Shell companies were originally intended to be among the chief victims of the new Rule 15c2-11. Many are companies no longer engaged in any business; some have been abandoned by management. Quite a few private companies choose to go public through reverse mergers with dormant shells; they believe it’s a cheaper and faster way to start reaping the benefits of public company status. That is not necessarily the case. While it often (though not always) is faster, it can be quite expensive, costing upwards of $100,000 even for a non-reporting shell, with the cost of the merger transaction factored in. For the money, the new issuer, often inexperienced, may find himself buying a pig in a poke: the shell may have skeletons in the closet in the form of undisclosed debt, former insiders with large undeclared positions, and more. Less naïve potential management may buy shells simply to conduct illegal and destructive pump and dump operations.
The SEC has never liked any of that. For several years, it attempted to deal with dormant shells by bringing mass suspensions at least once annually as part of what it called Operation Shell Expel. The program ran from 2012 through 2016. It was then inexplicably abandoned. In its heyday, it had been extremely successful. One well-known shell vendor sold his portfolio of shells that had suddenly become Grey at fire-sale prices. Others simply stepped away from the business.
But by 2017, the shell peddlers were back with a vengeance. Many got control of abandoned shells through custodianship actions brought in local courts in the state (usually Nevada or Wyoming) where the shell was domiciled. The actions were cheap and almost never contested. The new custodian could then “clean up” the shell and look for a buyer. Internet players began to follow individual shell vendors in the courts where they were active. The moment one who was perceived as arranging “good” deals filed a custodianship petition, stock in the shell would be snapped up, often on heavy volume at ever-increasing prices. That alone was often the play. Finding buyers for a shell can take time, in some cases more than a year. Penny speculators don’t want their money tied up for that long and are more likely to exit after the initial pop in price.
Obviously, that does not encourage “capital formation.” The SEC wanted to put a stop to the trafficking in shells, but there was a regulatory problem. The agency has for years defined shell companies as:
…any issuer, other than a business combination related shell company… or an asset-backed issuer… that has (1) no or nominal operations and (2) either (i) no or nominal assets, (ii) assets consisting solely of cash and cash equivalents, or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets.
But that only applied to SEC registrants; it did not apply to Pinks not required to make disclosure of any kind. A slightly different and more complex definition was adopted in the final rule:
The definition of shell company that the Commission is adopting does not preclude a broker-dealer, qualified IDQS, or registered national securities association from determining that an entity is a shell company based on an observation that a company has identified itself as a shell company (or as not a shell company) or, alternatively, review of a company’s financial information, including asset composition, operational expenditures, and income-related metrics. The definition of shell company under the amended Rule is consistent with the requirements of other established and broadly used Commission rules to provide market participants flexibility in analyzing the particular facts and circumstances involving an issuer, such as the issuer’s financial information and information related to its operations.
It would seem that considerable responsibility for identifying and dealing with shell companies will now fall to OTC Markets. It has not said how it plans to deal with that.
In the proposed rule, the SEC said it intended to prohibit market makers from relying on the piggyback exception for shell companies. Had that become part of the final rule, all of those companies would quickly have been relegated to the Greys. But cries of outrage from commenters persuaded the agency to compromise, and the result was a modified version of its original proposal:
Under the amended Rule, a broker-dealer may maintain a quoted market for the security of an issuer that the broker-dealer has a reasonable basis under the circumstances for believing is a shell company by relying on the piggyback exception during the 18-month period following the initial publication or submission of a priced bid or offer quotation for the security in an IDQS, assuming all other requirements of the piggyback exception are met… The Commission believes that compliance with the information review requirement is needed following the 18-month period to appropriately balance the facilitation of capital formation and the promotion of investor protection.
There is some confusion about the correct interpretation of “initial publication or submission of a priced bid or offer quotation for the security in an IDQS.” It seems to us it ought to mean that an OTC shell company would, like a SPAC, be able to qualify as compliant with Rule 15c2-11 only if it was new to the market. It would then have 18 months in which to find a buyer.
At the OTC Markets webinar, Zinn explained:
The way that it works is that for a new company coming on, after September 28th, that is a shell company within the definition of the rule, which includes those that disclose their shell status in their filings, those companies, starting from the point where they’re initially quoted, so that first day when they join the market and a broker-dealer has a priced bid or an ask in the security, they will be able to be quoted for an 18-month period after that.
But he added: “Any company that’s a shell as of September 28th has 18 months from that date to be the subject of a public quote if it remains a shell.” He may be confused by the SEC’s intentions because he finished by saying, “We are obviously constantly talking to the SEC about the application of this rule. This is our understanding based on those conversations, but we’ll also continue to push them to put out more specific guidance…”
Shell vendors may be perplexed as well, taking a wait-and-see stance until September 28. At least one who’s been very successful in recent years seems to be shifting his attention to exchange-listed issuers that might be receptive to a suitor interested in a buyout. The OTC custodianship plays that were attracting so much attention only six months ago have disappeared.
FINRA Weighs In
FINRA had been silent through the comment period for the proposed rule. Finally, on May 28, 2021, it filed with the SEC its own proposed rule change to members (i.e., broker-dealers’) requirements under FINRA Rule 6432 (Compliance with the Information Requirements of SEA Rule 15c2-11). It posted its proposal at its own website; the SEC did the same on June 9. Only one comment has been submitted to date; it is from OTC Link LLC and was written by Dan Zinn and Cass Sanford.
While FINRA approves of the idea of a qualified IDQS making determinations about an issuer’s compliance with Rule 15c2-11’s current information requirement, it points out that:
Under FINRA Rule 6432, no member may quote a non-exchange-listed security in a quotation medium unless the member has demonstrated compliance with FINRA Rule 6432 and the applicable requirements for information maintenance under Rule 15c2-11 by making a filing with, and in the form required by, FINRA (i.e., the Form 211). The Form 211 is designed to gather pertinent information regarding the subject issuer and security, the members knowledge of and relationship with the issuer, and the member’s intended quotation activities with respect to the security. FINRA uses the Form 211 in connection with its oversight of member compliance with Rule 15c2-11.
FINRA wants to make three amendments to its own Rule 6432. First, the IDQS would be required to submit a modified Form 211 in connection with each initial information review it conducts; second, that the IDQS be obliged to submit a daily security file to FINRA containing summary information for all securities quoted on its system, and finally, “other changes” to Rule 6432 and the Form 211 would be proposed to clarify the new elements of both.
It asks that on the day following the IDQS’s determination of an issuer’s compliance with Rule 15c2-11, it files a modified Form 211 by 6:30 p.m. Eastern time. It sees that as a good way to guarantee that trading will begin as quickly as possible. In a footnote, it adds its bombshell: “…the modified Form 211 must be reviewed and signed by a principal of the Qualified IDQS and the principal must certify, among other things, that neither the firm nor its associated persons have accepted or will accept any payment or other consideration for filing the Form 211.”
For the daily security file submission, FINRA wants:
Security symbol; Issuer name; If the non-exchange-listed equity security is being quoted pursuant to a processed Form 211 under FINRA Rule 6432(a); If applicable, the type of publicly available determination made by the Qualified IDQS (e.g., an initial review pursuant to Rule 15c2-11(a)(2), that the required information is current and publicly available under Rule 15c2-11 (f)(2)(iii)(B) or (f)(3)(ii)(A), or an exception under Rule 15c2-11(f)(7)) and the date on which such publicly available determination was made by the Qualified IDQS; With respect to a non-exchange-listed equity security for which the Qualified IDQS has made a publicly available determination under Rule 15c2-11(f)(7) relating to the availability of the piggyback exception under Rule 15c2-11(f)(3), whether the issuer is a shell company and, if a shell company, the number of days remaining in the applicable 18-month period under Rule 15c-2-11(f)(3)(i)(B)(2); If applicable, that the security is being quoted pursuant to an exception that does not rely on the Qualified IDQS’s publicly available determination and, if so, identify the exception relied upon by the subscriber; and Such other information as specified by FINRA in a Regulatory Notice (or similar communication). Perhaps such a list could be generated automatically and so present no difficulties for OTC Markets, but it seems it would have to be reviewed for accuracy, at least occasionally. Even so, it doesn’t seem to be problematic.
The “other amendments” are less substantive and should present no problems for OTC Markets.
The text of the amended Rule 6432 begins on page 35 of FINRA’s submission.
Zinn and Sanford posted their comment to the SEC on July 6. Their chief interest is in demonstrating that OTC Markets, as an IDQS, ought to be allowed to charge for its services. While they “do not expect the existing application of Rule 5250 to have a significant impact on our ability to perform initial information reviews, …we believe the modernized interpretation and application of Rule 5250 that we propose here would benefit issuers, investors and regulators alike.”
The thrust of Zinn and Sanford’s argument is that the prohibition on compensation for initial information reviews shouldn’t be applied to an IDQS because an IDQS isn’t a broker-dealer. Further, according to FINRA itself, a potential conflict only arises because for a market maker: “Accepting such prohibited payments compromises the independence of a firm’s decision regarding its quoting and market-making activities and, among other things, harms investor confidence in the overall marketplace because investors are unable to ascertain which quotations are based on actual interest and while are supported by issuers or promoters.” But an IDQS does not publish quotations or act as a market maker. It merely facilitates market maker quotations, and so the prohibition on accepting compensation should not extend to a “neutral market operator conducting initial information reviews or filing Form 211s [sic] with FINRA.”
No comment on the daily security file is offered.
On July 29, the SEC filed a new notice in connection with FINRA’s proposed amendments to Rule 5250. The deadline for the Commission’s decision would have been July 30, but the Division of Trading and Markets, “pursuant to delegated authority,” decided to move the critical date to September 13, by which time “the Commission shall either approve or disapprove, or institute proceedings to determine whether to disapprove, the proposed rule change.”
It seems the suspense will continue until September 28 is nearly upon us. In early summer, OTC Markets did its best to encourage non-compliant issuers to submit current information by June 30, noting that early submissions would guarantee compliance by the critical day in September. It says it’s working through applications now and will handle as many as it can, in the order in which they’re received.
Some, inevitably, will arrive too late. At the webinar in July, Zinn was asked what issuers should do if they end up without published quotations but want to return to normal trading. He replied that they’d have to apply for an Initial Information Review, which is a “higher standard” than the “ongoing information standard” that is being applied during this pre-September 28 period. He added casually that “things like audited financial statements are likely to be required.”
There was no further discussion of that astonishing suggestion. At some time in the future, will Pink Current Information issuers be required to produce audited financials? OTC Markets could do that: it’s a private company and can ask anything it wishes of the issuers that want to be quoted on its trading platform. But many issuers would be displeased and might well seek out a different IDQS.
For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email info@securitieslawyer101.com or visit www.securitieslawyer101.com. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes."
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