On September 16, 2020, the U.S. Securities and Exchange Commission (“SEC”) adopted amendments to its existing Rule 15c-11, which governs the disclosure obligations of market professionals with respect to the so-called “Over-the-Counter” securities. One may see this as a simple update of a Rule that has not been addressed since 1991 (almost 30 years); alternatively one may see this as part of an effort to review and revise the entire U.S. capital market system. I suggest that a lot of it is the latter; and that it reflects a recognition that the U.S. capital markets have materially evolved since 1933 when the Securities Act of 1933, as amended (the “33 Act”) became law. See my prior blog “Accredited Investor: Regulatory Design, Revised Definition, and the Unfinished Result.” In the end, I note that the SEC seeks to learn whether its definitional reworking provides the “foundation for the SEC’s ongoing efforts to assess whether the exempt offering framework” promotes capital formation and expands investment opportunity. These recent amendments to Rule 15c-11 follow the same path, albeit in a different arena. It has become increasingly apparent that the processes for raising risk capital in the U.S. market has become sclerotic so that far more money is raised in private placements than in public offerings. According to the SEC in 2019 (the most recent figures available), $2.7 trillion was raised in private markets, versus $1.2 trillion in public markets. Even in the “public offering” space, more enterprises seek to go public using “Direct Listings,” or what used to be derisively called “blank check” companies (subject, inter alia, to greater regulatory scrutiny, particularly at the state level), Special Purpose Acquisition Companies or (“SPAC”)’s.

Some History on the Rule

The U.S. capital markets, for a variety of reasons, embraced the “public auction” model for valuation and pricing. This in turn led to the development of stock exchanges; see the brief history in my prior blog “ SEC Seeks to Increase the Security of Data on the Consolidated Audit Trail of the National Market System.” But not every security was and is traded on an exchange. The capital markets in the U.S. are both broad and deep, consistent with academic surveys finding that the U.S. markets account for between 55% and 60% of the world’s capital markets. In 1913, the National Quotation Bureau (“NQB”) was organized and became the source to learn the prices quoted for stocks and for bonds. The stock quotes were published on pieces of pink-colored paper; quotes for bonds on yellow paper. Hence, pricing for equity securities not traded on an exchange was found in the Pink Sheets. Of course, the information was only as timely and accurate as voluntarily reported by participating broker/dealers. After the passage of the Securities Exchange Act, as amended, of 1934 (the “34 Act”), much of the developments in the U.S. capital markets for equities focused on exchange-traded securities; pricing and transactions were reported by the exchanges, bringing both greater transparency and timeliness to price-discovery. Efforts to allow for alternative means to access capital were undertaken by, among others, the National Association of Securities Dealers (“NASD”), whose trading activities were frequently “Over-the-Counter,” a term used at least since the 1870’s for securities bought and sold face-to-face between broker/dealers. The NASD eventually evolved into two separate institutions:

• An organization to oversee fair and equitable practices by participants, the National Association of Securities Dealers Regulatory Authority, which has become the Financial Institution Regulatory Authority or FINRA

• The National Association of Securities Dealers Automated Quotation system, which since 1971 has been called NASDAQ

NASDAQ is now second only to the New York Stock Exchange (“NYSE”) in size and scope. NASDAQ was different from the beginning, in that all trading occurs on an electronic platform. The NYSE, like all other exchanges, was an open and active in-person auction, with appointed firms called Specialists acting as intermediaries between buyers and sellers, keeping the market from freezing up in the case of imbalances between purchase and sell orders. Technological advances being what they are, now even the NYSE is primarily a digital trading platform so that although there are still Specialists on the NYSE, the differences between the NYSE and NASDAQ are decreasing every day.

The Evolution of the Pink Sheets

What about the outliers, those companies that do not wish to engage in public offerings registered with the SEC; or are foreign entities regulated under the laws of their place of organization; or utilize the “crowdfunding” capital raises under Regulation CF; or do not have the resources and/or desire to meet the periodic reporting requirements under the 34 Act? With little regulatory guidance from the SEC (Rule 15c-11 was initially adopted in 1971 and not amended since 1991), the capital markets for “outliers” have become more extensive and deeper over the years. As Commissioner Hester Peirce said in a statement issued on September 16, 2020, to accompany the SEC action in adopting amendments to Rule 15c-11, these “outliers” “…can provide investors with unique and attractive investment opportunities in a part of the market often overlooked by large investment firms.” She suggests that investors willing to bear the risks and “looking for hidden value” may find some of these “outliers” “particularly attractive.” As she says about the September 16 amendments, “… by promoting disclosure the Commission can empower investors to make up their own minds about the merit of any given investment.”

By 1963, the NQB was acquired by the legal publishing company Commerce Clearing House (“CCH”). CCH owned it for 30 years until 1993. By September 1999, the NQB introduced its real-time Electronic Quotation Service. In the following year, it changed its name to Pink Sheets LLC, and in 2008 to Pink OTC Markets, and then in 2010 to OTC Markets Group. A network of 89 broker/dealers price and trade securities on the various OTC Markets platforms. There are three OTC Markets Group market platforms: OTCQX, on which securities of the most seasoned companies are traded; OTCQB, on which securities can be traded only if they meet one cent ($0.01) minimum price requirement; and Pink, on which securities may be traded even if they are not registered with the SEC and have limited or no financial information. The SEC considers both the OTCQX and OTCQB to be “Established Public Markets,” which has allowed them, since SEC action in 2016, to function as the source of pricing for equity-based financings. The OTC Market Group can facilitate the electronic trading of securities on either of these platforms with OTC Link ATS, an SEC-registered Alternative Trading System. In addition, as a result of provisions in the JOBS (Jumpstart Our Business Startups) ACT of 2014 (as of November 2018), 33 states recognize that securities traded on the OTCQX qualify for secondary trading exemptions under the Blue Sky laws of those states. Similarly, 30 states accord the same recognition to securities traded on the OTCQB.

Pink, in contrast, is an open market with no financial standards or reporting requirements; the securities on this platform are not registered with the SEC and are not eligible for any accommodation under state Blue Sky laws. The companies whose securities are traded here may have current, limited, or NO public disclosures. Here “current” will have quarterly and annual reports available, but may not have audited financial information. These companies may be shell or development-stage businesses with little or no operations. “Limited” means that a company has submitted information not older than six months old to the OTC Markets, or has made a filing within the prior six months on the SEC’s electronic EDGAR filing system. This category frequently includes bankrupt entities or ones having financial difficulties. “No” information means that a company provides no information, or what it provides is more than six months old. Defunct former public companies and so-called “dark” companies with questionable management or operations may be found here. Beyond the three OTC Markets Group platforms, there are two other ”markets” for “over-the-counter” securities:

• The OTCBB or Over-the-Counter Bulletin Board, which is now little used in light of the evolution of the OTC Markets Group platforms

• The Grey Market (also known as the Other OTC), where trading is solely bilateral with no central listings or quotes, but trades are reported through self-regulatory organizations to market data companies

Rule 15c2-11 Amendments

SEC regulation in these parts of the U.S. capital market, except for enforcement actions in response to fraudulent activity, rely upon the strictures placed on market professionals, i.e., broker/dealers and investment advisers. This somewhat “back door” method of regulation reflects both history and a concern that the SEC is not fully empowered under the securities laws (especially the 33 Act and the 34 Act) to assert its authority over non-exchange markets. This method parallels the SEC regulation of municipal securities, although there the concerns about jurisdictional authority are even more pronounced.

Under existing Rule 15c2-11, a market professional may not recommend a security, effectuate a trade of a security, or cause a security to be listed on a qualified Interdealer Quotation System (“IDQS”) unless current information is publicly available about the company and its securities. The amended Rule spells out revised financial information requirements in order to be “current.” A market professional may publish a quotation regarding a security, if a publicly available balance sheet is dated within 16 months of the quotation, as well as profit and loss and retained earnings statements for the 12 months preceding the date of the balance sheet. This replaces a requirement in the existing Rule that a publicly available profit and loss statement and a statement of retained earnings be reviewed if the balance sheet is older than six months. Under the existing Rule, market professionals could publish quotations and could trade a security IF another market professional had performed the current information review required by that Rule. The Rule amendment materially limits the availability of this so-called “piggyback” exemption. Any market professional seeking to rely on the “piggyback” exemption will now have to include at least a one-way price quotation, and may not use this exception within 60 calendar days following the end of any SEC trading suspension of trading in that security. No market professional may rely on the “piggyback” exemption with respect to the securities of a shell company after 18 months. The amended Rule requires all market professionals, or an IDQS, to obtain and review (the “Information Review Requirement” or “IRR”) current publicly available information concerning the issuer and a security BEFORE the market professional or IDQS may trade or list a security. Here, “current” means timely filed or filed within 180 days of an identifiable date, where “filed” means the type of filing, and place filed required for inclusion on a particular OTC Markets Group platform. There is another exception in the existing Rule that allows a market professional to publish quotations on behalf of company insiders or affiliates of the company. Under the amended Rule, a market professional must have met the IRR BEFORE the market professional may rely on this exception to publish such a quotation.

Any issuer not subject to the SEC’s regular reporting requirements (such as those on the Pink platform, some of those on the OTCQC, and any on either OTCBB or the Grey Market) must disclose additional information in order to have a market professional involved, including the names of all company insiders among other items. Further, the Rule amendments require any market professional to review the financial statements for two prior fiscal years. However, this two-year statement review requirement will not be effective for two years, so the amendments do not have a retroactive effect on securities that are outstanding. The existing Rule does not address startups utilizing crowdfunding under Regulation CF, as the crowdfunding concept was not extant in 1991 with the last Rule amendments. The Rule amendments specifically require, as part of the IRR, review of the most recent annual report, or if no annual report is available, the offering statement and any amendments concerning the company and the security, as well as the status of meeting targeted offering amounts.

The amendments also create some new exceptions:

• For well-capitalized issuers, which are issuers with actively traded and highly liquid securities of issuers with at least $50 million in total assets and at least $10 million in unaffiliated shareholder equity

• For securities in an underwritten public offering, so long as the market professional is named as an underwriter of the offering in the prospectus or the offering statement

• For securities where the market professional relies on a third party (such as an IDQS) determination that the IRR has been met for purposes of submitting or publishing a quotation

The Rule amendments, including these new exceptions, should prove of particular importance to market professionals dealing with securities issued in reliance on Regulation A, Regulation CF, and Section 506 of Regulation D, as the expectation is that the amendments will facilitate the development of a deeper secondary market and, accordingly, enhanced liquidity for such investments.

Timing and Observations

The Rule amendments will be effective 60 days after it is published in the Federal Register. The amendments provide, as noted above, that the new two-prior-year financial statement review requirement will not apply for two years, so the amendments will not have a retroactive effect. Similarly, shell companies will have 18 months to transition to operating businesses before becoming ineligible for trading by a market professional. In addition, the amendments explicitly provide for a nine-month transition period in order to allow market professionals and issuers to make needed adjustments and/or seek exemptive relief from the SEC, so that securities may continue to be quoted and to trade on an OTC Markets platform, as opposed to falling into the Grey Market. In her statement dated September 16, 2016, Commissioner Hester Peirce underscores the Commission’s “willingness to consider exemptive relief to allow the continued quotation of securities of specific issuers…” This follows her acknowledgment that the amendments may make certain non-exchange-listed investments more, not less, illiquid due to the revised requirements and the hesitancy of some market professionals to engage in transactions unless the market professional is confident that the company involved has met the requirements of the Rule amendments. She also calls attention to the SEC Adopting Release’s suggestion that a so-called “expert market” might be created, which would allow a trading platform for Grey Market securities “by sophisticated or professional investors” — surely a recognition that the U.S. capital markets are both deeper and wider than the scope of the security exchanges. Once again the Commission seeks to enhance the ability to raise risk capital (especially by facilitating greater secondary market liquidity in non-exchange-listed investments), while at the same time restraining the use of such investments as vehicles for fraudulent exploitation, a difficult and tension-filled endeavor.