SEC Has Approved A Two-Year Tick Size Pilot Program For Smaller Public Companies
On May 6, 2015 the SEC approved a two-year pilot program with FINRA and the national securities exchanges that will widen the minimum quoting and trading increments, commonly referred to as tick sizes, for the stocks of smaller public companies. The goal of the program is to study whether wider tick sizes improve the market quality and trading of these stocks.
The basic premise is that if a tick size is wider, the spread will be bigger, and thus market makers and underwriters will have the ability to earn a larger profit on trading. If market makers and underwriters can earn larger profits on trading, they will have incentive to make markets, support liquidity and issue research on smaller public companies. The other side of the coin is that larger spreads and more profit for the traders equates to increased costs to the investors whose accounts are being traded.
The tick size program includes companies that meet the following $3 billion or less in market capitalization, an average trading volume of one million shares or less, and a volume weighted average price of at least $2.00 for every trading day. The pilot study group includes a control group of 1400 securities and three test groups with 400 securities in each. Notably, the tick size program will not include micro-cap securities with a weighted average price of less than $2.00 per day.
During the pilot the control group will be quoted at the current tick size increment of $.01 per share and will trade at the currently permitted increments. The first test group will be quoted in increments of $.05 but will continue to trade at any price increment that is currently permitted. The second test group will be quoted in increments of $.05 and will also trade at $.05 minimum increments subject to certain exceptions. The third test group will be quoted in increments of $.05 and will be subject to an additional “trade at” requirement to prevent price matching. The third test group will have the same exceptions as the second and an additional block size exception.
Background and Reasoning for the Program
Since the inception of decimalization in 2001 and minimum price variation of one penny for exchange-traded companies, there has been a significant change in the nature of trading and role of market participants. Many market participants believe that underwriters and market makers have lost their incentive to make markets and produce research for micro-, small- and mid-capitalization companies.
The JOBS Act directed the SEC to conduct a study and report to Congress on how decimalization affected the number of IPO’s and the liquidity and trading of stock in smaller public companies. The JOBS Act also gives the SEC the authority to designate a minimum increment for the trading of emerging growth companies that is more than $.01 but less than $.10. In July 2012 the SEC submitted the “Decimalization Report” to Congress, failing to reach a firm conclusion and instead realizing further research was needed, including by pursuing a pilot program to study the impact of wider tick sizes. The SEC believes that the current approved tick size pilot program will provide the necessary information to determine whether to permanently change tick sizes for these smaller companies.
As mentioned, the goal of the program is to study whether wider tick sizes improve the market quality and trading of these stocks. The basic premise is that if a tick size is wider, the spread will be bigger, and thus market makers and underwriters will have the ability to earn a larger profit on trading. If market makers and underwriters can earn larger profits on trading, they will have incentive to make markets, support liquidity and issue research on smaller public companies. Moreover, additional market makers may enter the market as they see an opportunity to earn value. Additional market makers will equate to additional liquidity, which in turn attract more investors.
Issuers benefit from increased liquidity and market activity and quality in several ways. More trading activity and increased investor awareness could reduce the company’s cost of capital and improve opportunities to attract capital. That is, more investors will be willing to invest directly into the company, through PIPE transactions, registered secondary offerings, equity lines and the like as they will see a strong exit strategy. Moreover, with higher liquidity and market value, the ultimate exit by these investors will have less of a downward impact on trading price. Where the investment instrument was convertible (such as convertible debt, warrants and options) using a market price formula, less downward pressure on trading price will mean fewer shares will need to be issued in the conversion and the existing shareholders will suffer less dilution.
In addition, one of the main purposes of going public is to use capital stock as currency in making acquisitions and attracting key executives. Where the company has an active trading market, market maker support and strong liquidity, the value of the capital stock is likewise higher. Not only will the capital cost of making stock-based acquisitions and attracting and retaining high-quality key executives be reduced but for some issuers, it will make the difference of being able to utilize this benefit of being public at all.
Although there is no doubt that improved liquidity, market activity and market maker and underwriter support is extremely beneficial to all public companies, and in serious need for improvement for smaller public companies, it is not known whether the increased tick size will have the desired outcome.
The other side of the coin is that larger spreads and more profit for the traders with the increased tick size equates to increased costs to the investors whose accounts are being traded. Moreover, the program itself will be complex and costly to implement for market participants. Market participants have stringent rules to follow for each test group to ensure a valid test result. Each participant must adopt written policies and procedures and monitor and report results.
Conclusion
It is important that the SEC and market participants actively seek to improve the market quality for smaller public companies, and this is just one measure in that wheelhouse. However, it is a two-year program. I’m anxious to see more timely efforts in this arena, such as through the launch of venture exchanges.
The Author
Attorney Laura Anthony
LAnthony@LegalAndCompliance.com
Founding Partner, Legal & Compliance, LLC
Corporate, Securities and Business Transaction 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. Ms. Anthony is also the host of LawCast.com, the securities law network.
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« The ECOS Matter; When Is A Reverse Split Effective? OTC Markets Comments on Proposed SEC Rules Regarding Amendments to Regulation D, Form D and Rule 156 »
The ECOS Matter; When Is A Reverse Split Effective?
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.
Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.
Download our mobile app at iTunes and Google Play.
© Legal & Compliance, LLC 2014
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