Shell Game

During conversations with compliance and risk departments over the past year, the topic of shell companies always comes up.  For diligent compliance officers the reason for this focus is obvious, shell companies and more specifically trading with their affiliates are noted specifically in key notices and regulations, including:

  • FINRA Regulatory Notice 09-05 – Unregistered Resales of Restricted Securities: Shell company status at the time of issuance is noted specifically as a red flag.
  • Office of Compliance Inspections and Examinations (OCIE) Alert October 2014 – Broker Dealer Controls Regarding Customer Sales of Microcap Securities: The alert noted that companies with nominal assets and low operating revenue should be a consideration when considering whether to file a Suspicious Activity Report (SAR).
  • Rule 144 – Specifically bars the use of the 144 safe harbor for securities issued by a shell company or former shell company[i].

Defining a Shell Company and Benchmarking Compliance

The compliance risks associated with shells and trading with their affiliates are clear but several issues come into play when trying to implement a review process/policy.  For starters, how is a shell company defined? Where can data be found to properly automate the process to identify current and former shell companies? And how can this be done without restricting a firm’s legal brokerage business and normal customer activity in securities of compliant companies?

Let’s start with the definition.  A Shell Company as defined in Rule 405 of the Securities Act is a company that has:

  • No or nominal operations; and
    • No or nominal assets
    • Assets consisting solely of cash and cash equivalents; or
    • Assets consisting of any amount of cash and cash equivalents and nominal other assets.

This definition is not 100% quantifiable but it does provide a benchmark for risk processes. Additionally, reporting issuers must disclose if they fall within the definition set in Rule 405, but enforcement cases show issuers sometimes skirt the issue.

Shell status information may be found within SEC financial reports (Ks/Qs) and is made available via data providers and in our Compliance Data and new Compliance Analytics products.

Data on SEC Reporting Shell Companies:

Financial Analysis with Regard to Shell Risk

For non-SEC reporting companies and foreign private issuers, ascertaining shell status becomes may be more problematic.  OTC Markets allows non-reporting companies and foreign private issuers to note their shell status to us via our Company Update Form, but because, just like the SEC flag this relies on issuer self-certification, other tests are needed.   One best practice approach is using financial statement analysis of the pertinent data points noted under Rule 405 to come up with a ‘proxy shell status.’

A cursory review of recent financials from Alternative Reporting and International Reporting companies, using the parameters of operating revenue less than 100K or Total Assets minus Cash and Cash Equivalents less than 100K, yield approximately 50 ‘proxy shells.’  Note that for many non-reporting companies there is no current financial data available, causing them to reside in Pink No Information. Many brokers’ best practice is to place automated restrictions on non-sophisticated clients buying these less transparent or riskier securities which has resulted in only ~1% of total OTC dollar volume being transacted in Pink No Information securities.

Additionally, using the same parameters, ~20 SEC Reporting companies would fall into the rubric of ‘proxy shell.’

Data-driven Compliance to Manage Shell Risk

Although there is gray-area in regards to shell status, there is also enough information available in the market to put an effective policy in place.  Financials data for Alternative Reporting, International Reporting and SEC Reporting is available on (within the ‘Financials’ page of a security’s detailed information section) and within our Compliance products.   Shells and Penny Stocks are also not permitted on our OTCQX Market.  If an issuer is not making adequate current information available to the market, then that should be a major consideration in any risk policy or customer trading restrictions.

The most sophisticated firms are building data driven compliance processes to efficiently serve their clients, manage risk and keep bad customers off their books.  You will only lose the shell game by ignoring the data all together.

[i] Former Shell companies may use 144 if they cease being a shell company and are subject to the reporting requirements under 13 or 15(d) of the Exchange Act.  One year must elapse between the filing of a Form 10 and use of 144.

[ii] Noted as a Shell company in the past 2 years

*Former Shell companies may use 144 if they cease being a shell company and are subject to the reporting requirements under 13 or 15(d) of the Exchange Act.  One year must elapse between the filing of a Form 10 and use of 144.

**Noted as a Shell company in the past 2 years

Matthew Fuchs, EVP of Market Data, leads the product development, distribution and sales of market data at OTC Markets Group. Prior to joining OTC Markets Group, he served in a number of financial technology roles at the National Research Exchange, Bearing Point and Arthur Andersen. Matt received a BA from Columbia University

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