SEC Issues White Paper On Penny Stock Risks
On December 16, 2016, the SEC announced several new settled enforcement proceedings against market participants including issuers, attorneys and a transfer agent, related to penny stock fraud. On the same day the SEC issued a new white paper detailing the risks associated with investing in penny stocks. This blog summarizes the SEC white paper.
As I have written about on numerous occasions, the prevention of micro-cap fraud is and will always be a primary focus of the SEC and other securities regulators. In fact, the SEC will go to great lengths to investigate and ultimately prosecute micro-cap fraud. See my blog HERE regarding the recent somewhat scandalous case involving Guy Gentile.
Introduction
The SEC Division of Economic and Risk Analysis published a white paper on the risks and consequences of investing in stocks quoted in the micro-cap markets versus those listed on a national securities exchange. The paper reviewed 1.8 million trades by more than 200,000 investors and concludes that returns on investment in the micro-cap markets tend to be negative with the returns and risk worsening for less transparent companies or those involved in improper promotional campaigns.
The white paper notes that the incidence of and amount of negative returns, as well as alleged market manipulation increase with the fewer disclosure-related requirements associated with the company. The white paper, on the whole, is very negative towards OTC Markets securities. However, off the top, I think the white paper is skewed unfairly against OTC Markets securities when it should target those lower-tier securities that do not provide disclosures to the public.
This blog will summarize the white paper, including many of its facts and figures, but will find issue with its framework. The white paper does not give fair distinction to the higher OTCQX tier of OTC Markets. In fact, “OTCQX” only appears twice in the entire white paper, both in a footnote that purports to list the OTCQX requirements, but fails to mention the quantitative requirements, including that the security not be a penny stock as defined by the federal securities laws. The shortened “QX” does appear 13 times in the white paper, providing some factual and statistical information such as market size and trading patterns, but again, ignores the meaningful distinction related to the penny stock definition. For a review of the OTCQX tier of OTC Markets and its listing requirements, see my blog HERE.
It is axiomatic that the vast majority of new jobs are created by small and emerging companies and that these companies are critical to the economic well being of the United States. See, for example, my blog on the SEC report on the definition of accredited investor HERE and its study on private placements HERE.
According to both Bloomberg and Forbes, 8 out of 10 new businesses fail within 18 months and that number jumps to 96% in the first 10 years. However, despite that failure rate, it is indisputable that we need entrepreneurs to continue forming new businesses and access supportive capital, to have a healthy economy.
Likewise, it is axiomatic to all micro-cap market participants that those companies that fail to provide meaningful disclosure to the public, are more likely to result in investment losses. Those companies are also more likely to engage in market manipulation and other securities law violations. However, those companies that do provide meaningful disclosure to the public, whether through SEC reporting or alternatively to the OTC Markets, and especially those companies that trade on the OTCQX, are the very small and emerging companies that are necessary and vital to our healthy economy. They may be the 8 out of 10 or the 96%, but some will also be the 2 out of 10 and 4% – and all are necessary.
Also, the fact is that bank financing is not readily available for these companies, and they have no choice but to try to access capital through the public. That public wants an exit strategy and that exit strategy tends to be the public markets. Where the companies are small and immature in their business life cycle, the OTC Markets provide that secondary trading market. In discussing this aspect of the economies of these small public companies, they are more positively referred to by the SEC as “venture” companies and the trading market as a “venture exchange” (see my blog HERE).
Many times when a company ceases to provide disclosure or information to the public and remains dark for a period of time, its business operations have failed, it has gone private, or otherwise has been abandoned. These companies continue to trade, and sometimes with high volume with no public information. The SEC makes an effort to eliminate these companies through its Operation Shell-Expel (see HERE), but unfortunately many remain and new ones are added all the time as the 8-out-of-10 cycle continues.
Although all penny stocks are risky, and are undeniably the highest-risk investments, grouping all OTC Markets into the white paper, in the fashion that the SEC has done, strikes me as fundamentally unfair. Throughout my summary of the SEC White Paper, I provide thoughts and commentary.
SEC White Paper
The SEC White Paper begins with an introduction on some high-level differences between an exchange traded security and one on the OTC Markets. One of the biggest distinctions is that the majority of ownership and trading of an exchange listed security is by institutional investors, whereas the majority of ownership and trading on the OTC Markets is by individuals. The SEC points out that institutions tend to be more proactive in research and shareholder activism, creating a check on corporate governance. As an aside, these institutions are also more sophisticated and able to assert greater influence and power over a company than an individual small shareholder.
The SEC quickly highlights the negative literature on OTC Markets securities, including that they have poor liquidity, generate negative and volatile returns and are often subject to market manipulation, including by the dissemination of false and misleading information. Although OTC securities offer the opportunity to invest in early-stage companies that may grow to be larger successful ones, the number that do exceed is small (such as the 2 out of 10 in my summary above).
One portion of the white paper’s information I find interesting is that despite the risks, OTC Markets continue to grow and investor demands for these stocks continues to rise. The SEC offers two hypotheses for this. The first is that OTC investors are simply gambling for the big return, just as they do with the lottery. The second is that OTC Markets investors simply make bad investment decisions. However, the report does admit that little is known about the characteristics of OTC investors and that this is likely the first comprehensive study trying to determine those demographics. Personally, I also think that many OTC Markets investors are day traders and that although a particular stock may go down over time, those day traders are taking advantage of the small intraday price changes to make a profit.
The SEC reviewed 1.8 million trades by more than 200,000 investors and concludes that returns on investment in the micro-cap markets tend to be negative, with the returns and risk worsening for less transparent companies or those involved in improper promotional campaigns, and are also worse for elderly and retired investors and those with lower levels of income and education. The SEC white paper purports to be the first study of its kind that examines investor outcomes around stock promotions and level of disclosure.
I would suggest that the exact same results (i.e., lower returns on less transparent investments and those engaged in improper promotional campaigns and lower returns for the elderly and lower income and education demographic) would be found for any investments in any studied market and are not unique to OTC Markets securities. To be clear, I don’t think the correlation is necessarily improper activity, though that could be the case especially when looking at some stock promotions. Companies that provide less disclosure may have less capital and financial resources to further their business plan and, as such, are far riskier investments. Also, companies that provide less disclosure may be less interested in furthering the public aspect of their business. Even if the underlying business is sound, if they are not providing public disclosure, the stock price and liquidity are unlikely to reflect the underlying business, which could result in poor investor returns.
The SEC white paper continues with a three-part discussion: (i) OTC Market structure and size; (ii) review of academic literature; and (iii) analysis of OTC investor demographics and outcomes.
OTC Market Structure and Size
The SEC white paper describes the basic makeup of OTC Markets including its three tiers of OTC Pink, OTCQB and OTCQX. I’ve written about these market tiers many times. For a review of the three tiers, see my blog HERE, though I note that both the OTCQB and OTCQX have updated their listing standards since that blog was written. The OTC Pink remains unchanged. For the most current listing standards on the OTCQX see HERE and for the OTCQB see HERE.
The SEC white paper also references the OTCBB, which technically still exists, but has fewer than 400 listed securities and does not have a readily accessible quote page.
The SEC white paper has a lot of information on the market size and its growth over the years. Without getting into a lot of facts and figures, I note that the OTC Markets grew by 47% from 2012 through 2015, with $238 billion of trading in 2015. There are approximately 10,000 securities quoted on OTC Markets, as compared to approximately 2,700 on NASDAQ, of which only approximately 675 are micro-cap companies.
The OTC Markets monthly newsletter gives a complete review and breakdown of the size of OTC Markets. For the one month of December 31, 2016, the following is the number of traded securities and volume:
| Monthly Trade Summary – December 2016 | |||||||||||||||||||||||||||||||||
|
Literature Review
The SEC white paper continues with a summary of recent academic research and analysis including on OTC Markets securities’ liquidity, returns, market manipulation, transition to an exchange and investor participation.
Liquidity refers to the ability of shareholders to quickly buy and sell securities near the market price without substantial price impact. Where there is a lack of liquidity, it is difficult to sell. Also, low-volume stocks tend to have wider price fluctuations and bid-ask spreads, and are more expensive for dealers to hold in inventory. OTC Markets securities are less liquid than those listed on a national exchange such as the NYSE MKT or NASDAQ. Research also shows that there tends to be lower liquidity with less transparency and disclosure. None of this is surprising, though many of us that work in the OTC Markets space have seen the anomaly of a company with no information, and likely no underlying business or management, trading on heavy volume.
The returns on OTC Markets securities are also very different than exchange traded securities. Returns on OTC Markets are often negative, volatile and skewed (the lottery factor). Where the majority of trades have negative returns, there is the incidence of extremely high, lottery-like returns on some of the securities. This, again, is not surprising. OTC Markets-traded companies tend to be smaller companies and thus would naturally have a smaller market capitalization and smaller returns as well as the potential for larger upside.
Again, returns on companies that provide less transparency and public information tend to be lower. Interestingly, another hypothesis as to why returns are lower is the short-sale constraints on OTC Market securities. Many OTC Market securities are ineligible for margin (and thus short sales), and locating shares for borrow can be challenging. Those that are margin-eligible usually have a very high carry interest and per-share transaction cost for short sales. The argument is that short sales create an equilibrium and thus help reflect a truer stock price such that the stock will be less vulnerable to negative price adjustments. However, unfortunately, sophisticated traders can open offshore accounts that will allow for short selling of OTC Market securities, opening those same securities up to manipulation by those investors.
OTC Markets securities are relatively often the target of market manipulation, including outright fraudulent disclosures and pump-and-dump schemes. Generally these schemes are conducted in the trading of those companies that are less transparent in disclosures. A market manipulation scheme can involve the dissemination of false information followed by taking advantage of the price changes that result. The scheme can be perpetrated by the company and its insiders, or by unaffiliated investors. Examples include spam and email campaigns, rumors and false information in Internet chat rooms or forums, and false “analyst reports.” Research shows these schemes are effective – that is, the price increases while the stock is being touted and falls when the campaign is over.
Obviously not all increases in stock prices are a result of improper behavior. OTC Markets stocks react to legitimate news and growth as well. In fact, the majority of extreme increases in trading price and volume are the result of changes in company fundamentals and not market manipulation. Moreover, not investor relations and stock promotion is perfectly legal and can be completely legitimate. It is when false or misleading information is being disseminated, or targeted marketing aimed at vulnerable investor groups is used, that it is problematic. The key is recognizing the difference, which generally involves transparency from companies that provide steady, consistent disclosure with apparent credible information.
Many OTC investors are hoping to “bet” on the company that will grow and move to an exchange where it is likely the stock price will increase substantially, as will liquidity. The SEC white paper gives dismal statistics on the rates of graduation. However, it does note that the rate of movement to an exchange is much higher for OTCQX or OTCQB (9%) than OTC Pink companies (less than 1%). The SEC white paper also suggests that companies that graduate to an exchange from the OTC Markets underperform those companies that go public onto an exchange in the first instance.
The last area that the SEC white paper discusses in this section is investor participation and, in particular, why that investor participation continues to grow year over year. The SEC white paper gives two hypotheses, the first being that investors are drawn by the opportunity for lottery-like payoff and the second is that investors are “duped about the stock return probabilities.” Although this sounds harsh, the white paper is not actually referring to market manipulation, but rather suggests that all OTC investors, including the most sophisticated, make poor estimates on return probabilities. No reason for this is offered.
Studies show that although investors frequently lose small investments in OTC stocks, they also occasionally receive an extremely large return. As such, the SEC white paper suggests that these investors are really just gamblers. I’m sure that oftentimes is correct.
Data Analysis and Investor Demographics
The Division of Economic and Risk Analysis studied a sampling of trades for specific securities and time periods which included information on the issuer, trade and investor. The purpose of the review was to determine a relationship between investor returns on the one hand and stock promotions, company transparency and investor demographics on the other hand. However, the information used for the analysis is admittedly biased in that such information was taken from the SEC enforcement files for the year 2014. Since one or more parties to the trades were the subject of enforcement proceedings, this information would not be indicative of the usual OTC company.
The SEC white paper comes to the conclusion that there is a positive correlation between losses and market manipulation and lack of transparency. As discussed above, this is not surprising and is actually quite logical. The white paper also found a positive correlation between losses and elderly, lower-income and poorly educated investors.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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FINRA Seeks to Eliminate the OTCBB and Impose Regulations on the OTC Markets
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
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.
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Management’s Discussion and Analysis of Financial Condition and Results of Operation (MD&A)
Management’s discussion and analysis of financial condition and results of operation, commonly referred to as MD&A is an integral parts of annual (Form 10-K) and quarterly (Form 10-Q) reports filed with the Securities and Exchange Commission (SEC). MD&A is also included in registration statements filed under both the Securities Exchange Act of 1934 (Form 10) and Securities Act of 1933 (Form S-1). MD&A requires the most input and effort from officers and directors of a company and due to the many components of required information, often generates SEC review and comments. Item 303 of Regulation S-K sets forth the required content for MD&A.
A MD&A discussion for quarterly reports on Form 10-Q is abbreviated from the requirements for annual reports on Form 10-K and registration statements. Although quarterly reports must discuss each item enumerated below the discussion is expected to be more focused concentrating on the most relevant and material items. In addition, as with my other blogs, this discussion will be limited to the requirements for small public companies (i.e. those with revenues of less than $75 million).
The SEC has issued guidance and interpretation on MD&A, which is helpful in understanding its required content. Pursuant to the SEC, MD&A has three primary purposes. These are:
• to provide a narrative explanation of a company’s financial statements that enables investors to see the company through the eyes of management;
• to enhance the overall financial disclosure and provide the context within which financial information should be analyzed; and
• to provide information about the quality of, and potential variability of, a company’s earnings and cash flow, so that investors can ascertain the likelihood that past performance is indicative of future performance.
Management, and company counsel, should keep these purposes in mind in drafting and finalizing MD&A. The content should not be overly technical, but neither should it be a forum for marketing content. Now, onto the specific MD&A requirements as set forth in Item 303 of Regulation S-K.
In each annual report on Form 10-K, and registration statements on either Forms 10 or S-1, a company must discuss its financial condition, changes in financial condition and results of operations. In addition to the four areas of discussion listed below, a company must include any other relevant information within its knowledge, which information provides a better or more complete understanding of their finances and financial condition. The four areas of financial discussion include:
A company must identify any known trends or known demands, commitments, events or uncertainties that will result in or reasonably could result in an increase or decrease in liquidity. In addition, a company must identify sources and uses of liquidity and any known changes thereto. Explanations of the information provided is required. In layman terms, liquidity is a discussion of sources of cash and uses of cash, and factors that could change or impact either, both as reflected in the financial period covered by the subject report, and for the future. Although not all inclusive, the discussion, at a minimum, should address all items included in the statement of cash flows provided as part of the financial statements. This item, together with the second area of discussion, capital resources, are considered so important the SEC has issued an interpretive release addressing these two areas separately from the rest of MD&A.
A discussion of capital resources includes all material commitments for capital expenditures, the purpose and the source of funds for these commitments. This would include outstanding debts and obligations and simply put, where the money will come from to pay them. In addition, capital resources include a discussion of trends, favorable and unfavorable, that could impact capital resources. An obvious example would be a change in government regulation directly related to the company’s business.
Results of operations include four areas of discussion: (i) unusual or infrequent events that have impacted on a company’s financial condition. An example would be a discontinuance of a specific product line, or sale of company subsidiary. (ii) trends that could have an impact on sales or revenues or income in general, including trends impacting costs and expenses; (iii) a narrative discussion of increases or decreases in sale or revenues; and (iv)impact of inflation and other external financial conditions.
Off balance sheet arrangements have gained notoriety as a result of the recent economic turmoil caused by the mortgage scandal. An off balance sheet arrangement is any arrangement that could have an impact on a balance sheet, the most obvious example being a guarantee of a third party’s obligation. Accordingly, if a company has such an arrangement to report, they are required to provide a detailed analysis including the potential impact and relative importance of the arrangement.
Attorney Laura Anthony,
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions
Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public Companies as well as private Companies intending to go public on the Over the Counter Bulletin Board (OTCBB), now known as the OTCQB. For more than a decade Ms. Anthony has dedicated her securities law practice towards being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.
Ms. Anthony’s focus includes but is not limited to compliance with the reporting requirements of the Securities Exchange Act of 1934, as amended, (“Exchange Act”) including Forms 10-Q, 10-K and 8-K and the proxy requirements of Section 14. In addition, Ms. Anthony prepares private placement memorandums, registration statements under both the Exchange Act and Securities Act of 1933, as amended (“Securities Act”). Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of the Exchange Act, state law and FINRA for corporate changes such as name changes, reverse and forward splits and change of domicile.
Contact Legal & Compliance LLC for a free initial consultation or second opinion on an existing matter.
« Form 10-Q – Quarterly Reports SEC Staff Review of Super 8-K’s »
OTCQB and OTCQX Compared and Contrasted
Over the past few years, the historical PinkSheets has undergone some considerable changes, starting with the creation of certain tiers of Issuers and culminating in its refurbished website and new URL “OTCMarkets.com”.
The new OTCMarkets.com divides Issuers into three (3) levels: OTCQX; OTCQB and PinkSheets. From a fundamental perspective, Issuers on the OTCQX must be fully reporting and current in their reporting obligations with the SEC and also undergo a quality review by industry professionals. Issuers on the OTCQB must be fully reporting and current in their reporting obligations with the SEC but do not undergo additional quality review.
Issuers on the OTCQB are analogous to previous OTCBB listed entities. Although the OTCBB technically still exists, it is losing company quotations daily, mainly as market makers choose the full service, one stop shopping of the OTC Markets, to quote the stock of over the counter trading Issuers. OTCQB Issuers are current with their reporting requirements to the SEC pursuant to the Exchange Act of 1934. Market Makers quoting the stock of OTCQB Issuers either have a current 15c2-11 or are relying on the piggy back qualification.
Issuers with stock quoted on the OTCQX are not only current with their reporting obligations, but have undergone industry professional review. That is, in addition to meeting the requirements of the securities laws and SEC, these entities have opted to undergo greater scrutiny from the industry. The benefits to Investors in being able to rely on this quality review are enormous.
OTC Markets has established standardized methods for professionals to review the quality of Issuer information. In addition, OTC Markets has set forth standards for the qualifications of those responsible for undertaking the quality review. Lastly, OTC Markets maintains a strict accountability policy for securities attorneys, PCAOB auditors and other professionals who do not perform their review obligations properly and/or who do not adhere to OTC Markets standards. Issuer service providers that report false information to OTC Markets may ultimately find themselves blacklisted from the website. Consequently, it is essential that attorneys, auditors and any other professionals who submit Issuer data to OTC Markets confirm with absolute certainty that they their information is correct and complete.
Prior to the enactment of the OTCQX tier by the OTC Markets, for quality of disclosure review, Investors had to rely on either the SEC review process or analyst reports. However, these sources are not consistent and as for the later, not necessarily reliable. The SEC does not review all documents filed by all Issuers, not even close. They simply do not have the resources nor personnel to do so. Accordingly, the quality of disclosure of any given Issuer may not meet even basic legal requirements and an Investor would have no easy way of determining which filings have been reviewed and which have not.
Relying on analysts’ reports entails tremendous risk because not all of them are licensed. Many “analysts” are simply stock promoters being paid to write glowing recommendations about a particular stock. Even the most well-intentioned analysts do not always verify the information provided to them by the issuer. Many are seeking to line their own pockets by selling their shares in an inflated market after their favorable report is disseminated. Inversely, others have shorted the stock and will profit in the down market after their unfavorable report reaches the street. Ultimately, there is no easy way for an Investor to discern whether a given report is prepared by a licensed, unbiased, honest professional – until now.
In addition, OTCQX offers Investors and Issuers various perks usually associated with trading on an Exchange (a stock exchange, such as the NASDAQ is different than the Over the Counter Market in that they have listing standards, such as price of stock, and have ongoing governance and compliance standards, such as audit committee review). These perks include, but are not limited to, real time quotes and various computerized communication resources for investor relations.
Attorney Laura Anthony
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions
Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public Companies as well as private Companies intending to go public on the Over the Counter Bulletin Board (OTCBB), now known as the OTCQB. For more than a decade Ms. Anthony has dedicated her securities law practice towards being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.
Ms. Anthony’s focus includes but is not limited to compliance with the reporting requirements of the Securities Exchange Act of 1934, as amended, (“Exchange Act”) including Forms 10-Q, 10-K and 8-K and the proxy requirements of Section 14. In addition, Ms. Anthony prepares private placement memorandums, registration statements under both the Exchange Act and Securities Act of 1933, as amended (“Securities Act”). Moreover, Ms. Anthony represents both target and acquiring companies in reverse and forward mergers, including preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of the Exchange Act, state law and FINRA for corporate changes such as name changes, reverse and forward splits and change of domicile.
Contact Legal & Compliance, LLC for a free initial consultation or second opinion on an existing matter.
« Performing Due Diligence on Subject Companies During Reverse Mergers Registering An IPO On Form S-1, Part One »
The End Of An Era; The OTCBB Has Been Replaced By The OTCQB
A few months ago I wrote an article predicting that the new “OTC Markets,” formerly known as the Pink Sheets, and it’s OTCQX and OTCQB quotation tiers were replacing the antiquated, formerly FINRA-run OTCBB. Current events add further evidence to this view. Recently, more than 1000 Companies which were trading on both the OTCBB and OTCQB were delisted from the OTCBB and now trade exclusively on the OTCQB tier of the OTC Markets. These entities are quickly becoming known by their new moniker, OTCQB Companies.
The Investment Banking firm of Rodman & Renshaw acquired the OTCBB from FINRA last year.
An OTCBB By Any Other Name
For more than a year leading up to this large scale, mass delistment, it has been impossible to decipher between an OTCBB Company and a Reporting Pink Sheet Company when viewing the OTC Markets website. Both entities appeared under the heading of “OTCQB.” It was essential to reference other source material in order to make the distinction.
The now privately owned and operated OTCBB quietly delisted approximately 1,000 fully reporting and current, public companies from its quotation medium, initially citing “failure to comply with Rule 15c2-11”. Subsequent delistments cited “Ineligible for quotation on OTCBB due to quoting inactivity under SEC Rule 15c2-11.”
Delistments Means Little to Nothing
Most, if not all, of these companies did not receive notice of their “delisting”. Moreover, most, if not all, of these companies still do not know that they are no longer OTCBB quoted companies. In fact, the change has had little if no impact on these companies and will likely not have future impact. Each of these companies continue to be quoted on the OTCQB on the website for OTC Markets.
Issuer Reporting Obligations
Issuers on the OTCQB must be fully reporting and current in their reporting obligations with the SEC. Although the entire Over the Counter is regulated by the SEC and FINRA, the OTC Markets and the OTCBB are both now privately owned and merely serve as quotation mediums. However, and most importantly, the OTC Markets is more user friendly and factually up to date and accurate than the website for the OTCBB. So, if all Over the Counter quotes can be found at www.otcmarkets.com and companies trading on the OTCQB have the exact same standards as the OTCBB, and FINRA is no longer directly associated with the OTCBB, is there any reason for the OTCBB to even exist?
The fact sheet on www.otcmarkets.com has this to say regarding OTCQB quoted securities:
“With over 94% of all market maker quotes in OTC securities published on OTC Markets Group’s platform vs. 6% on the FINRA BB, it is important that OTC Markets Group provide a separate designation to identify OTC-traded companies that are U.S. registered and reporting. OTC Markets Group has launched the OTCQBtm marketplace to help investors easily identify SEC reporting companies and regulated banks that are current with their disclosure obligations.”
In summary, the curtains have closed on the OTCBB in name only and its business as usual for the new OTCQB.
The Author
Attorney Laura Anthony,
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions
Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public Companies as well as private Companies intending to go public on the Over the Counter Bulletin Board (OTCBB), now known as the OTCQB. For more than a decade Ms. Anthony has dedicated her securities law practice towards being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.
Ms. Anthony’s focus includes but is not limited to compliance with the reporting requirements of the Securities Exchange Act of 1934, as amended, (“Exchange Act”) including Forms 10-Q, 10-K and 8-K and the proxy requirements of Section 14. In addition, Ms. Anthony prepares private placement memorandums, registration statements under both the Exchange Act and Securities Act of 1933, as amended (“Securities Act”). Moreover, Ms. Anthony represents both target and acquiring companies in reverse and forward mergers, including preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of the Exchange Act, state law and FINRA for corporate changes such as name changes, reverse and forward splits and change of domicile.
Contact Legal & Compliance. LLC for a free initial consultation or second opinion on an existing matter.
Alternatives To Going Public – Private Company Financing Options »