Transfer Agents, DTC Still Chilly On Issuer Freeze Policies (Updated)

(Editor’s note: On December 6, 2016 the SEC finally published its acceptance of DTC’s rule changes affecting how it will impose chills and locks on US corporate issuers. The agency’s decision marks the end of a contentious debate between DTC, issuers and their transfer agents. Still, reservations remain. “The vast majority of the new rules represent a dramatic improvement over the DTC’s historic practices and will benefit issuers greatly,” says Harvey Kesner, a partner with the law firm of Sichenzia Ross Ference Kesner in New York. “However, in allowing the DTC to retain some discretion, the SEC is potentially harming issuers, transfer agents and investors, should the DTC not be judicious in using its discretion.”

The US Securities and Exchange Commission’s efforts to curb fraud in the microcap market could hit a roadblock if transfer agents and the Depository Trust Company (DTC) don’t reach a consensus on the way the US central securities depository can freeze a company from using its services.

The Securities Transfer Association (STA), the trade group representing about 150 transfer agents, has asked the SEC to reject a rule change proposed by DTC last month which specified four circumstances under which the DTC can chill or lock issuers out of its services. The STA agreed with the first three, but disagreed with the DTC’s request that it be allowed to freeze an issuer out of its services at will. The SEC is responsible for approving any rule changes made by DTC, the US national depository. Comments on the proposal were due by June 30.

Transfer agents, which perform administrative work for registered shareholder accounts, are considered the first line of defense against microcap fraud, followed by the DTC. Transfer agents agree that the DTC has the right to “chill” or “lock” firms out of its services, but say that the depository has not always been fair when doing so. Making matters worse for issuers, the chill or lock can last anywhere from a few months to a few years.

Small-cap penny stock firms are the most susceptible to fraud and those planning to commit fraud will try to mislead transfer agents into removing restrictions which prevent private shares from being sold in the public market. Transfer agents for microcap firms may not have sufficient staff or experience to catch the scam. If unregistered shares that are not qualified to be sold to the public under federal law end up in the open market, con artists can set up “pump and dump” operations. That is, they artificially drive up the stock price by releasing false information to lure investors into buying shares, while selling their own holdings at the inflated prices. The unwary investors are left to discover that their “sure-fire” investment has tanked. The Financial Industry Regulatory Authority (FINRA), the broker-dealer self-regulatory organization, has cited examples of fraud in which holders of restricted securities were able to get the legends, or ownership restrictions, on such securities lifted by transfer agents unaware that they were helping perpetuate fraud.

Once a firm goes public, DTC calls the shots on whether or not it approves of a company’s shares becoming depository eligible. It has the authority to do so as the umbrella organization for clearing and settling US securities transactions. Most investors hold their shares in book-entry form, in the name of a financial intermediary which is a member of DTC. If DTC suspects an issuer hasn’t been following the law — that is, if shares are deposited in violation of state or federal law, there is an enforcement action against an issuer or it simply loses its transfer agent — it can subsequently either “chill” or “lock” out the issuer.

Of the two scenarios, a chill is the milder penalty. A chill is placed on one or more specific services the DTC offers such as the deposit of shares by its participants. A “lock” represents a freeze on all services. If trades in a company can’t be settled in book-entry form through DTC, an issuer can kiss goodbye any hope of establishing a liquid market for its shares. Trading volume will plummet as investors would have to settle their shares using certificates — a costly and time-consuming process.

Bad Blood

The STA’s disagreement between the STA and DTC over the DTC’s new proposal isn’t the first time the two organizations have butted heads. The DTC’s new request follows several failed attempts at reaching a consensus with issuers, their transfer agents, and legal counsel on how it will handle chills and locks following a 2012 decision by an SEC administrative judge. In the case involving a chill DTC imposed on International Power Group (IPG), the judge ruled that DTC had to adopt fair procedures concerning the chills and locks process. However, because the judge didn’t clearly define what those procedures should be, it was up to DTC to work out the details.

In a proposed rule change first filed with the SEC in December 2013 and subsequently amended, DTC tried to lay out terms for imposing and lifting chills and locks. But DTCC’s critics remained unhappy about the organization not providing corporations affected by chills and locks their “due process.” In the 2013 proposed rule change, issuers were not granted the right to appeal DTC’s decision to an independent panel. In 2014, the DTC withdrew yet another application for a rule change with the SEC at the eleventh hour.

The DTC wouldn’t respond to any questions about its proposal, whose timing of its proposal appears to be a calculated move to capitalize on the SEC’s attempt to ensure transfer agents do their part in reducing microcap fraud. Last year, as part of its concept release for upgrading antiquated rules for transfer agents, the SEC sought industry comment on proposed new rules requiring transfer agents to follow some common procedures for removing legends on restricted securities. The SEC noted that the removal of legends by transfer agents can often be a central element contributing to illegal, unregistered distributions of securities. In some cases, the SEC has charged transfer agents for violating SEC rules by helping effectuate an illegal unregistered distribution of shares or violating anti-fraud provisions. The STA responded by asking the SEC to grant transfer agents a “safe harbor” from any regulatory penalties if they followed the new rules.

In its request for a rule change last month, DTC acknowledged the inadequacy of its current policies to prevent fraud and the need for change. DTC has typically imposed a deposit chill when it detected suspiciously large deposits of a thinly traded eligible security. The chill would be maintained until the issuer could provide a legal opinion that the security fulfilled DTC’s requirements for eligibility — a process which could take years to resolve due to an issuer’s non-responsiveness, refusal or inability to submit the required legal opinion.

DTC also imposes a global lock when a governmental or regulatory authority has started a proceeding or legal action alleging violations of SEC regulations. The global lock could be released when the underlying enforcement action was withdrawn, dismissed, or otherwise resolved in a final, non-appealable judgment in favor of the wrongdoers. However, many enforcement actions are only resolved after several years and commonly without any definitive determination of wrongdoing, says DTC.

In its new proposal to the SEC, the DTC says that it now wants to impose a “chill” or more severe “lock” on an issuer when the SEC , FINRA or a court require that trading in a stock be halted. However, the DTC also wants to impose a restriction on issuers using DTC’s services to “avert an imminent harm, injury or other such material adverse consequence to DTC or its participants that could further arise from further deposits of, or continued book-entry services with respect to, an eligible security.”

The STA says that the DTC should not have that much leeway. In a letter to the SEC, Charles Rossi, chairman of the STA’s board advisory committee, says that if the SEC allows DTC to freeze issuers out of the depository’s services at will, it should require DTC to reverse the chill or lock in 10 days unless there is a trading halt imposed by the SEC, FINRA or a court order.

“The DTC’s discretion represents an extremely broad standard that would allow it to take action without any real evidence of the likelihood of actual harm or violation of objective standards,” says Rossi. Such an arbitrary restriction couldn’t be lifted unless the DTC determines the release of the restriction would not pose a threat of imminent adverse consequences to the DTC or its participants. The DTC would not pinpoint when that would happen and although the person responsible for lifting the restriction would be a different DTC officer from the one who issued the restriction, they are still colleagues. Hence, Rossi suggests, there would be a conflict of interest.

“DTC has made some progress from past proposals on when it will chill or lock out an issuer, aligning itself with the actions of proper authorities. But we are uncomfortable with any proposal that would give it subjective, open-ended discretion over when it will chill an issuer or what process it will use to remove the chill,” says Kara Kennedy, executive director of ClearTrust, a Lutz, Florida-based transfer agent, which serves small public companies and community banks. “The inclusion of DTC’s subjective discretion as an option brings us back to square one, where we were four years ago.”

In his letter to the SEC, Rossi called on the SEC’s commissioners rather than its staff to take over ruling on the DTC’s proposal. The reason: DTC has stalled complying with the SEC’s ruling in 2012 and the financial industry shouldn’t be forced to respond to further potential amendments which fail to propose uniform, transparent processes. Rossi also took the opportunity to ask the SEC to review DTC’s other allegedly unfair policies, such as when it allows transfer agents access to its FAST program to make shares of the corporate issues they service eligible for the depository’s direct registration system (DRS). The standards for membership in FAST are not fully transparent and not applied uniformly, he says. The DRS enables investors to keep shares in their own names on the books of transfer agents without holding any certificates.

The STA is the only organization that responded to the SEC’s request for feedback comment on DTC’s new proposal. It remains to be seen whether DTC would be willing to break the stalemate with transfer agents by acquiescing to the STA’s desire that it eliminate its discretion in implementing chills or locks or limits itself to a 10 day period. Then again, DTC might not have to be accommodating. Given the SEC’s current interest in preventing microcap fraud and its interest in updating transfer agent rules, DTC might be successful in winning the SEC’s approval for its new proposal.