“One of his favorite sources was the Pink Sheets, a weekly printed on pink paper, which gave information about the stocks of companies so small that they were not traded on a stock exchange. Another was the National Quotation book, which came out only every six months and described stocks of companies so minuscule that they never even made it into the Pink Sheets. No company was too small, no detail too obscure, to pass through his sieve.” “I would pore through volumes of businesses, and I’d find one or two that I could put ten or fifteen thousand dollars into that were just ridiculously cheap.” Alice Schroeder’s book The Snowball: Warren Buffett and the Business of Life.
State of Change in the Expert Market
The National Quotation books and Pink Sheets of Warren Buffet’s early investing days have long since been replaced by more efficient, regulated electronic OTC Markets. The deep-digging Buffet approach, however, has been adopted by many successful value investors and still persists today. With newer technology meeting the needs of modern regulations, the Expert Market provides a home for brokers and small investors to find liquidity in off-the-run stocks and for sophisticated investors to seek out bargains.
The Expert Market is a distinct market tier that allows broker-dealers to trade securities with regulatory and other restrictions. It has grown in response to recent amendments to SEC Rule 15c2-11. Under that rule, when companies fail to publish required current information, brokers may only publish unsolicited quotes, meaning quotes representing limit orders from investors who are not company affiliates or insiders. Following changes to Rule 15c2-11, in September 2021, the Expert Market expanded to include thousands of these “dark” securities. As an additional protection, Expert Market quotes are distributed only to broker-dealers, institutions, and accredited investors.
The Expert Market serves three vital regulatory purposes. First, it provides broker-dealers with an electronic market on which to meet their FINRA-mandated agency and Best Execution responsibilities in these securities. Second, by serving as a more restricted venue for broker-dealers to represent customer limit orders in securities that do not meet the Pink Current or Pink Limited requirements, it gives effect to the SEC’s goal of encouraging public company disclosure. Third, by limiting quote distribution to professionals, such offers are not considered general solicitation under state and federal securities laws.
Trades in Expert Market Securities that are not deemed “Restricted Securities” by FINRA1, are reported and distributed through normal market data distribution channels. FINRA’s dissemination of public trade data in Expert Market securities is an easy way for investors and broker-dealers to identify securities they may be able buy and sell without additional restrictions beyond Rule 15c2-11. It is important to note the distinction between quoting, the data which is restricted to professionals, and trading, the data which is publicly disseminated by FINRA.
Brokers can buy or sell the securities for a range of investors, subject to any specific trading restrictions. Even for unrestricted securities, certain brokers may limit retail investors to only selling, and others may require order-by-order affirmations that the customer is not an insider and/or has the necessary experience and risk tolerance. Approaches vary, and liquidity will evolve as sophisticated investors press their brokers to let them submit and display more orders in Expert Market securities that are trading at attractive valuations.
Because there are no proprietary market maker quotes to provide continuous prices in the Expert Market, spreads will be significantly wider, volatility higher, and liquidity lower than publicly quoted securities. With wider-spread securities, investors can often find better prices by placing limit orders that are displayed by brokers in the Expert Market.
There is a public policy advantage to providing an “outsider” trading venue that allows non-controlling shareholders an avenue to sell through regulated broker-dealers. Regardless of how the company performs or how those controlling it behave, an outside investor should be able to sell that stock as they would any other piece of their property. This also serves an investor protection purpose, as a non-controlling investor unhappy with the company’s direction may have no other recourse but to sell their shares. Likewise, a trading market provides an alternative to company buybacks and allows sophisticated investors to acquire stakes.
In contrast, company officers, directors, and large shareholders often control the company’s direction and disclosure. Those insiders, employees, and affiliates have information about the company that is not otherwise available to outside investors and should be prevented from selling or buying back shares2 unless the company makes current information publicly available.
By the Numbers
Currently there are 3,336 securities on the Expert Market, the vast majority related to their failure to meet the requirements of Rule 15c2-11. Of this large group 2,495 are domestic and 841 are international. A large tranche of the domestic issuers have gone dark, are defunct or represent orphaned securities. 689 of the domestic securities are SEC registrants out of compliance with their reporting obligations.
How the Expert Market Could Evolve
The Expert Market’s structure and number of included companies position it for significant evolution. Rather than simply writing off these securities, we examine below this market’s potential utility going forward. For example, the Expert Market can become an entry point for specific security types, or act as a bridge to the public markets for professionals trading private issuer shares.
As a regulated market platform for brokers with an institutional focus, the Expert Market also provides the means for broker-dealers to quote and trade restricted securities without engaging in general solicitation. This feature helps alleviate concerns about inadvertently violating state and federal securities regulations around general solicitation of private securities. With pre-trade transparency for professionals and an open network of FINRA-regulated broker-dealers, pricing can be a benchmark for both Best Execution and portfolio valuation. From an investor standpoint, the market can operate with a focus on improving execution quality and price competition while providing a utility for broker-dealers to perform their agency obligations.
Home for 144A Securities
The Expert Market may also function as a designated market for Rule 144A securities, catering to the specific characteristics of this restricted security type. Under the 144A classification, the Expert Market could assume a critical role by enabling the sale of such securities to institutions, essentially functioning as a secondary market. However, to participate as a buyer, an institution would need to demonstrate to their brokers that it is a Qualified Institutional Buyer (QIB) as defined in 144A. This mechanism would help facilitate compliant Rule 144A transactions.
Bridge from Private to Public
The Expert Market offers a bridge to help companies and investors transition from the private to the public sector. At its core, the market could facilitate private sales of shares to individuals meeting the SEC’s ‘accredited investor’ criteria. This process can gradually transform private securities into publicly tradable assets over time.
Securities Act includes the concept of private offerings that protect the public by limiting the distribution of the offering information. It is not inconceivable that a similar concept should develop under the Exchange Act for secondary trading of private securities. When bids and offers are restricted from general distribution, accredited investors should be free to trade private securities through competing broker-dealers.
The market could extend its reach further by accommodating other restricted security types, catering to accredited investors, including substantial institutions operating under distinct thresholds. Notably, the Expert Market could serve as the conduit for restricted stock desks of investment banks, accommodating trades that may not find a place in conventional markets but can seamlessly occur within its ecosystem. Essentially, the Expert Market would form a critical link that facilitates the evolution of securities from private holdings to public trading while also providing a space to monetize restricted assets.
Bankruptcies, Distressed and Orphaned Securities
As companies work through the restructuring process or financial reporting issues, many will have existing shareholders and debt holders who want to sell their holdings to interested buyers. While these companies do not have the updated financial reporting to allow them to remain on Pink, the Expert Market could serve as a home for companies to get their house in order.
Orphaned and formerly private securities that have come to rest in investor portfolios may not meet the criteria for trading on public market tiers. Brokers can find liquidity on the Expert Market for their clients. It could include securities that do not have a symbol or a CUSIP number or domestic companies ineligible for clearing through DTC. The Expert Market’s envisioned function as a trading venue for these securities highlights its potential to provide a valuable solution, catering to assets that might otherwise struggle to find liquidity due to their unique circumstances.
The Expert Market plays a vital role in shielding public investors from exposure to securities of issuers that may not provide sufficient information in the SEC’s view. The unique market structure offers broker-dealers a means to compliantly trade institutional-only securities with attributes unsuited for retail trading. With alternative investments expanding and private markets growing, more and more securities are ending up in investor portfolios. The Expert Market stands ready to help brokers provide better prices for investors and serve sophisticated investors as they analyze, value, and trade a range of securities.
[1] Under FINRA Rule 6420, “OTC equity security” means any equity security that is not an “NMS stock” as that term is defined in Rule 600(b) of SEC Regulation NMS; provided, however, that the term “OTC Equity Security” shall not include any restricted equity security. “Restricted Equity Security” is defined under FINRA Rule 6420 as any equity security that meets the definition of “restricted security” under Securities Act Rule 144(a)(3). Trades in restricted equity securities that are not effected pursuant to Rule 144A are not reportable under FINRA rules. Trades reported to FINRA in 144A transactions are not distributed to the public.
[2] Rule 10b-5 under the Securities Exchange Act of 1934 targets securities fraud. This rule makes it illegal for anybody to directly or indirectly use any measure to defraud, make false statements, omit relevant information, or otherwise conduct business operations that would deceive another person in the process of conducting transactions involving stock and other securities. Rule 10b-5 also applies to Insiders and companies buying or selling shares in public markets or using those prices as justification for private transactions when a company is dark or delinquent in their filings.
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