DTCC Puts Defrosting of Issuer Chills on Hold: Now What?

By all appearances, it’s back to square one for US corporate issuers when it comes to dealing with the Depository Trust & Clearing Corporation and the manner in which it imposes minor or more severe restrictions on a newly public company accessing some or all of its services.

Any possible future changes in DTCC’s adjudication of so-called “chills” and “locks” are now anybody’s guess. The DTCC declined to respond to FinOps Report’s request for comment on why it suddenly withdrew a proposal with the Securities and Exchange Commission to change its rules. The SEC is responsible for approving any change in DTCC’s procedures. If the change had been approved, issuers might have been guaranteed some advance notice of DTCC’s intent to impose restrictions, along with clearer instructions on how they could be reversed.

With DTCC yanking the proposal at the eleventh hour — right before August 21 when the SEC was set to issue its decision on the proposed rule change — industry consensus is that DTCC got wind that the SEC would be rejecting the rule change. Market watcher suggest that, given all the tit-for-tat verbal judo between DTCC and its critics — including issuers, transfer agents and corporate attorneys — over the rule change during the past few months, DTCC couldn’t really afford any more negative publicity.

Regardless of the reason it withdrew the proposed rule change, DTCC is left with two options: continue with the controversial status quo or start all over again by redrafting and resubmitting. Naturally, its critics are hoping the US clearing and depository giant decides to play ball and give them what they want — the fair shake they believed they’ve been denied so far — when it resubmits its newly worded proposal for a rule change.

What’s at Stake

Here is what the dispute is all about in a nutshell: As the umbrella organization clearing and settling US securities transactions, DTCC gets to call the shots on whether or not it approves of a company’s shares becoming depository-eligible when a firm goes public. If DTCC suspects an issuer hasn’t been following the law — that is, if shares are deposited in violation of state or federal law as could occur in a reverse merger, there is an enforcement action against an issuer, or it simply loses its transfer agent — it can subsequently either “chill” some of its services to the issuer or “lock” the issuer out of all of them.

In other words, DTCC can refuse to allow further shares to be deposited or withdrawn by its participant banks and broker-dealers. It also can refuse to allow trades in the company’s shares to be settled electronically on its books. That is until the issuer remedies whatever DTCC thinks it has done wrong.

DTCC’s critics insist the market infrastructure makes it very hard to do so, and a chill or lock can easily last for several months or even years. In the meantime, if the trades of an issuer’s stock can’t be settled electronically on the books of Depository Trust Company, the settlement house subsidiary of DTCC, investors would have to rely on moving paper certificates through transfer agents. It’s a far more expensive and time-consuming method and is considered a death knell by issuers, because trading in their shares comes to a virtual halt. Microcap companies are the ones affected most often, because of the higher potential for fraud.

DTCC’s critics acknowledge that the depository does have the right to chill or lock out a company, but argue that DTCC’s approach is draconian. It doesn’t give companies proper notification of when a chill or lock will be imposed and little recourse to rectify the situation. In a 2012 case involving a chill DTCC imposed on International Power Group, an SEC administrative judge ruled that DTCC must adopt fair procedures concerning the chills and locks process. However, because the judge didn’t clearly define just what those procedures should be, it was up to DTCC to work out the nitty-gritty. Therein lies the rub. DTCC can’t seem to agree with issuers, their corporate legal counsels, and their transfer agents on what the new procedures should be.

“Due Process”

In the proposed rule change first filed with the SEC in December 2013 and amended since then, DTCC appears more accommodating in laying out procedures for imposing and lifting chills and locks. It says it will provide advance notice to issuers about when a chill or lock will be imposed and more guidance on the legal opinions necessary to reverse the actions. But DTCC’s critics are still unhappy that the organization is not providing corporations affected by chills and locks their “due process.” In the proposed rule change, issuers were not granted the right to appeal DTCC’s decision to an independent panel, they say.

DTCC’s unwillingness to submit to the decision of an independent panel is “the only point in the rule change to which we object and hope DTCC incorporates the request when it files for a new rule change,” says Charlie Rossi, former president of the Securities Transfer Association, who now serves as an adviser to the trade group representing recordkeepers for registered shareholder accounts.

Others want DTCC to take any new proposed rule change a step further. “An independent hearing is just one of the critical elements that needs to be added to any proposed rule change,” says Gary Emmanuel, a corporate and securities attorney with the law firm of Sichenzia Ross Friedman Ference in New York. “Because the chills and locks process has such dramatic ramifications for issuers, we need a more reasonable process for companies to get a chill or lock lifted.”

What can issuers do in the meantime? “Should DTCC follow its current course of action which is not to give issuers due process, they may decide to file an injunction to prevent the DTCC from issuing a chill or lock,” says Simon Kogan, an attorney in Staten Island, New York who represents issuers fighting to overturn DTCC’s chill or lock. Of course, seeking an injunction can also be costly because of the high burden of proof and there is no guarantee of success.

Three chief executives of microcap companies contacted by FinOps refused to publicly comment on DTCC’s chills and locks policies for fear of alienating DTCC enough to either be the target of a chill or lock or not get their current one rescinded. The National Investor Relations Institute, the Alexandria,Va-based trade group representing investor relations specialists, says it is not familiar with the matter and referred FinOps to the STA.

But speaking on condition of anonymity, investor relations directors at two US microcap firms for which DTCC placed and later rescinded a chill called their experiences “harrowing.” They are grateful for the DTCC’s change of heart but are adamant the DTCC should change its policies to reduce the time it takes to lift a chill or lock.

“It’s just a bad situation,” says one investor relations manager. “We think the DTCC policies should be a lot more fair and we are sitting on the edge of our chairs waiting to see what it comes up with now.”