In a pair of recent opinions, the Securities and Exchange Commission (SEC) found that FINRA acted within the scope of its rules and governing statutory scheme in refusing to announce corporate actions for companies whose executives were subjects of regulatory actions alleging securities laws violations.

FINRA is a self-regulatory organization (SRO) responsible for regulating the market for securities.  It owns and operates the OTC Bulletin Board (OTCBB), an electronic inter-dealer quotation system that FINRA provides to its members for securities not listed on a national securities exchange, such as NASDAQ and NYSE.  FINRA provides various services for companies whose securities are listed on the OTCBB, such as processing requests to announce and effectuate certain corporate actions, including mergers, dividends, splits, and name and domicile changes.

In 2010, based on concerns that FINRA’s corporate action announcement processing services could potentially be used by companies to perpetrate stock fraud and other securities laws violations, FINRA proposed, and the SEC approved, FINRA Rule 6490.  This rule permits FINRA to deny an issuer’s request that FINRA announce a corporate action under certain circumstances.  Specifically, FINRA Rule 6490(d)(3) states that where a company-related action is deemed deficient (i.e., FINRA has actual knowledge that officers or directors connected to the company are the subject of an adjudicated or settled regulatory action related to fraud or other securities laws violations), FINRA may determine not to process the corporate action if refusing to do so promotes the protection of investors, the public interest and the maintenance of fair and orderly securities markets.

In In the Matter of the Application of mPhase Technologies, Inc ., mPhase Technologies, Inc. (“mPhase”), an issuer of securities formerly quoted on the OTCBB, filed an application with FINRA requesting an announcement that mPhase intended to effectuate a reverse stock split.  On October 2, 2012, FINRA notified mPhase that it had denied the company’s request to process the reverse stock split because of FINRA’s concerns that mPhase’s CEO and COO were the subject of a regulatory action alleging securities fraud and other securities laws violations.  mPhase appealed FINRA’s decision to a FINRA subcommittee, arguing that the regulatory action against mPhase’s executives should not per se constitute a “deficiency” under FINRA rules.  The subcommittee affirmed FINRA’s initial determination.  It found that although the SEC brought the regulatory action against mPhase’s executives five years before mPhase sought to effectuate the reverse stock split and mPhase was not a party to that action, it involved several serious violations of the federal securities laws and disgorgement of significant amounts of ill-gotten gains.  mPhase appealed FINRA’s decision to the SEC.

In the Matter of the Application of Positron Corporation presented a similar set of facts.  There, Positron Corporation (“Positron”), an issuer of securities quoted on the OTCBB, filed an application with FINRA requesting an announcement that Positron was effectuating a reverse stock split and changing its corporate domicile.  FINRA denied the application.  It found that Positron’s request was deficient and that the processing of the announcement was not in the public interest on the grounds that:

  1. Positron’s CEO and chairman had consented in federal district court to an injunction against future violations of antifraud and disclosure provisions of the federal securities laws; and
  2. Positron’s CEO was the subject of a pending SEC administrative proceeding  to determine whether a securities industry suspension or bar against him was warranted.  Positron appealed FINRA’s decision to a FINRA subcommittee, arguing that FINRA’s determination was not in the public interest because the reverse stock split and change in domicile would benefit its shareholders.   Positron, like mPhase, appealed FINRA’s decision to the SEC.

The SEC dismissed both appeals, holding that FINRA properly exercised its discretion in refusing to announce the companies’ corporate actions.  With respect to mPhase, the SEC explained that although the regulatory action involving mPhase’s executives resulted in a settlement order, the underlying factual findings of the settlement were a proper subject of consideration by FINRA in determining whether it was necessary for the protection of investors and market integrity to deny mPhase’s application.  The settlement order did not require FINRA to deny the request, and mPhase had an opportunity to dispute its relevance; however, the SEC found that FINRA properly considered the underlying facts of the settlement order in making its determination.  Similarly, with respect to Positron, the SEC held that the district court injunction entered against Positron’s CEO and the pending SEC regulatory action relating to the same securities laws violations were properly considered in FINRA’s decision to deny Positron’s application, based on the seriousness of the misconduct.

In further support of its denial of both appeals, the SEC found that the plain language of FINRA Rule 6490(d)(3) vests FINRA with authority and discretion to refuse to announce corporate actions based upon the facts and circumstances that gave rise to the regulatory actions against the companies’ executives.  The SEC also found that FINRA’s determinations comported with its mandate to protect investors, promote the public interest, and maintain fair and orderly securities markets.

The SEC’s opinions make clear that SROs may rely on the plain language of their SEC-approved rules in determining whether to permit companies to have access to their services.  This is especially the case where an SRO’s rules provide, like FINRA’s rules, that it may deny a company access to services based on ongoing or settled regulatory proceedings against the company’s executives, even where the company was not named as a party in these proceedings.  These recent opinions also reflect the potentially far-reaching effects that settling regulatory enforcement proceedings may have on individuals and the companies with which they later become affiliated.