be filed, including:

Read More

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 ofLawCast.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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« DTC Again Proposes Procedures For Issuers Subject To Chills And Locks SEC Requests Comment On Changes To Subpart 400 To Regulation S-K »

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

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

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SEC Continues Efforts To Prevent Microcap Fraud

Posted by Securities Attorney Laura Anthony | August 16, 2016 Tags: Finra, Micro-Cap Fraud, Microcap Fraud, SEC

As I’ve written about numerous times in the past, a primary agenda of the SEC and FINRA is to prevent small- and micro-cap fraud. On March 23, 2016, the SEC charged Guy Gentile with penny stock fraud. The SEC complaint, as well as numerous industry articles and a blog by Mr. Gentile himself, reveal in-depth efforts by the SEC together with FINRA and the FBI and DOJ to remove recidivist and bad actors from the micro-cap system. While the methods used by the regulators have been the subject of heated debates and articles, the message and result remain that the SEC is committed to its efforts to deter securities law violations.

Although small- and micro-cap fraud has always been an important area of concern and enforcement by the SEC since the financial crisis of 2008, it has increasingly been a focus. Regulators have amplified their efforts through regulations and stronger enforcement, including the SEC Broken Windows policy, increased Dodd-Frank whistleblower activity and reward payments, CEO and CFO liability for SEC reports under the Sarbanes-Oxley Act and increased bad actor prohibitions. See my blog HERE related to the SEC Broken Windows policy and CEO/CFO liability (as an aside, I note that the proposed Stronger Enforcement of Civil Penalties Act never made it past its introduction in July 2015) and HERE related to Rule 506 and Regulation A bad actor prohibitions.

The fight against small- and micro-cap fraud is an industry positive overall. While not a regulator, OTC Markets itself has taken great strides in improving the quality of and information available related to OTC Markets-traded companies, including through qualitative and quantitative standards for quotation on both the OTCQB (see my blog HERE) and OTCQX (see my blog HERE).

The Guy Gentile Case

On March 23, 2016, the SEC charged Guy Gentile with penny stock fraud. The SEC litigation release alleges that Gentile, who owned and operated Sure Trader, a registered broker-dealer, engaged in manipulative trading, provided illegal kickbacks, illegally issued unregistered stock and distributed promotional mailings of glossy newsletters using fake publication names to pump the stocks of at least two penny stocks (KYUS and RVNG). The SEC continues that Gentile misled investors with positive but fake price and volume trends while concealing the control persons’ identities and compensation. Apparently, Gentile, together with attorney Adam Gottbetter and a few stock promoters, controlled large blocks of the companies’ stock, which control was not disclosed in company filings or the promotional activities.

The SEC complaint, filed in March 2016, details Gentile’s actions involving KYUS and RVNG, which actions occurred in 2007 and 2008. As alleged by the SEC, the entire history of RVNG and KYUS was a fraud, from its creation using a sham registration (see my blog HERE for more on this) to its issuances of freely tradable securities to insiders, manipulative trades and promotional activities.

The SEC complaint does not address the fact that a period of 8-9 years went by between the illegal activities and the filing of the complaint. Guy Gentile has written a detailed blog explaining his version of events, or more precisely, what happened in the missing years. In particular, Gentile claims that he was arrested in 2012 and that from that time until the complaint against him in March 2016, he acted as a cooperating witness and SEC and FBI informant, assisting in the indictment of over a dozen individuals related to hundreds of millions of dollars in pump-and-dump and other illegal activities and resulting in over $12 million in fines and disgorgements with the potential of tens of millions more to come.

Gentile details his involvement in elaborate, and sometimes dangerous, undercover operations. The complaint, together with Gentile’s blog and numerous industry articles on the events, reads like a movie. It is undisputed that Gentile’s brokerage firm, Sure Trader, which was based in the Bahamas, remained in business and continued to market to U.S.-based retail customers after Gentile’s arrest in 2012 and through at least July 2015. It appears that the entire firm was wired up and all happenings were being recorded by the FBI.

Guy Gentile’s biggest defense is the statute of limitations, which is five years. However, apparently he signed a waiver of the statute of limitations while acting as an informant.

The prevention of fraud has been on the SEC agenda since the commission was founded in 1933, with efforts intensifying as the sophistication of the marketplace has grown. On November 17, 2009, President Obama established, by executive order, an Interagency Financial Fraud Enforcement Task Force to strengthen efforts to combat financial crime. To start, the Department of Justice led the task force and the Department of Treasury, HUD and the SEC served on the steering committee. The task force’s leadership, along with representatives from federal agencies and regulatory authorities, continue to work with state and local partners to investigate and prosecute significant financial crimes, address discrimination in the lending and financial markets, and recover proceeds for victims.

Putting aside the entertainment value of the entire case, it does fully illustrate the commitment by regulators to attack small- and micro-cap fraud. Clearly, the more of these egregious activities that are uncovered and prosecuted, the more success legitimate small businesses will have raising capital, growing, and supporting the U.S. economy including through job creation.

Conclusion

It is undisputed that emerging companies play a critical role in the U.S. economy, supporting growth, innovation and job creation. The JOBS Act made dramatic changes to the landscape for the marketing and selling of both private and public securities. These significant changes include: (i) the creation of Rule 506(c), which came into effect on September 23, 2013, and allows for general solicitation and advertising in private offerings where the purchasers are limited to accredited investors; (ii) the overhaul of Regulation A creating two tiers of offerings, which came into effect on June 19, 2015, and allows for both pre-filing and post-filing marketing of an offering, called “testing the waters”; (iii) the addition of Section 5(d) of the Securities Act, which came into effect in April 2012, permitting emerging-growth companies to test the waters by engaging in pre- and post-filing communications with qualified institutional buyers or institutions that are accredited investors; and (iv) Title III crowdfunding, which came into effect on May 19, 2016, and allows for the use of Internet-based marketing and sales of securities offerings.

Furthermore, the OTC Markets has proven itself as a small-cap venture exchange, supporting the secondary trading of small and emerging growth companies and providing a respected trading platform for companies prior to moving on to an exchange such as NASDAQ or the NYSE MKT.

The other side of these initiatives is the real concern of fraud. I’m not expressing an opinion on the methods used by the regulators in this case, but I do support the efforts. I also believe in the basic principle that it is better for the industry that investors believe egregious fraudulent activities will be prosecuted.

This firm does not participate in SEC enforcement proceedings or related litigation matters; however, as with any good securities attorney, we keep our clients informed of the law so that they can avoid participation in these proceedings.

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.

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The ECOS Matter; When Is A Reverse Split Effective?

Posted by Securities Attorney Laura Anthony | March 11, 2015 Tags: Duty of Care, Finra, Going Public Attorneys, OTC Attorneys, OTC Marketplace, OTC Markets Attorneys, Reverse Merger Attorneys, Reverse Mergers Attorneys, Reverse split, Rule 10b-17, Rule 6490

In what was presumably an unintended consequence, the application of an SEC- approved FINRA regulation has resulted in a conflict between state and federal corporate law for a small publicly traded company.

On September 16, 2014, Ecolocap Solutions, Inc. (“ECOS”) filed a Form 8-K in which it disclosed that FINRA had refused to process its 1-for-2,000 reverse split. At the time of the FINRA refusal, ECOS had already received board and shareholder approval and had filed the necessary amended articles with the State of Nevada, legally effectuating the reverse split in accordance with state law. Moreover, ECOS is subject to the reporting requirements under the Securities Exchange Act of 1934, as amended (“Exchange Act”), and had filed a preliminary and then definitive 14C information statement with the SEC, reporting the shareholder approval of the split.

The ECOS 8-K attached a copy of the FINRA denial letter, which can be viewed HERE. In support of its denial of the reverse split, FINRA relied upon its discretion under FINRA Rule 6490 and the existence of a previous SEC action against an individual who is the principal of an entity that is a convertible note holder of ECOS. In particular, FINRA cited an SEC order issued on November 25, 2013 against Curt Kramer, Mazuma Corporation, Mazuma Funding Corporation and Mazuma Holding Corporation involving violations of Section 5 of the Securities Act of 1933 and Rule 504. FINRA cited that Curt Kramer is a principal of Asher Enterprises and that Asher Enterprises, in turn, is a convertible note holder in ECOS and therefore FINRA was refusing to process the reverse split.

In its 8-K filing, ECOS took a strong stance against FINRA, stating that pricing information published by FINRA is inaccurate. In support of their position, ECOS sets forth that the subject reverse split was already legally effective in accordance with state law and therefore FINRA’s refusal to reflect such capital change in ECOS trading quotation results in public misinformation regarding the company’s capitalization. ECOS also objected to FINRA’s application of Rule 6490 in this case by denying that either Mr. Kramer or Asher Enterprises is “connected” with the company as contemplated by the Rule. Furthermore, they stated that the subject SEC action was completely unrelated to ECOS or the reverse split.

Although FINRA has not issued a responsive statement, one of its mandates is to protect investors and maintain fair and orderly markets. In this instance, the Company’s stock is actively trading at $.0001 per share. The Company’s total outstanding shares increased from 893,615,983 one year ago to 6,865,010,372 as of April 2014. ECOS has been in the development stage since January 1, 2007 and has not reported any revenues since September, 2010. The overwhelming majority of the increase in outstanding stock is the result of the conversion of convertible debt, and most of funds received by the company from the note holders was used for salaries, as well as interest on the convertible debt and fees for staying a publicly-traded company (such as satisfying reporting obligations). Although the information in the Company’s filings as to its business operations is sparse, it has been in the same business with the same management since 2007, without any financial success. As of June 30, 2014, the Company had approximately $664,000 in convertible outstanding notes payable. The Company intends to complete a 1:2000 reverse split, which will reduce the total outstanding shares to 3.9 million and presumably increase the share price to $.20.

However, the Company’s new, higher share price will likely be temporary due to the lack of any underlying business success to create support for a higher market valuation. In addition, FINRA realizes that in all probability, upon enactment of the inflated share price, existing note holders have an increased incentive to convert their debt into freely tradable shares and may begin selling these shares in the market. Should such selling pressure occur, and the new share price decrease, any shareholder that purchased at $.20 will most likely suffer a loss. Should the cycle of selling continue, the outstanding shares will increase, potentially into the billions, until the share price is once again $.0001. Taking this into account, FINRA’s concerns are self-evident.

There clearly exists a fundamental conflict between federal and state law and the ability to regulate corporate actions. It raises the basic question of “When is a reverse split effective?” If pursued, this action opens the door for court interpretation of FINRA’s authority under Rule 6490 in general.

Rule 6490

Effective September 27, 2010, the SEC approved FINRA Rule 6490 (Processing of Company Related Actions). Rule 6490 requires that corporations whose securities are trading on the over-the-counter market (OTCQX, OTCQB, OTCBB or pinksheets) timely notify FINRA of certain corporate actions, such as dividends, forward or reverse splits, rights or subscription offerings, and name changes. The Rule grants FINRA discretionary power when processing documents related to the announcements.

Rule 6490 works in conjunction with Exchange Act Rule 10b-17. Rule 10b-17 provides that “it shall constitute a manipulative or deceptive device or contrivance as used in section 10(b) of the Act for any issuer of a class of securities publicly traded… to fail to give notice in accordance with paragraph (b) of this section of the following actions relating to such class of securities: (1) a dividend or other distribution in cash or in kind… (2) a stock split or reverse split; or (3) a rights or other subscription offering.” Section (b) requires that notice be given to FINRA “no later than 10 days prior to the record date involved.”

FINRA also issues trading symbols to over-the-counter traded issuers and maintains a database of trading symbols for issuers. When FINRA completes the processing of a corporate action, OTC marketplace is notified of such changes and actions. Most commonly, changes and actions include the re-pricing of securities after a forward or reverse split and the issuance of a new trading symbol following a name change or merger.

Prior to 2010, FINRA’s role has been predominantly ministerial due to their limited jurisdictional ability to impose informational or other regulatory requirements, and fundamental lack of power to reject requested changes. However, since the SEC began expressing concern that entities were using FINRA to assist in fraudulent activities, Rule 6490 was created.

The Rule codifies FINRA’s authority to conduct in-depth reviews of company-related actions and equips the staff with discretion to refuse the processing of such actions in situations when the information or requisite forms are incomplete or when certain indicators of potential fraud exist. FINRA staff now possesses broad discretion to request additional documents and supporting evidence to verify the accuracy of submitted information.

Rule 6490(d)(3) provides:

(3) Deficiency Determination

In circumstances where an SEA Rule 10b-17 Action or Other Company-Related Action is deemed deficient, the Department may determine that it is necessary for the protection of investors, the public interest and to maintain fair and orderly markets, that documentation related to such SEA Rule 10b-17 Action or Other Company-Related Action will not be processed. In instances where the Department makes such a deficiency determination, the request to process documentation related to the SEA Rule 10b-17 Action or Other Company-Related Action, as applicable, will be closed, subject to paragraphs (d)(4) and (e) of this Rule. The Department shall make such deficiency determinations solely on the basis of one or more of the following factors: (1) FINRA staff reasonably believes the forms and all supporting documentation, in whole or in part, may not be complete, accurate or with proper authority; (2) the issuer is not current in its reporting requirements, if applicable, to the SEC or other regulatory authority; (3) FINRA has actual knowledge that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected to the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action are the subject of a pending, adjudicated or settled regulatory action or investigation by a federal, state or foreign regulatory agency, or a self-regulatory organization; or a civil or criminal action related to fraud or securities laws violations; (4) a state, federal or foreign authority or self-regulatory organization has provided information to FINRA, or FINRA otherwise has actual knowledge indicating that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected with the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action may be potentially involved in fraudulent activities related to the securities markets and/or pose a threat to public investors; and/or (5) there is significant uncertainty in the settlement and clearance process for the security. (emphasis added)

Exchange Act Rule 10b-17 appears to be limited to notice and allows the SEC to pursue an enforcement action for the failure to give such notice in a timely manner. Rule 6490 goes further, stating a corporation action “will not be processed” if FINRA makes a “deficiency determination.” Clearly subsections (3) and (4) give broad discretionary authority to FINRA to render such a deficiency determination and refuse to process an action.

Further exacerbating the existing conflict between the application of state and federal law is the fact that FINRA requires that a Company submit the file-stamped amendments to its corporate charter as part of their review process. Simply stated, the FINRA corporate action process requires that a Company legally completes the corporate action (reverse split, name change, etc.) on the state level prior to issuing a determination as to whether it will process the already-completed change with the marketplace.

State vs. Federal Regulation of Corporate Law

Historically the regulation of corporate law has been firmly within the power and authority of the states. However, over the past few decades the federal government has become increasingly active in matters of corporate governance. In waves, typically following a period of scandal in business or financial markets, the federal government has enacted regulation either directly or indirectly imposing upon state corporate regulations. The predominant method of federal regulation of corporate governance is through the enactment of mandatory terms that either reverse or preempt state law rules on the same point.

State corporation law is generally based on the Delaware and Model Act and offers corporations a degree of flexibility from a menu of reasonable alternatives that can be tailored to companies’ business sectors, markets and corporate culture. Moreover, state judiciaries review and rule upon corporate governance matters considering the facts and circumstances of each case and setting factual precedence based on such individual circumstances. The traditional fiduciary duties that govern state corporations laws include the duties of care and loyalty and are tempered by the business judgment rule.

The duty of care requires that directors exercise the same level of care that would be expected from an ordinarily prudent person in the conduct of his or her own affairs. This includes making an informed decision, seeking the advice of experts when necessary, and considering both the positive and negative impacts of a decision. The duty of loyalty is essentially a proscription against conflict of interest and self-dealing. The business judgment rule basically says that if a director follows both his duty of loyalty and duty of care, then the decision should be deferred to.

Director actions that result in a fraud upon shareholders and investors is actionable under federal (and state) securities laws. Both the state and federal securities regulators are charged with preventing fraud on the markets and protecting the integrity of the trading markets in general.

Conclusion

The ECOS matter has raised heated debate on whether FINRA fairly applied its authority in this case and as to the meaning of “connected.” Publicly traded companies, by nature, have ever-evolving shareholders and investors, the identities of which are often not in the power or control of the company itself. Stock is personal property that generally may be freely transferred by its owners (which should not be confused with suggesting that such transferred stock is always freely tradable on a public market). Debt instruments are negotiable instruments and generally transferrable by the debt holder. The sale and transfer of such debt instruments is common. In the small cap world, changes in management and control are fairly commonplace, as is the change in the business direction of a company.

Regulators are tasked with the job of supporting these changes in the small and micro-cap space and giving every entrepreneur a fair shot while preventing abuses in the system and what such as in this case, they ultimately see, as crossing the line.

Clearly it is problematic when state and federal rules and regulations cause a conflicting result, leaving a board of directors, shareholders and the investing public in a state of flux. What is the capitalization of ECOS? In accordance with state law, the company has approximately 3.4 million shares issued and outstanding; however, according to the over-the-counter marketplace, the company has approximately 6.8 billion shares outstanding. Legally it seems that the company has 3.4 million shares of stock outstanding at a trading price of $.0001 and that FINRA’s refusal to process relates solely to a refusal to re-price the stock as a result of the reverse split and not a broader refusal to recognize the validly of the share reduction itself.

However, many people in the industry are debating the impact and meaning of the decision with divergent views and conclusions, including the legal effect of the reverse split.

A discussion of federal law pre-emption is beyond the scope of this blog. However, even if I did include a treatise on the subject, the answer would be difficult. As an attorney I could write a very good argument that state law applies (the states regulate corporations and where the federal law would yield a different result, state law should apply), and I could also write a very good argument that federal law applies (the states regulate corporations and where the federal law would yield a different result, state law should apply except where there is a competing strong federal policy – such as the regulation of public markets). I could argue that the federal government has no right to stop a corporation from effectuating a name change or reverse split but only the power to prosecute the failure to provide adequate notice of same. I could also argue that the federal government has the right to take actions that may prevent fraud being committed on public markets, including by refusing to allow a name change or reverse split.

The Author

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

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. Inquiries of a technical nature are always encouraged.

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FINRA Seeks to Eliminate the OTCBB and Impose Regulations on the OTC Markets

Posted by Securities Attorney Laura Anthony | March 11, 2015 Tags: Finra, OTC BB, OTC Markets, OTCBB, OTCQX, PinkSheets, Rule 6431

On October 7, 2014, the SEC published a release instituting proceedings to determine whether to approve FINRA’s request to delete the rules related to, and the operations of, the OTC Bulletin Board quotation service. On June 27, 2014, FINRA quietly filed a proposed rule change with the SEC seeking to adopt rules relating to the quotation requirements for OTC equity services and to delete the rules relating to the OTCBB and thus cease its operations. Although the rule filing was published in the Federal Register, it garnered no attention in the small cap marketplace. Only one comment letter, from OTC Market Group, Inc. (“OTC Markets”) (i.e., the entity that owns and operates the inter-dealer quotation system known by its OTC Pink, OTCQB and OTCQX quotation tiers) was submitted in response to the filing.

The OTCBB has become increasingly irrelevant in the OTC marketplace for years. In October 2010, I wrote a blog titled “Has the OTCBB been replaced by the OTCQX and OTCQB”; at the time and up until May 16, 2013, my opinion was “yes” with one caveat. Prior to May 16, 2013, the OTCBB was considered “an established market” but the OTCQB and OTCQX were not. On May 16, 2013, that caveat was removed (see the blog detailing the changes Here) In particular, on May 16, 2013, the SEC updated their Compliance and Disclosure Interpretations confirming that the OTCQB and OTCQX marketplaces are now considered public marketplaces for purposes of establishing a public market price when registering securities for resale in equity line financings.

Since that time, the OTCBB has been largely irrelevant, and worse, a cause of confusion in the OTC marketplace. The OTC market is comprised of publicly traded securities that are not listed on a national securities exchange. The trading platforms for OTC securities are referred to as “inter-dealer quotation systems.” Today there are two main inter-dealer quotation systems: (i) the OTC Markets comprised of OTCQX, OTCQB, and pinksheets (www.otcmarkets.com); and (ii) the FINRA owed OTCBB (www.otcbb.com). Many small cap participants believe that the OTC marketplace is comprised of a single marketplace, and are confused by the actual existence of two such marketplaces.

The regulatory framework related to inter-dealer quotation services and OTC securities in general is widely centered on ensuring compliance with Section 17B of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Section 17B of the Exchange Act is the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (the “Penny Stock Act”). Although a complete discussion of the Penny Stock Act is beyond the scope of this blog, the goal of the Act is to ensure the widespread dissemination of reliable and accurate quotation information on penny stocks. Over time, the OTC Markets has become much more efficient in meeting the goals of the Penny Stock Act while at the same time, the OTCBB has become much less efficient at meeting those same goals.

As set forth in the SEC Release, “FINRA proposed to adopt rules: (1) governing the treatment of quotations in OTC equity securities by member inter-dealer quotation systems and addressing fair and non-discriminatory access to such systems; (2) requiring member inter-dealer quotation systems to provide FINRA with a written description of quotation-related data products offered and related pricing information, including fees, rebates, discounts and cross-product pricing incentives; (3) expanding the reporting requirements related to quotation information in OTC equity securities; and (4) deleting the Rule 6500 Series and related rules and thereby ceasing operation of the OTCBB.”

The FINRA rule release seeks to eliminate the OTCBB and impose governing regulations on the remaining inter-dealer quotation system—to wit, the OTC Markets comprised of the OTCQX, OTCQB, and pinksheets (www.otcmarkets.com).

Proposed Deletion of the OTCBB Related Rules and OTCBB Marketplace

FINRA is proposing to delete the FINRA Rule 6500 Series, which governs the operation of the OTCBB, and cease operation of the OTCBB. In its request, FINRA states that the level of transparency in OTC equity securities facilitated by the OTCBB has been declining significantly for years such that the amount of information widely available to investors relying on the OTCBB bid and offer data has become negligible. FINRA further expressed its belief that “the remaining OTCBB information being disseminated to investors is so incomplete as to be potentially misleading with respect to the current pricing in these securities.”

There are approximately 10,000 OTC equity securities quoted on the OTC Markets, of which less than 10% are duly quoted on the OTC Markets and OTCBB and fewer than twelve (yes, 12) are solely quoted on the OTCBB. Moreover, it is widely known in the industry that the technology used to facilitate quotation on the OTCBB is antiquated and unreliable such that broker-dealers are derisive of using the system. Accordingly, FINRA notes that the discontinuance of the OTCBB will not have an impact on issuers, investors or member firms. FINRA has also committed to take steps to ensure a smooth transition for those few issuers still using the OTCBB system, including by directly contacting these issuers and assisting with a transition to OTC Markets.

Finally, FINRA believes that the requirements related to the Penny Stock Act, and in particular widely disseminated information regarding penny stocks, better lay with the issuers, broker-dealers, and FINRA members (such as OTC Markets) rather than with FINRA itself, which is an SRO (self-regulatory organization). In other words, FINRA does not believe it needs to own and operate an inter-dealer quotation system. However, presumably to address the SEC concerns in this regard, if the availability of quotation information to investors significantly declines, FINRA has committed to revisit and, if necessary, file a proposed rule change to establish an SRO-operated inter-dealer quotation system (or other measure) to ensure that compliance with the Penny Stock Act is met.

In response to FINRA’s request to eliminate the OTCBB, the SEC received a single comment letter and it was from OTC Markets. Needless to say, OTC Markets strongly supports the proposal as well as the proposed amendments to Rule 6431 discussed below. OTC Markets welcomes the enhanced responsibility and regulations imposed upon it and FINRA’s oversight as a regulator, and it agreed with all aspects of FINRA’s proposals. OTC Markets stated that the discontinuation of FINRA’s OTCBB, together with FINRA’s expanded oversight of OTC Markets, would help eliminate investor and issuer confusion while promoting compliance with the Penny Stock Act.

OTC Markets points out that “FINRA’s OTCBB no longer provides broker-dealers with an effective service for pricing securities, and market participants will be better served by FINRA regulating Qualifying IQSs [inter-dealer quotation services] instead of expending resources trying to operate the OTCBB.”

The Proposed Regulatory Rule Changes Related to Inter-Dealer Quotation Systems

Pursuant to Section 15A of the Exchange Act, FINRA is tasked with adopting and implementing regulations designed “to produce fair and informative quotations, to prevent fictitious or misleading quotations, and to promote orderly procedures for collecting, distributing, and publishing quotations.” In that regard, FINRA has developed a regulatory framework including FINRA’s Rule 6400 series (Quoting and Trading in OTC Equity Securities) and Rule 5200 Series (Quotation and Trading Obligations and Practices) and the Rule 6500 series, governing the OTCBB. FINRA also owns and operates the OTCBB.

The current regulatory framework governs the FINRA member firm’s quotation activity and not the inter-dealer quotation service itself. That is, the current regulatory framework governs the broker-dealers/FINRA member firms’ activities in entering quotes on the inter-dealer quotation system, but does not impose rules or regulations on the inter-dealer quotation system itself.

For example, there are rules that require FINRA members to either file a Form 211 with FINRA including due diligence and disclosure on the company whose securities are being quoted, or be able to rely on another firm’s 211 filing (piggyback qualified) prior to initiating a quote; rules related to minimum bid price increments ($0.0001 for OTC equity securities priced under $1.00 and $.01 for those priced over $1.00); rules prohibiting cross-quotation; rules requiring the display of customer limit orders; and a requirement that any quoted bid or asked price represent a bona fide bid for or offer of such security (i.e., the “fictitious quotation” prohibition).

FINRA is now proposing to adopt rules that regulate the inter-dealer quotation service itself, which after elimination of the OTCBB will be comprised of the OTC Markets, including the OTCQX, OTCQB, and pinksheets.

Proposed Rule 6431 Amendment

FINRA is proposing to implement new regulations by amending Rule 6431 to require OTC Markets (or any inter-dealer quotation service) to: “(1) adopt and provide to FINRA written policies and procedures relating to the collection and dissemination of quotation information in OTC equity securities, (2) establish and provide to FINRA fair and non-discriminatory written standards for granting access to quoting and trading on its system, and (3) provide to FINRA for regulatory purposes a written description of each quotation-related data product offered by such member inter-dealer quotation system and related pricing information, including fees, rebates, discounts and cross-product pricing incentives.”

Rule 6431 (Recording of Quotation Information) was originally implemented in 2003 to provide FINRA with access to quotation information on the OTC marketplace. When implemented, FINRA member broker-dealers had the duty to independently report to FINRA when quoting on the OTC Markets, because at the time OTC Markets was not, in and of itself, a FINRA member. Since that time, OTC Markets has become a licensed ATS (Alternative Trading System) and FINRA member. The proposed Rule 6431 amendment includes an adjustment such that now OTC Markets will be required to provide the quotation information and the broker-dealer will not. In practice, OTC Markets has been submitting the information on behalf of member firms already, and the rule change will codify this practice and officially relieve the broker-dealer member firm from the obligation.

As the vast majority of securities quoted on the OTC markets are also penny stocks, the new rules will also bolster the Exchange Act requirements related to ensuring the availability and dissemination of reliable and accurate information on penny stocks.

(1) Written policies and procedures relating to the collection and dissemination of quotation information

The amended Rule 6431 would require OTC Markets (or any inter-dealer quotation service) to establish, maintain and enforce fair and reasonable written policies and procedures relating to the collection and dissemination of quotation information in OTC equity securities. Such policies and procedures must ensure that quotations received are treated fairly and consistently and include methods for prioritizing and displaying such quotations. In simple terms, if an investor enters a buy or sell order with a broker, or a market maker enters such buy or sell order for their own account, there must be systems in place to ensure that that order is treated fairly vis-a-vis competing buy and sell orders on behalf of other investors through other brokerage firms and market makers.

In that regard, under amended Rule 6431, the OTC Markets will be required to address its method for ranking quotations, including factors such as price, size, time, capacity and type of quotation and any other factors used or considered in ranking and displaying quotations. OTC Markets will also be required to provide FINRA with a copy of its written policies and procedures relating to the collection and dissemination of quotation information, and any material updates, modifications and revisions thereto, upon enactment of the Rule change and thereafter within five business days following the establishment or material change in such written policy or procedure.

(2) Written standards for granting access to quoting and trading on its system

The amended Rule 6431 would require OTC Markets to establish “fair and non-discriminatory written standards for granting access to quoting and trading on the system that do not unreasonably prohibit or limit any person in respect to access to services offered by such inter-dealer quotation system.” In addition, OTC Markets will be required to keep records of all grants of access and denials or limitations of access, including the reasons for denying or limiting access. OTC Markets must provide FINRA with a copy of these written standards upon enactment of the Rule change and thereafter within five business days following the establishment or material change in such written standards.

(3) Written description of each quotation-related data product and related pricing information

The amended Rule 6431 would require OTC Markets to prepare a written description of each quotation-related product offered and related pricing information, including fees, rebates, discounts and cross-product pricing incentives—for example, the listing requirements for the OTCQB including application and annual fees (see Here); the OTC Disclosure and News Service; and the various other products and services offered by OTC Markets. OTC Markets must provide FINRA with a copy of the written product descriptions upon enactment of the Rule change and thereafter within five business days following the establishment or material change in such products or pricing.

SEC Proceedings Related to Approval of the Proposals

The SEC has instituted proceedings to determine whether the proposed rule changes, including elimination of the OTCBB, should be approved. The SEC is requesting comments from interested persons in support or opposition to the change. The SEC notes that in considering the proposal, it must (i) determine whether the changes are “designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest”; (ii) the rules include provisions governing the form and content of quotations on the OTC marketplace; and (iii) whether the rules support the Penny Stock Act.

The SEC has opened a 21-day total period to submit comments and a 35-day total comment period including time for rebuttals to submitted comments.

Brief Commentary

First, like OTC Markets, I am proponent of the rule changes all around. The discontinuation of the OTCBB is a natural and necessary progression of the reality of the marketplace.

However, neither the legal publications by FINRA or the SEC nor the comment letter from OTC Markets address some basic market realities. That is, with the elimination of the OTCBB and the implementation of listing standards and fees associated with quotation on the OTCQB, a new regime has been established for OTC market securities. Penny Stock issuers that are subject to the reporting requirements of the Exchange Act will no longer have the ability to achieve the turnkey credibility associated with not being a pinksheet.

Although pinksheets will now include a large class of entities that are subject to the Exchange Act reporting requirements, in order to achieve a level of credibility and prestige, such issuers will be required to meet the quotation standards and pay the fees associated with listing on the OTCQB or OTCQX. I wonder if issuers that do not meet the standards for the OTCQB will opt to cease being subject to the Exchange Act reporting requirements in a sort of acquiescence to the new regime – i.e., if we are going to be a pinksheet anyway, why report, resulting in an overall reduced level of disclosure in the OTC marketplace.

The Author

Attorney Laura Anthony

LAnthony@LegalAndCompliance.com

Founding Partner, Legal & Compliance, LLC

Securities, Reverse Merger and Corporate Attorneys

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