After clearing the SEC and FINRA, DTC approval used to be a matter of course for a company ready to be publicly-traded, now it is an obstacle barring some companies from trading, what happened?
Imagine successfully navigating the 110 meter hurdles and crossing the finish line only to find another hurdle in your path at 115 meters? That is exactly what many smaller issuers are encountering. After successfully navigating their registration statement through the Securities and Exchange Commission and their 15c2-11 through FINRA, and actually getting a trading symbol for the OTC Bulletin Board, some smaller issuers are being told their shares cannot trade electronically due to a holdup at The Depository Trust Company (DTC). Not only is this holdup an aggravation for the company and its shareholders, it can be a very expensive one due to the fact the company is already subject to the reporting requirements of the Securities and Exchange Act of 1934, as amended (“Exchange Act”). What happened? Why has DTC-eligibility become a road block?
What is DTC?
DTC is a subsidiary of The Depository Trust & Clearing Company. According to its website, DTC was created in 1973 to “reduce costs and provide clearing and settlement efficiencies by immobilizing securities and making “book-entry” changes to ownership of the securities. DTC provides securities movements for NSCC’s net settlements, and settlement for institutional trades (which typically involve money and securities transfers between custodian banks and broker/dealers), as well as money market instruments.” Everyone got that? O.k., in layman’s terms this means DTC provides the electronic basis through which stock sales bought and sold through brokers are transferred from the seller’s brokerage account to the buyer’s account. For example, when you place an order through your broker to buy shares of XYZ, Inc. that order goes through your broker to a clearing firm and then on to DTC to be processed. DTC receives the order and then operates back through the clearing firm and the seller’s broker to move the shares from the seller’s account to the buyer’s account. It is in this manner that shares are bought and sold electronically since, obviously, paper certificates are not transferred between owners that own shares in “electronic format” in their brokerage accounts. Therefore, if an issuer is not “DTC eligible” then its shares cannot be electronically transferred between brokerage accounts, which, based on the realities of the marketplace (especially the OTC Bulletin Board), means shares of the company will not be traded (technically the shares can be traded manually between accounts, but this takes days and is not a realistic option for companies relying on broker dealers for stock transactions – like all the companies on the OTC Bulletin Board). What this boils down to is that while DTC-eligibility is not a requirement to trade on the OTC Bulletin Board, it is a necessity to process trades on the OTC Bulletin Board if the company’s stock is going to trade with any volume.
As stated above, historically, approval by DTC was a matter of course after a company cleared SEC comments on its registration statement and cleared FINRA comments on its 15c2-11. Once this occurred one of the company’s shareholders would deposit shares with their broker and the broker, at times with the company’s transfer agent, would apply for DTC-eligibility through a clearing firm affiliated with DTC. Once the request was granted the company’s shareholders could then buy and sell stock electronically through brokers. But this seemingly automatic approval by DTC is not occurring any longer for many small issuers, and many are having trouble even finding a broker and/or clearing firm even willing to submit the DTC-eligibility application. Why? What happened? The cause is easy to pinpoint, it’s the reaction by DTC, brokers and clearing firms is much more difficult to grasp and has left many companies wondering exactly what they need to do to get DTC-eligibility.In January 2009, FINRA issued Regulatory Notice 09-05. In a nutshell this release was a reminder to FINRA’s member firms (broker-dealers) of their responsibility to ensure that federal securities laws and FINRA rules are complied with when they are participating in the sales of unregistered securities. According to the Release it was issued in response to some of its member firms missing “red flags” that signaled the possibility of illegal, unregistered distributions of certain companies’ stock. The gist of the Release was that FINRA’s member firms needed to make the necessary investigations of issuers and their stock issuances to ensure there were no illegal, unregistered distributions. Because smaller companies, without long operating histories, were more likely to trigger the “red flags” mentioned in the Release the Release has had its biggest impact on smaller public companies. FINRA’s member firms, broker-dealers, and the other entities involved in clearing stock transactions for the member firms, primarily clearing firms and DTC, have taken the Release to be a “shot across the bow” regarding their potential liability for any involvement they have with issuers or shareholders that are found to have conducted illegal, unregistered resales of the issuer’s securities.
What impact has this had smaller companies ability to get DTC-eligibility?
The actual impact of the Release, the reasoning behind member firms’ reaction, and what actual changes occurred with broker-dealers, clearing firms and DTC, is difficult to gauge as many of the entities in the chain will not talk directly with issuers and/or shareholders (its primarily the clearing firms and DTC that won’t talk directly with issuers and shareholders), so issuers and shareholders are left finding out information from brokers. So, while we are not privy to any actual changes in processes, etc., we can see the resulting impact of the Release on smaller public companies that did not yet have DTC-eligibility. For many of the shareholders of these companies they were told there was a holdup in process of obtaining DTC-eligibility and until that approval occurred the shares could not be processed for sale in a broker transaction. The reasons the shareholders were given by brokers were plentiful: “We are not submitting requests to the clearing firm to apply for DTC-eligibility at this time,” or “The clearing firm we use is not submitting DTC applications at this time, oh, and neither are any other clearing firms” or “We have requested the clearing firm to submit the DTC application, and they have done so, but DTC is reviewing its own internal procedures and it not processing any applications at this time.” Although the reasons varied, the impact was the same. Broker-dealers, clearing firms and DTC seemingly stopped all processing of stock for shareholders of these new issuers that were applying for DTC-eligibility for the first time and, therefore, shareholders of impacted issuers could not trade their shares in a broker transaction.
The negative impact this had on the issuers and their shareholders is difficult to overstate. In many instances, the shareholders of these companies had invested money in a small, promising private company years earlier and were finally in position to have the opportunity to get some return on their investment (even if they did not want to sell, just knowing the opportunity was there was what many were waiting for). They had followed the company’s registration statement through its amendments in the months-long process with the SEC and learned in a press release that the company’s 15c2-11 had cleared FINRA and the company finally had a ticker symbol. Then they learn they could not deposit and trade their shares. Even for the companies that have now resolved the issue, it was a very frustrating time and one that had an impact on its shareholders. For other companies the frustration is still going on.Thankfully, for some companies the issue has been resolved and they eventually received DTC-eligibility. I realize this article would prove more valuable if it disclosed how certain companies finally got over the final DTC hurdle, but at this time how this happened or why it happened after months of confusing answers is impossible to know. In theory, the broker-dealers, clearing houses, and DTC have developed, or are in the process of developing, procedures to process the requests of these newly-public companies in order to determine DTC-eligibility. However, to be fair to smaller companies considering going public, if the broker-dealers, clearing firms, and DTC have developed criteria for what companies they will approve and process to get DTC-eligibility, I hope they will share that information so small, private companies (and the practitioners that advise them) can make a decision as to what impact that may have on the company’s decision to start the going public process. While SEC and FINRA approval are far from guarantees when you start the going public process at least the review criteria and review process are known factors. DTC-eligibility should be the same.
A couple recent developments are worth mentioning. First, there has been some mention of a “DTC-eligibility fee” being charged in the range of $3,500 to $6,000, which, if true, is remarkably high considering the services performed. I think everyone is o.k. with a “risk premium” for the services for new small public companies in light of the FINRA Release, but that fee range is absurd. Second, and more importantly, according to the latest rumors, any name change, stock split or other activity that requires an issuer obtain a new CUSIP number will cause the company to need to re-apply for DTC-eligibility, which, based on what has occurred recently with new public companies, could be a time-consuming, expensive process with no known conclusion. Additionally, there is allegedly a legal opinion that may be required for these companies to obtain and submit to DTC with their re-application. This could also prove to be an expensive proposition. Stay tuned to our website for the latest updates as things are changing quickly, and be careful of hurdles appearing after the finish line, they can really trip you up.
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Craig V. Butler, Esq. is an attorney with The Lebrecht Group, APLC, located in Irvine, California and Salt Lake City, Utah. He can be reached at (949) 635-1240 or via e-mail at firstname.lastname@example.org with questions or comments. Please visit our website at www.thelebrechtgroup.com for future updates and other information.