On December 5, 2013, The Depository Trust Company filed with the SEC proposed rules to modify its rules and procedures relating to deposit and transfer restrictions imposed or to be imposed by the DTC on an issuer’s securities. The aim of the rule change is to create greater transparency and an opportunity for an issuer to be heard. Click here for the complete text of the SEC release and here for the actual text of the amended rule.
No DTC service means no trading
DTC is the nation’s central securities depository. It performs services and maintains securities accounts for its participants, primarily banks and broker dealers, including the deposit with DTC of so-called eligible securities (i.e. “freely tradable" as substantiated by a legal opinion by the issuer’s outside counsel) for credit to a participant’s securities account. This process enables the electronic trading of securities so that investors and their brokers no longer have to handle physical certificates. These days, electronic trading is virtually the only way to transfer stock and other securities; brokers will only rarely accept certificates.
DTC may decline (additional) deposits of an issuer’s securities or refuse to perform all services including transfers if there is concern regarding a security’s eligibility based on suspicions that the particular security was issued without registration or a valid exemption. DTC restrictions may be categorized as follows:
What’s the problem?
Although the proposed rule is a promising start in the process of righting DTC procedural wrongs, the rule leaves much to be desired. I want to highlight one aspect of the proposal that impacts many small companies that have been the subject of a deposit chill for an extended period of time.
The rule proposes that restrictions be lifted automatically after a certain period of time in analogy to the holding periods of Rule 144 under the Securities Act of 1933. Specifically, it allows for a global lock removal within six months (in the case of a reporting issuer) or one year (in the case of a non-reporting issuer) after the disposition of the enforcement proceeding, or, if the global lock was the result of the issuer’s failure to respond adequately to the DTC, six months or one year, as the case may be, after the imposition of the global lock.
The proposed rule provides for the automatic lifting of global locks but not of deposit chills. The problem with that approach is that issuers whose securities have been the subject of a deposit chill will not be able to benefit from an automatic lifting of that deposit chill following the Rule 144 holding period time lapse. This can be especially painful for a smaller issuer whose securities have been under a deposit chill that predates International Power without making it into the big league of global lock subjects. They will now need the additional imposition of a global lock followed by a six month or one year waiting period, as the case may be, before the lock is released automatically. By that time, it may be too late to salvage what is left of the company’s business. Note that a deposit chill can be almost as draconian as a global lock as it effectively bars an issuer from raising additional financing. Both sanctions represent a sort of securities purgatory that could seriously imperil a small company’s continued existence.
In addition, from the perspective of the small issuer subjected to a pre-International Power deposit chill, differentiating between the removal of a deposit chill and a global lock as proposed by the rule has the bizarre effect that a global lock which is typically imposed as a result of law-enforcement or enforcement proceedings is easier to remedy than a deposit chill which is usually imposed based on mere concerns regarding a security’s eligibility.
Issuers of low-priced or thinly traded securities are the most likely targets of a DTC service suspension. A portion of those issuers lack real businesses and their securities are the most easily manipulated. I am not advocating for the rescue of microcap corporate trash that produces nothing more than “blue sky” type promises of eternal peace on earth, global cooling and total reforestation of the Amazon rainforest. However, there are many small companies that offer real goods and services; that are growing, and that need capital to expand. Their prospects are greatly diminished because of the yoke of a long term deposit chill.
To be clear, based on DTC's requirement that securities held in its inventory must be fungible (click here for an explanation of that concept), we can understand the argument that only a global lock lends itself to a free-up analogous to Rule 144 since the only way to ensure that a person has held his shares for the requisite six-month or one-year period is through a global lock which makes it impossible to transfer a security. No such assurance exists under a deposit chill since securities that were already in the system at the time of the imposition of the chill may be freely transferred. Nevertheless, it seems fundamentally unfair to treat chilled shares more severely than locked shares for the reasons expressed above.
What to do
In the spirit of jumpstarting business startups (JOBS Act, anybody?), it would serve the public interest and the investment community to have a deposit chill lifted automatically after a period of time, just like a global lock, at least for those chills imposed prior to the International Power ruling when DTC did not bother to advise issuers of a service suspension. Alternatively, the rule should allow for a fairness determination based on the facts and circumstances of the particular case that enough time has passed for the pre-International Power deposit chill to be lifted and allow the company to move on. Facts that may weigh in favor of a lifting of the chill should include the existence of a legitimate business; the length of time the chill has been in effect (especially if the chill predates the SEC’s International Power ruling); the minor nature of the alleged violations that resulted in the issuance of the securities as to which there exists concern (including a finding that the alleged violations were committed by persons not affiliated with the issuer); and the small number of issuer’s shares as to which there exists a concern as a proportion of the total number of shares outstanding.
The comment period for the proposal has now ended. Based on the small number of comment letters submitted to the SEC, this proposal does not appear to have created much buzz. That is unfortunate because DTC's actions have a potentially significant and negative impact on many small companies at a time when they need all the help they can get from regulators and SRO's such as DTC.
Bottom line: the proposed rule was not written in the spirit of the JOBS Act
No DTC service means no trading
DTC is the nation’s central securities depository. It performs services and maintains securities accounts for its participants, primarily banks and broker dealers, including the deposit with DTC of so-called eligible securities (i.e. “freely tradable" as substantiated by a legal opinion by the issuer’s outside counsel) for credit to a participant’s securities account. This process enables the electronic trading of securities so that investors and their brokers no longer have to handle physical certificates. These days, electronic trading is virtually the only way to transfer stock and other securities; brokers will only rarely accept certificates.
DTC may decline (additional) deposits of an issuer’s securities or refuse to perform all services including transfers if there is concern regarding a security’s eligibility based on suspicions that the particular security was issued without registration or a valid exemption. DTC restrictions may be categorized as follows:
- A Deposit Chill is typically imposed when the DTC detects large volume deposits of low-priced or thinly traded securities and its monitoring otherwise suggests that an issue may not be freely tradable; and
- A Global Lock is typically imposed when (i) the DTC becomes aware of law-enforcement or regulatory proceeding alleging the unregistered distribution of securities in violation of the federal securities laws, or (ii) an issuer fails to respond adequately to DTC’s imposition of a deposit chill.
What’s the problem?
Although the proposed rule is a promising start in the process of righting DTC procedural wrongs, the rule leaves much to be desired. I want to highlight one aspect of the proposal that impacts many small companies that have been the subject of a deposit chill for an extended period of time.
The rule proposes that restrictions be lifted automatically after a certain period of time in analogy to the holding periods of Rule 144 under the Securities Act of 1933. Specifically, it allows for a global lock removal within six months (in the case of a reporting issuer) or one year (in the case of a non-reporting issuer) after the disposition of the enforcement proceeding, or, if the global lock was the result of the issuer’s failure to respond adequately to the DTC, six months or one year, as the case may be, after the imposition of the global lock.
The proposed rule provides for the automatic lifting of global locks but not of deposit chills. The problem with that approach is that issuers whose securities have been the subject of a deposit chill will not be able to benefit from an automatic lifting of that deposit chill following the Rule 144 holding period time lapse. This can be especially painful for a smaller issuer whose securities have been under a deposit chill that predates International Power without making it into the big league of global lock subjects. They will now need the additional imposition of a global lock followed by a six month or one year waiting period, as the case may be, before the lock is released automatically. By that time, it may be too late to salvage what is left of the company’s business. Note that a deposit chill can be almost as draconian as a global lock as it effectively bars an issuer from raising additional financing. Both sanctions represent a sort of securities purgatory that could seriously imperil a small company’s continued existence.
In addition, from the perspective of the small issuer subjected to a pre-International Power deposit chill, differentiating between the removal of a deposit chill and a global lock as proposed by the rule has the bizarre effect that a global lock which is typically imposed as a result of law-enforcement or enforcement proceedings is easier to remedy than a deposit chill which is usually imposed based on mere concerns regarding a security’s eligibility.
Issuers of low-priced or thinly traded securities are the most likely targets of a DTC service suspension. A portion of those issuers lack real businesses and their securities are the most easily manipulated. I am not advocating for the rescue of microcap corporate trash that produces nothing more than “blue sky” type promises of eternal peace on earth, global cooling and total reforestation of the Amazon rainforest. However, there are many small companies that offer real goods and services; that are growing, and that need capital to expand. Their prospects are greatly diminished because of the yoke of a long term deposit chill.
To be clear, based on DTC's requirement that securities held in its inventory must be fungible (click here for an explanation of that concept), we can understand the argument that only a global lock lends itself to a free-up analogous to Rule 144 since the only way to ensure that a person has held his shares for the requisite six-month or one-year period is through a global lock which makes it impossible to transfer a security. No such assurance exists under a deposit chill since securities that were already in the system at the time of the imposition of the chill may be freely transferred. Nevertheless, it seems fundamentally unfair to treat chilled shares more severely than locked shares for the reasons expressed above.
What to do
In the spirit of jumpstarting business startups (JOBS Act, anybody?), it would serve the public interest and the investment community to have a deposit chill lifted automatically after a period of time, just like a global lock, at least for those chills imposed prior to the International Power ruling when DTC did not bother to advise issuers of a service suspension. Alternatively, the rule should allow for a fairness determination based on the facts and circumstances of the particular case that enough time has passed for the pre-International Power deposit chill to be lifted and allow the company to move on. Facts that may weigh in favor of a lifting of the chill should include the existence of a legitimate business; the length of time the chill has been in effect (especially if the chill predates the SEC’s International Power ruling); the minor nature of the alleged violations that resulted in the issuance of the securities as to which there exists concern (including a finding that the alleged violations were committed by persons not affiliated with the issuer); and the small number of issuer’s shares as to which there exists a concern as a proportion of the total number of shares outstanding.
The comment period for the proposal has now ended. Based on the small number of comment letters submitted to the SEC, this proposal does not appear to have created much buzz. That is unfortunate because DTC's actions have a potentially significant and negative impact on many small companies at a time when they need all the help they can get from regulators and SRO's such as DTC.
Bottom line: the proposed rule was not written in the spirit of the JOBS Act
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