Palm Beach Attorney Laura Anthony Explains SEC Observations on Equity Market Structure, Rule 15c2-11 and Penny Stocks

Recently, SEC Chairman Jay Clayton and Brett Redfearn, Director of the Division of Trading and Markets, gave a speech to the Gabelli School of Business at Fordham University regarding the U.S. equity market structure, including plans for future reform. Chair Clayton begins his remarks by praising the Treasury Department’s four core principles reports. In particular, the Treasury Department has issued four reports in response to an executive order dated February 3, 2017 requiring it to identify laws, treaties, regulations, guidance, reporting and record-keeping requirements, and other government policies that promote or inhibit federal regulation of the U.S. financial system.

The four reports include thorough discussions and frame the issues on: (i) Banks and Credit Unions; (ii) Capital Markets; (iii) Asset Management and Insurance; and (iv) Nonbank Financials, Fintech and Innovation.

The executive order dated February 3, 2017 directed the Treasury Department to issue reports with the following objectives:

    • Empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth;
    • Prevent taxpayer-funded bailouts;
    • Foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry;
    • Enable American companies to be competitive with foreign firms in domestic and foreign markets;
    • Advance American interests in international financial regulatory negotiations and meetings;
    • Make regulation efficient, effective, and appropriately tailored; and
    • Restore public accountability within federal financial regulatory agencies and rationalize the federal financial regulatory framework.

Chair Clayton and Director Redfearn began with a review of the recently adopted SEC’s initiatives related to market structure. In particular, in 2018 the SEC: (i) adopted the transaction fee pilot; (ii) adopted rules to provide for greater transparency of broker order routing practices; and (iii) adopted rules related to the operational transparency of alternative trading systems (“ATSs”) that trade national market system (“NMS”) stocks. The new rules were designed to increase efficiency in markets and importantly provide more transparency and disclosure to investors.

Clayton and Redfearn then turned to the equity market structure agenda for 2019, which is focused on a review and possible overhaul to Regulation NMS. Regulation NMS is comprised of various rules designed to ensure the best execution of orders, best quotation displays and access to market data. The “Order Protection Rule” requires trading centers to establish, maintain and enforce written policies and procedures designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers.

The “Access Rule” requires fair and non-discriminatory access to quotations, establishes a limit on access fees to harmonize the pricing of quotations and requires each national securities exchange and national securities association to adopt, maintain, and enforce written rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations. The “Sub-Penny Rule” prohibits market participants from accepting, ranking or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny. The “Market Data Rules” requires consolidating, distributing and displaying market information.

In recent roundtables on the topics of the market structure for thinly traded securities, regulatory approaches to combating retail fraud, and market data and market access, Chair Clayton and Director Redfearn realized the impact of Regulation NMS on these matters. Each of these topics was then addressed.

Thinly Traded Securities

Regulation NMS mandates a single market structure for all exchange-listed stocks, regardless of whether they trade 10,000 times per day or 10 times per day. The relative lack of liquidity in the stocks of smaller companies not only affects investors when they trade, but also detracts from the companies’ prospects of success. Illiquidity hampers the ability to raise additional capital, obtain research coverage, engage in mergers and acquisitions, and hire and retain personnel. Furthermore, securities with lower volumes have wider spreads, less displayed size, and higher transaction costs for investors.

One idea to improve liquidity is to restrict unlisted trading privileges while continuing to allow off-exchange trading for certain thinly traded securities. Similar to market maker piggyback rights for OTC traded securities, when a company goes public on an exchange, other exchanges can also trade the same security after the first trade on the primary exchange. This is referred to as unlisted trading privileges or UTP. Where a security is thinly traded, allowing trading on multiple platforms can exacerbate the issue. If all trading is executed on a single exchange, theoretically, the volume of trading will increase.

Moreover, institutions are particularly hampered from trading in thinly traded securities as a result of Regulation NMS. That is, the Regulation requires that an indication of interest (a bid) be made public in quotation mediums which indication could itself drive prices up. The risk of information leakage and price impact has been quoted as a reason why a buy-side trader would avoid displaying trading interest on an exchange in the current market structure.

Combating Retail Fraud - Rule 15c2-11; Penny Stocks and Transfer Agents

The SEC has clearly been focused on retail fraud, and in particular with respect to micro-cap and digital asset securities, under the current regime. The SEC has actively pursued suspected retail fraud and scams in the last few years with the bringing of multiple enforcement actions and imposition of trading suspensions.

It seems that the SEC intends to review FINRA Rule 6432 and Rule 15c-211 as well.

FINRA Rule 6432 requires that all broker-dealers have and maintain certain information on a non-exchange traded company security prior to resuming or initiating a quotation of that security. Generally, a non-exchange traded security is quoted on the OTC Markets. Compliance with the rule is demonstrated by filing a Form 211 with FINRA.

The specific information required to be maintained by the broker-dealer is delineated in Securities Act Rule 15c2-11. The core principle behind Rule 15c2-11 is that adequate current information be available when a security enters the marketplace. The information required by the Rule includes either: (i) a prospectus filed under the Securities Act of 1933, such as a Form S-1, which went effective less than 90 days prior; (ii) a qualified Regulation A offering circular that was qualified less than 40 days prior; (iii) the company’s most recent annual reported filed under Section 13 or 15(d) of the Exchange Act or under Regulation A and quarterly reports to date; (iv) information published pursuant to Rule 12g3-2(b) for foreign issuers (see HERE); or (v) specified information that is similar to what would be included in items (i) through (iv).

The 15c2-11 piggyback exception provides that if an OTC Markets security has been quoted during the past 30 calendar days, and during those 30 days the security was quoted on at least 12 days without more than a four-consecutive-day break in quotation, then a broker-dealer may “piggyback” off of prior broker-dealer information. In other words, once an initial Form 211 has been filed and approved by FINRA by a market maker and the stock quoted for 30 days by that market maker, subsequent broker-dealers can quote the stock and make markets without resubmitting information to FINRA. The piggyback exception lasts in perpetuity as long as a stock continues to be quoted. As a result of the piggyback exception, the current information required by Rule 15c2-11 may only actually be available in the marketplace at the time of the Form 211 application and not years later while the security continues to trade.

Rule 15c2-11 was enacted in 1970 to ensure that proper information was available prior to quoting a security in an effort to prevent micro-cap fraud. At the time of enactment of the rule, the Internet was not available for access to information. In reality, a broker-dealer never provides the information to investors, FINRA does not make or require the information to be made public, and the broker-dealer never updates information, even after years and years. Moreover, since enactment of the rules, the Internet has created a whole new disclosure possibility and OTC Markets itself has enacted disclosure requirements, processes and procedures. The current system does not satisfy the intended goals or legislative intent and is unnecessarily cumbersome at the beginning of a company’s quotation life with no follow-through.

The industry seems to agree that 15c2-11 needs to be revised once more and Chair Clayton and Director Redfearn have acknowledged the issue. Chair Clayton has directed the Division of Trading and Markets staff to promptly prepare a recommendation to the SEC to update the rules.

Optimistically, the SEC will review and consider the OTC Markets’ suggestions for modification of the rules, including (i) make the Form 211 process more objective and efficient (currently FINRA conducts a merit review as opposed to a disclosure review); (ii) Form 211 materials should be made public and issuers should be liable for any misrepresentations; (iii) Interdealer Quotation Systems should be able to review 211 applications from broker-dealers; and (iv) allow broker-dealers to receive expense reimbursement for the 211 due diligence process.

Chair Clayton and Director Redfearn also touched on the topic of penny stocks. Penny stocks are generally defined by Exchange Act Rule 3a51-1 as securities priced below $5.00. The world of penny stocks has taken a hit lately, with Bank of America and its brokerage Merrill Lynch exiting the space altogether as numerous enforcement proceedings have been initiated against clearing firms that accept customer deposits of low-priced securities.

Chair Clayton indicates that he has asked the SEC staff to review the sales practice requirements relating to penny stocks. Director Redfearn adds that the staff plans to re-examine the current exceptions from the definition of “penny stock” with a view of providing heightened protections for retail customers.

According to the majority of information that exists on the topic, it appears that the SEC views a stock trading at $.01 with no current information the same way they view an OTCQX or Nasdaq Capital Markets security trading at $1.50 that is current in all its SEC Reporting Obligations.

While there are indeed companies trading in the micro-cap space that have no legitimate reason to do so, there are a far greater number of very promising, exceedingly innovative companies that contribute new jobs to the US economy while bolstering domestic growth overall.

In order for this market sector to operate efficiently, it is essential that a standardized and universally accepted system of comprised of definition, clarification and categorization be put into place. This will allow the wheat to be separated from the chaff in a manner that is consistent and confident.

Director Redfearn has also turned his attention toward transfer agents, mentioning the 2015 Advance Notice of Proposed Rulemaking and Concept Release on Transfer Agents. The goal is to further rules that apply to transfer agents in terms of their obligations related to the tracking and removal of restrictive legends.

Market Data and Market Access

There are currently two main sources of market data and market access in the U.S. equity markets. The first is the consolidated public data feeds distributed pursuant to national market system plans jointly operated by the exchanges and FINRA. The second is an array of proprietary data products and access services that the exchanges and other providers sell to the marketplace. The second set generally are faster, more content-rich, and more costly than the consolidated data feeds.

The SEC is exploring improving the free data feeds issued by the exchanges and FINRA, including to improve speed, content, order protection and best execution, depth of information, governance, transparency and fair and efficient access to the information.

The Author

Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm

Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service.

Palm Beach attorney Laura Anthony is also the author of, the leading news source for Pubco officers and directors, the producer and host of, Corporate Finance in Focus, and a contributor to The Huffington Post, Law360 and ABA Journal. Ms. Anthony is recognized by Martindale-Hubbel as one of America’s Most Honored Professionals and is also the recipient of the Martindale-Hubbel Distinguished® Rating.

Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital.

Ms. Anthony is on the board of directors for the American Red Cross for Palm Beach and Martin Counties, and provides financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several other Palm Beach philanthropic organizations. Attorney Laura Anthony currently resides in Palm Beach with her husband and daughter.

Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.

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