DTCC’s Issuer Chills: Unfreezing Sparks Debate

Chills typically precede colds or fevers, which can be treated through medication.

But when the chills are related to cancellation of settlement and other  services  by the US market infrastructure Depository Trust & Clearing Corp. (DTCC), they can be as deadly as the Bubonic plague, say critics, who are now battling the efforts of its subsidiary Depository Trust Company (DTC) on its version of relief from the chills.

What would ordinarily be a slam-dunk approval of DTC’s proposed new procedures for due process by the Securities and Exchange Commission (SEC) has turned into a lengthy bout of verbal judo between the US securities depository on the one side and the Securities Transfer Association (STA) and law firms representing issuers on the other. The STA represents banks and companies hired by US corporations to service their registered shareholders. In the midst of this debate, the SEC, the US regulatory agency responsible for overseeing the DTC, now says it needs more time to ponder its decision. 

Depository Trust & Clearing Company (DTC) is responsible for the clearing and settling millions of US securities trades each year, as well as serving as the depository where shares and ownership records are maintained. To correctly manage the post-trade process, it must make certain that the securities are depository-eligible. In plain English that means the DTC must provide its blessings that the issuers are legit and are following mandated regulatory, legal, and operational procedures.

It’s a pretty powerful role because without DTC eligibility, it becomes much more difficult for an issuer to maintain an active market in its stock. Even after a security becomes DTC-eligible, the DTC can always decide to limit or terminate its services. If the DTC decides to “chill” an issuer, it can restrict some services such as limiting the ability of a bank or broker-dealer member to deposit or withdraw shares. If it decides to issue a “global lock” or freeze,  it terminates all services. Either way, the chill or lock can be effective for a few days or longer. If the cause of the DTC’s actions cannot be rectified, the issuer’s securities will be removed from DTC’s depository, which practically speaking means that trades can only be processed through the physical delivery of stock certificates between a buyer and seller’s bank and brokerage firm. Bottom line: a trade which would normally take three days to settle will take several weeks.

Although there are no official figures tallying up just how many companies have been subject to chills or freezes, DTC’s critics insist that such corporations have rarely received proper notice of the DTC’s actions or were provided a way to quickly rectify them. They term this deprivation of “due process,” equating it with being judged and sentenced without having a chance to defend themselves or even be told what the charges are.

Following a 2012 court case calling for the DTC to follow due process, the DTC agreed to institute new rules intended to provide fair procedures when imposing chills. But critics insist the DTC’s new proposed rules are still a bit draconian.

Crime and Punishment

The stakes are high for US corporations — particularly small-cap penny stock firms — because most US investors hold their shares in the name of their broker-dealer or banks which are members of  the DTC and must follow its rules. If the DTC decides the shares are no longer depository-eligible or can’t be settled on its books, trading volume will plummet, say the issuers’ attorneys, citing the anecdotes of damage to issuer corporations that have subsequently gone out of business. To sell any shares after issuers lose out on the DTC’s services, investors have to process their trades through transfer agents of the issuer corporations — a costly and cumbersome process limited exclusively to institutional investors, say the DTC’s critics .

No one really questions DTC’s authority or rationale for chilling a stock. The DTC does have legitimate reasons, such as when it suspects shares have been deposited into the depository in violation of state or federal law or when the DTC becomes aware of an enforcement action against an issuer. “The reality is that microcap issuers lose DTC’s services for two primary reasons: illegal issuances of free-trading securities based upon flawed tradability opinions and fraudulent investor relations activity,” says Brenda Hamilton of Hamilton & Associates Law Group in Boca Raton, Fla.in a company blog. “It should come as no surprise to microcap management that DTC reviews their issuance of free trading shares since these are the securities that DTC holds in its depository under the nominee name Cede & Co.”

However, no one likes the DTC’s tactics. The DTC allegedly does not offer inform issuers and their transfer agents well in advance of a chill and give them enough of an opportunity to address its concerns, or why it thinks they deserve a chill.

The DTC appears to be taking the criticism — and more importantly the SEC’s ruling — into consideration. It now says it will provide a notice to the issuer that a chill has been or will be imposed, detail the specific grounds for the chill, explain the actions the issuer must take to life the chill, and provide a mechanism for the automatic lifting of the chill in certain circumstances after a period of time.

“DTC will undertake to review written submissions of the issuer objecting to the restriction and to render a final decision concerning the restriction and maintain a complete record for submission to the SEC in the event an issuer appeals,” writes Isaac Montal, managing director and deputy general counsel at DTCC in an April 29 letter to the SEC, summarizing the organization’s new proposals.

So what’s wrong with that approach? While it wins praise from Hamilton, other attorneys for corporations affected by the DTC’s chills and transfer agents aren’t impressed. Relying on written correspondence isn’t enough to ensure due process and the issuer should be entitled to an “evidentiary hearing” before an independent panel, they insist. If other self-regulatory organizations such as the Financial Industry Regulatory Authority (FINRA) and NASDAQ allow for hearings when carrying out similar regulatory actions, they argue, so should DTC.

“We are puzzled by the DTC’s resistance to affording issuers a fair hearing,” writes Charles Rossi, chairman of the STA Board Advisory Committee in the trade group’s letter to the SEC. While Rossi says he appreciates the DTC’s willingness to provide an internal appeals process, he adds that by allowing issuers the right to be heard by an independent panel of non-DTC industry professionals, the DTC could also ensure issuers can present arguments, respond to questions and provide additional evidence in their favor.

The DTC was unavailable for further comment, as were several transfer agent companies, which the STA lists as members.

Flawed Comparisons

In its correspondence with the SEC, the DTC counters that FINRA and NASDAQ’s adjudicatory procedures don’t apply to chills. “Whether arising in the context of deposit chills or global locks these reviews do not implicate the hotly contested factual disputes and allegations of illegal and fraudulent conduct that characterize the regulatory and disciplinary proceedings that the STA proposes as models for DTC,” Montal responds in an April 29 letter to the SEC.

Although the DTC does acknowledge that its rule changes were prompted by the SEC’s ruling in 2012 involving International Power Group, it insists that the STA and others have misinterpreted the regulatory agency’s decision. “The Commission did not cite FINRA Rule 9588 [allowing hearings] as a prototype for the DTC to follow with respect to the imposition of all deposit chills and locks,” says DTC’s Montal.

Here is what the International Power Group case is about in a nutshell: the waste-to-energy company appealed to the SEC’s administrative court about a DTC decision to chill its stock after the DTC refused to allow the firm an oral hearing to contest the chill. The SEC ultimately didn’t exactly accuse the DTC of wrongdoing in its decision to chill the stock, but did say the DTC should adopt fair procedures for imposing chills to be applied uniformly in the future.

Still, by not clearly explaining what those procedures should be, securities attorneys not involved in the case tell FinOps Report, the SEC inadvertently opened the Pandora’s box for interpretation. That is where the heated debate comes into the picture.

In the latest in a series of letters to the SEC, the law firm of Sichenzia Ross Friedman Ference in New York argues that DTC should follow US constitutional requirements when providing fair procedures to ensure due process. By failing to do so through an oral hearing, the DTC is harming issuers and innocent investors.

The reason: the law firm says that retail investors are in practice prevented from selling their shares on the public market because brokers will generally not process trades of shares in certificated form through transfer agents. Issuers, in turn, are hurt by not having complete access to the public market and for undercapitalized companies, the DTC’s decision is a blemish which could affect institutional investment.

“Ironically,” Gary Emmanuel, an attorney with Sichenzia Ross Friedman Ference, tells FinOps, “DTC does allow for issuers to be heard under its rules of operation when taking certain actions such as when it determines that a security ceases to be eligible for DTC’s services, but it doesn’t think these rules apply when it comes to chills.” The distinction doesn’t make sense, says Emmanuel. The STA agrees.

In its last letter to the SEC on May 6 responding to Sichenzia Ross Friedman Ference’s arguments, the DTC makes one final stab at proving it is in the right. While Sichenzia Ross Friedman Ference is throwing around phrases such as constitutional standards, the DTC emphasizes that it relying on the letter of the SEC’s own rules.

“The proposed rules unquestionably satisfy these requirements [of Section 17A]. They provide issuers with notice and moreover a clearcut and fair procedure to establish that deposited securities are freely tradeable or that its securities are not the subject of an enforcement action,” writes Montal.

Any arguments that the DTC is unfair to issuers and investors is hogwash, according to the DTC. Neither a deposit chill nor a global lock prevents trading of an affected security and issuers can work through the new rules to resolve deposit chills quickly by submitting an appropriate legal opinion substantiating that the issuers satisfy DTC’s eligibility standard. “It is only in those cases where the issuer does not submit an opinion substantiating that its securities satisfy DTC’s eligibility standards that the DTC imposes or maintains the restriction,” says Montal.

When it comes to harming investors, the DTC says they reap what they sow. If the SEC has brought an enforcement action against them for “illegal distributions” of shares they are responsible for the adverse effects resulting from their actions. As a registered clearing agency, the DTC is obligated to protect the “integrity of its inventory” from being “tainted.” Period. Case closed.

However, to some attorneys, it is unclear just how the inventory is being “tainted.” And when it comes to reviewing legal opinions, the DTC  still has the final call on whether they are good enough to rescind the chill, they argue.

It’s now in the SEC’s hands to decide whether the medicine the DTC wants to offer to address a chill will make the patients — the issuers — and their extended families — the transfer agents and attorneys — well, or at least satisfied with how they’re being treated.