The SEC’s proposed amendments to Rule 15c2-11 focus on ways to incentivize additional company disclosure in the public markets.  While we strongly support the overall goals of the proposed amendments to increase information availability for investors, we are mindful that this rule has far reaching implications that will reduce market efficiency in certain areas.  With the OTC markets serving a wide range of investors, brokers, advisors and public companies, it is important that market participants understand and share their comments with the SEC.   We all share a common goal that the rule proposal is modernized in a streamlined manner that improves secondary trading in all securities and increases the competitiveness of America’s public markets.

To date, the comments we’ve provided include a series of recommendations to improve the effectiveness of the rule proposal. Importantly, our comments prioritize market efficiency and capital formation while still enhancing investor protection. Given this is a complex issue, we wanted to break down the core elements of the current rule proposal and the potential impact to the constituents who play an integral role in maintaining the equilibrium of our financial ecosystem.

 

What is the Impact for Investors Should More Than 3,000 Securities Be Eliminated from the Public Markets?

The SEC’s proposal recognizes the disclosure standards OTC Markets Group uses for our OTCQX, OTCQB and Pink Current Information designations. This means the vast majority of companies trading on these markets would remain quoted based on meeting our current information standards. The rule proposal would allow broker-dealers to rely on those designations when quoting these securities on OTC Link ATS.
However, under the rule proposal, more than 3,000 “No Information” securities that do not make current information available would no longer be eligible for public quoting.  Without an alternative solution, these securities would instead be relegated to the Grey market.  Transactions in Grey market securities have no public quote, forcing brokers to source liquidity and pricing primarily over the phone without data-driven technology.  Investors would then suffer from the lack of price discovery and broker-dealers’ inability to utilize technology or ensure best execution.   Some securities may no longer be traded or cleared by brokers or market makers because of expanded regulatory obligations.

Sophisticated, independent investors willing to take on riskier investments worry that without a regulated electronic trading market, the value of their investments will be depleted, destroying millions in shareholder value.

 

The Implications for Individual and Professional Investors

Every public market investor who holds shares in a company should have the opportunity to liquidate their holdings at the best possible price. It is important to note the implications for sophisticated, smaller, professional investors that do their research and make markets work — driving valuation through thoughtful analysis.

One of the largest sources of comments on the SEC’s rule proposal has been from individuals and professional investment managers who maintain a long-term value investment philosophy.

Many of these investors are the disciples of Benjamin Graham, and his book The Intelligent Investor.   It is easy to understand why these thoughtful investors adamantly oppose the SEC curbing their ability to invest in shares of distressed or dark companies that do not make current information available and do not want  those markets to be closed.  Their investments, which include distressed companies, bankruptcies and cash shells, would no longer have a public market on which to be quoted. Without a regulated, electronic market available to trade these securities, the value of these types of securities held by professional investors’ will become artificially depressed, leaving them unable to liquidate their holdings at the best possible price.

It is important to note that professional investors, both large and small, who actually do the hard work of researching securities to determine valuations through fundamental analysis, express the most concern about the impact of a rule that would require companies to make current information publicly available.

Dating back to the paper Pink Sheets, the OTC markets have provided a platform for value investors to find bargains. Such investors are guided by a strategy that says investors should do their own research to find stocks trading for less than their intrinsic value– a form of fundamental securities analysis that requires investors to dig deep for information about companies.  As value investing is a school of numbers and probabilities, there are never Blue-Chip pretensions if the price is right. Those days are well described in The Snowball: Warren Buffett and the Business of Life, by Alice Schroeder:

One of Warren Buffett’s 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.”

 

Start-Ups and Early Stage Companies: Today’s “Shells” Face a Barrier to Entry into the Public Markets

We are concerned that many start-ups and early stage companies could get swept up in the rule proposal’s broadly written “shell company” definition.  Potentially, any company without significant operating revenue or issuers whose assets are primarily cash or securities, may now be categorized as a shell.  Under the rule proposal, any company considered a “shell” would no longer be eligible for public market maker quotations and would be traded only on the Grey market.

Industries such as biotech and life sciences have traditionally benefited from using reverse takeovers to efficiently and quickly go public.  These companies often have very little revenues or operations as they try to pioneer an academic theory or a speculative technology.  It is therefore hard to predict which will succeed.  That said, we need to give these more nascent companies an opportunity to thrive in the public markets.  Instead of banning all companies with the characteristics of a shell, regulations must foster best practices and better transparency.

We must also define the parameters used to characterize a “shell” so that start-ups and other early-stage companies aren’t harmed in the process.  To protect investors, the SEC should focus on directly addressing the problem of pump-and-dump schemes involving shells.  This would include banning all promotion of shells, restricting share sales by shell company insiders and affiliates, and restarting the restriction clock after any reverse takeover of a shell or business combination where a larger company merges into a smaller operating company. These changes would help make shell companies a safer capital formation tool. The SEC should strive to achieve its investor protection goals without harming capital formation and entry into the public markets.

What about investments in SPACS and companies in liquidation? 

There are many reasons a company may only hold cash and securities, particularly when combined with an investor focused governance structure.  A company holding a securities portfolio, a firm with an independent board, or a company with an approved plan of liquidation are all types of securities that should have a transparent public market — provided they disclose adequate current information.  The SEC’s rule proposal places an inequitable burden on these types of securities and their investors, particularly in comparison to the more modest burden placed on operating companies.

 

What Happens to Companies that Encounter Financial Reporting Difficulties? 

Today’s market volatility and global economic uncertainty will lead to many more bankruptcies, financial reporting and corporate disruptions in the months ahead.  The rule proposal, as currently written, could severely restrict market efficiency and transparency in companies that file for bankruptcy, are economically distressed or have financial reporting difficulties. These market conditions call to mind the important footprint left by 2008 financial crisis.  It serves as a reminder of the importance for even large-cap Fortune 500 companies impacted by financial difficulties and bankruptcies to have a public market for their investors, and to be able to demonstrate the value of their equities, as they reorganized.

For example, General Growth Properties, a mall operator, filed for bankruptcy in 2009 and was delisted from the NYSE.  Bill Ackman, a renowned fundamental investor, made a large bet the General Growth Properties shares had value, even when many sceptics said otherwise.  By allowing those shares to continue trading OTC, the public markets provided a tangible solution. That confidence helped the company subsequently recover, while allowing the shareholders to retain more value.  The company’s market did not close, and electronic trading, market making, and best execution continued.

“Clearly, we think there’s plenty of asset value over liabilities,” he said. “We think (there’s) huge potential award relative to limited risk. Limited depends on your stomach.”  Bill Ackman on investing in General Growth Properties during bankruptcy[1]

[1] https://www.reuters.com/article/generalgrowth-ackman/investor-ackman-sees-13-fold-return-on-general-growth-stake-idUSN2728005920090528

Under the current rules, when companies are no longer able to provide financial reporting they are labeled as delinquent, while investors in their shares still have a transparent and efficient market.  More importantly, minority investors can sell their shares to more risk tolerant players. These types of securities are clearly designated with a “stop sign” icon and a “warning” symbol on our website, indicating that investors should undertake additional due diligence and that those with material inside information may be violating securities laws if current information is not publicly available.

Many brokers have put safeguards in place to ensure that less sophisticated investors can receive best execution when they liquidate shares but are restricted from opening new positions.  Codifying these practices for the purpose of better gating these markets will protect main street investors and help stop insiders from preying upon their minority investors.

 

Understanding the Impact to the Broker-Dealer Community

The role of a broker-dealer should be to provide transparent pricing and liquidity in the stock.  The SEC proposal would require broker-dealers trading No Information securities to restrict limit orders from affiliates and limit shell company trading.  For electronic market makers, the proposal would turn the colloquial Know Your Customer, or ‘KYC’ obligation into a Know Your Correspondents Customers, ‘KYCC’ standard on a transaction by transaction basis. This is essentially unworkable and valuable market makers may exit the market entirely due to the high risk of fines for non-compliance.

Regulated broker-dealers provide transparent pricing and liquidity and ensure that their best execution obligations are met.  Similar to the risk posed to professional investors, the largest risk for broker-dealers is the potential that 3,000+ No Information stocks would fall into the Grey market – with sparse pricing information, a lack of transparency, and no electronic mechanism to facilitate best execution.

 

Our Solution: An Expert Market

We propose that securities without current information available be made eligible for quoting on an “Expert” market, where quotes are distributed only to professional investors and other regulated or sophisticated participants.  Retail investors would be restricted from viewing quotations in “Expert” securities; however, they would still be able to receive best execution from their broker-dealer when selling their shares.

One rule proposal cannot solve all problems, and when attempted, it can often become overreaching and problematic.  We see a successfully streamlined and modernized Rule 15c2-11 as part of an integrated effort that includes other rule updates designed to:

  1. Restore trust and transparency to the share issuance process by modernizing the SEC’s transfer agent rules
  2. Better inform market participants with improved insider reporting and disclosure and regular large investor filings for all publicly traded securities
  3. Eliminate information asymmetries by clarifying Rule 10b-5 restrictions on insiders and affiliates trading when adequate current information is not publicly available or increase restrictions on current and former affiliates selling after business combinations or reverse takeovers
  4. Initiate a thoughtful industry discussion of when and how less sophisticated investors should be gated from higher risk areas of the securities markets to protect them from their lack of understanding.

We remain committed to working with regulators, and with continued industry engagement and feedback, we believe an amended Rule 15c2-11 can be appropriately tailored to help improve the transparency and efficiency of the OTC markets for all stakeholders.

OTC Markets Group welcomes your feedback.  We encourage you to contribute to this discussion and share your perspectives by filing a comment with the SEC.

For more information about the rule proposal, please click on the following video and visit OTC Markets Public Policy Page.