Issues Facing Small Cap Issuers
As the market operator where thousands of small and micro-cap securities trade, we occasionally hear from issuers and their investors who are frustrated when brokers won’t deposit their stock. While this is generally perceived to be an OTC issue, the reality is that this affects privately issued shares on all public markets, including national exchanges.
The problems with the deposit of shares often center around broker-dealers’ gatekeeper responsibility to understand “how” the company’s shares were obtained and know “who” the investor looking to complete the transaction is, so as to protect public markets from illegal distributions of securities.
KYC (Know Your Customer) and Anti-Money Laundering (AML) compliance checks
Rules and regulations governing the broker-dealer industry require that firms know how a shareholder obtained their shares, as well as whether those shares are restricted. The Patriot Act and other regulations also require brokerage firms to perform adequate KYC (Know Your Customer) and Anti-Money Laundering (AML) compliance checks. Failure to comply could result in significant financial fines or worse. A case in point is Bank of America Corp.’s Merrill Lynch unit which recently agreed to pay $1.4 million to settle SEC allegations that it did not do enough to investigate red flags surrounding the deposit, and subsequent sale by an affiliate, of unregistered shares of NYSE listed financial-software company Longtop Financial Technologies Ltd.
Questions to Ask when Accepting Deposit of Shares
When deciding to accept a deposit of shares, brokers often assess the following:
- Are the shares in Certificate form? Are they legended?
- Is the holder an affiliate of the issuer?
- How were the shares acquired? Was it done through a private transaction (or chain of transactions) with an issuer or affiliate? At a material discount to market prices?
- Are those shares currently restricted? If not, is there adequate legal documentation showing the shares are freely tradable?
- What is the company’s share structure and share issuance history? Has the company done a number of issuances/private placements? How many shares does the company have outstanding?
- Does the holder have an existing account with the brokerage firm? If so, for how long, and what is the total value of the account?
When the share deposit is rejected, it is often due to the company not being fully transparent…or not disclosing the necessary information about itself or its officers’ activities and securities holdings.
It’s a well-established fact that a broker who is offered a modest amount of a widely-traded security by a responsible customer, whose lack of relationship to the issuer is well-known, can safely handle those trades. In cases where the share deposit is rejected, it is often due to the company not being fully transparent or not disclosing the necessary information about itself or its officers’ activities and securities holdings.
Other Issues that can raise concern are that the issuer is seeking to evade registration requirements and that the seller may be operating as an unregistered underwriter. These risks are increased for companies that are issuing significant amounts of shares in the private market at significantly discounted prices to anonymous or opaque intermediaries (PIPES/equity lines/toxic converts). Additionally, unknown investors seeking to open a new brokerage account for the sole purpose of depositing large blocks of little-known shares (and then trading those shares) will be a red flag to brokers.
The Broker-Dealer Gatekeeper Process
The broker-dealer gatekeeper process, which plays a critical role in protecting market integrity, the investor and small cap companies more broadly, tends to work better with increased disclosure around private securities offerings and transparency by the entities and advisors that participate in offerings. Since its inception, OTC Markets Group has taken a proactive approach to create tools to help compliance teams gain more transparency around OTC equity securities.
A Proactive Approach Towards More Transparency around OTC Equity Securities
- Securities are organized into three distinct market tiers based on the quality of disclosure they provide.
- Our Compliance Analytics Data File and newly introduced Compliance Statistics page on www.otcmarkets.com enable broker-dealers and clearing firms to price and assess risk based on a compliance and minimum financial standards test to which our OTCQX and OTCQB companies must conform.
- Our Transfer Agent Verified Shares Program provides investors with reliable current and historical shares outstanding data for OTCQX, OTCQB and Pink securities; this information helps combat Section 5 Securities Act violations and insider trading and enhances the role of transfer agents as trusted record keepers.
- Our Issuer Compliance team evaluates individual securities based upon a wide range of compliance-related criteria such as: concentration of ownership, number of investors, whether there has been any promotional activity—and if so, was it disclosed.
- Caveat Emptor designations display a public interest concern (promotion, regulatory investigation, suspension, etc.)
- Our Stock Promotion Flag and Policy requires issuers to address manipulative stock promotion and quickly correct any false statements or materially misleading information helps to prevent disruption of our public markets
Issuers and Investors will always face some level of questions when depositing their shares with their brokers
Keeping all of the above in mind, issuers and investors will always face some level of questions when depositing their shares with brokers, irrespective of the market on which they trade, if they have a limited history with a brokerage firm or are trying to affect a transaction that raises any possible regulatory red flags.
We are happy to answer questions and welcome feedback from our community of investors, brokers and issuers on these issues. For more information about OTC Markets Group, please visit our website www.otcmarkets.com.