On October 17, 2011, the Microcap Fraud Working Group (Working Group) hosted a public roundtable to discuss the regulatory issues involved in the execution, clearance, and settlement of microcap securities. The Working Group is a joint initiative of the Securities and Exchange Commission’s Division of Enforcement and its Office of Compliance Inspections and Examinations, and is charged with the primary responsibility of detecting and deterring fraud involving microcap securities.
The roundtable was split into three panels: (1) Compliance Challenges Associated with Microcap Securities; (2) Anti-Money Laundering Monitoring; and (3) Potential Changes to the Regulatory Framework Concerning Microcap Securities.
The panelists included representatives from the Depository Trust & Clearing Corporation (DTC) and FINRA, as well as securities lawyers and executive officers from capital market firms.
Two themes pervaded the three panels: communication and transparency. Several of the panelists conveyed issuer frustration with the lack of consistent communication from the SEC as to how issuers should tackle their securities compliance obligations when circumstances suggest that they may be participating in illegal resales of restricted securities. Similarly, it was suggested that the DTC was less than transparent in providing issuers and transfer agents with specific reasons that a transaction is flagged. However, despite complaints about the SEC and DTC’s inconsistent communication and lack of transparency, a DTC representative informed the audience and panelists that there has been a steady increase in the filings of suspicious activity reports (SARs) — due, in part, to Section 314(b) of the Patriot Act and FINRA Notice 09-05. Since 2003, SAR filings have increased from only 32 to an expected 1,800 reports in 2011. Notably, Section 314(b) permits financial institutions, upon notice to the Department of the Treasury, to exchange information with one another to identify and report to the federal government activities that may involve money laundering or terrorist activity. And FINRA Notice 09-05, generally, is a reminder to broker-dealers of their responsibility to ensure compliance with the federal securities laws and FINRA rules when broker-dealers are participating in the sales of unregistered securities.
When asked for suggestions to improve the regulatory framework concerning microcap securities, the panelists named several. First, it was suggested that there needed to be greater communication among the SEC, DTC, and market-makers in determining whether trading in a security should be halted. Other panelists suggested that the SEC shore up its controls related to the purchase and sale of securities in the public markets where there is little to no current information available for the issuers of such securities. Other panelists believed that the SEC should consider reforming its rules that are designed to prevent fraud. For example, one panelist suggested that the definition of “investment adviser” under Section 202(a)(11) of the Investment Advisers Act be revised to be more encompassing. Another panelist suggested that the SEC should consider an annual review of the clearance controls provided for in Rule 15c2-11 under the Securities Exchange Act of 1934, as amended, which generally imposes certain information review and maintenance obligations on broker-dealers that publish quotations in a quotation medium for securities that are quoted on the OTC Bulletin Board and Pink Sheets. More specifically, Rule 15c2-11 proscribes broker-dealers from submitting a quotation for a covered OTC equity security before it has gathered and reviewed current information about the issuer whose security is the subject of the quotation.
The burden to monitor and control illegal, unregistered distribution of securities falls on the shoulders of all the players involved, including the SEC, DTC, financial institutions, and issuers, among others. But securities firms potentially bear the biggest responsibility to ensure that they have written procedures in place that are reasonably designed to detect the sale of unregistered securities. And while these procedures and controls will vary from firm to firm depending on the circumstances surrounding the proposed distribution and resale, all such firms must be prudent in acknowledging this obligation and implementing procedures.