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SEC Chair Jay Clayton Discusses Direction Of SEC

In a much talked about speech to the Economic Club of New York on July 12, 2017, SEC Chairman Jay Clayton set forth his thoughts on SEC policy, including a list of guiding principles for his tenure. Chair Clayton’s underlying theme is the furtherance of opportunities and protection of Main Street investors, a welcome viewpoint from the securities markets’ top regulator. This was Chair Clayton’s first public speech in his new role and follows Commissioner Michael Piwowar’s recent remarks to the SEC-NYU Dialogue on Securities Market Regulation largely related to the U.S. IPO market. For a summary of Commissioner Piwowar’s speech, read HERE.

Guiding Principles

Chair Clayton outlined a list of eight guiding principles for the SEC.

#1: The SEC’s Mission is its touchstone

As described by Chair Clayton, the SEC has a three part mission: (i) to protect investors; (ii) to maintain fair, orderly and efficient markets, and (iii) to facilitate capital formation. Chair Clayton stresses that it is important to give each part of the three-part mission equal priority. For more information on the role and purpose of the SEC, see HERE.

#2: SEC Analysis Starts and ends with the long-term interests of the Main Street investor

According to Clayton, an assessment of whether the SEC is being true to its three-part mission requires an analysis of the long-term interests of the Main Street investors, including individual retirement accounts. This involves reviewing actions in light of the impact on investment opportunities, benefits and disclosure information for “Mr. and Mrs. 401(k).”

#3: The SEC’s historic approach to regulation is sound

As I’ve written about many times, disclosure and materiality have been at the center of the SEC’s historic regulatory approach. Chair Clayton reiterates that point. The SEC does not conduct merit reviews of filings and registration statements but rather focuses on whether the disclosures provided by a company provide potential investors and the marketplace with the information necessary to make an informed investment decision. For more information on disclosure requirements and recent initiatives, see HERE and HERE.

In addition to disclosure rules, the SEC places heightened responsibility on the individuals and people that actively participate in the securities markets. The SEC has made it a priority to review and pursue enforcement actions, where appropriate, against securities exchanges, clearing agencies, broker-dealers and investment advisors. In that regard, the SEC has historically and will continue to enforce antifraud provisions. Clayton states that “wholesale changes to the Commissions’ fundamental regulatory approach would not make sense.”

#4: Regulatory actions drive change, and change can have lasting effects

Under the fourth principle, Clayton continues to speak of the benefits of the disclosure-based system for public company capital markets. However, he does note that over time, new disclosure rules have been added on to the old, based on determinations beyond materiality, and that the SEC now needs to conduct a cumulative and not just incremental view of the disclosure rules and regulations.

Clayton specifically points to the much talked about decline in the number of IPO’s over the last two decades. He also points out that the median word count for SEC filings has more than doubled in over the same period, and that reports lack readability. Clayton points out, and I agree, that fewer small and medium-sized public companies affects the liquidity and trading for all public companies in that size range. A reduction of U.S. listed public companies is a serious issue for the U.S. economy and an improvement in this regard is a clear priority to the SEC.

For more on the SEC’s ongoing Disclosure Effectiveness program, see the further reading section at the end of this blog.

#5: As markets evolve, so must the SEC

Technology and innovation are constantly disrupting the way in which markets work and investors transact. Chair Clayton is well aware that the SEC must keep up with these changes and “strive to ensure that our rules and operations reflect the realities of our capital markets.” Clayton sees this as an opportunity to make improvements and efficiencies.

The SEC itself has utilized technology to improve its own systems, including through the use of algorithms and analytics to detect companies and individuals engaged in suspicious behavior. The SEC is adapting machine learning and artificial intelligence to new functions, including analyzing regulatory filings. On the other side, the SEC has to be aware of the costs involved with implementing these changes, versus the benefits derived.

#6: Effective rulemaking does not end with rule adoption

The SEC has developed robust processes for obtaining public input (comments) and performing economic analysis related to its rulemaking. Clayton is committed to ensuring that the SEC perform rigorous economic analysis in both the proposed and adoption stages of new rules. Clayton is aware of the principle of unintended consequences in rulemaking and is committed to ensuring that rules be reviewed retrospectively as well. Clayton states, “[W]e should listen to investors and others about where rules are, or are not, functioning as intended.”

Although Clayton does not get into specifics, certainly changes are necessary in the disclosure requirements, fiduciary rule, Dodd-Frank rollbacks (see HERE on the Financial Choice Act 2.0); finders’ fees (see HERE for more), eligibility for Regulation A+ (see HERE for more), and small business-venture capital marketplace.

#7: The costs of a rule now often include the cost of demonstrating compliance

Clayton states, “[R]ules are meant to be followed, and the public depends on regulators to make sure that happens. It is incumbent on the Commission to write rules so that those subject to them can ascertain how to comply and — now more than ever — how to demonstrate that compliance.” Vaguely worded rules end up with subpar compliance and enforcement. Clayton refers to the officer and director certifications required by the Sarbanes-Oxley Act and the need to create a system of internal controls to support the ultimate words on the paper – which system can be hugely expensive.

I note that understanding rules and their application is one of the biggest hurdles in the small-cap industry, including where responsibility lies vis-à-vis different participants in the marketplace. For example, the responsibility of a company, transfer agent, introducing broker, and clearing broker in the chain of the issuance and ultimate trading of a security, continues to provide challenges for all participants. Often participants are left with an education and interpretation by enforcement process, rather than what would be a much more efficient system providing participants with the knowledge and tools to create compliance systems that prevent fraud and related issues and reduce the need for retrospective enforcement.

#8: Coordination is key

Clayton notes that “the SEC shares the financial services space with many other regulatory players charged with overseeing related or overlapping industries and market participants.” There are more than 15 U.S. federal regulatory bodies and over 50 state and territory regulators, plus the Department of Justice, state attorneys general, self-regulatory organizations (SRO – such as FINRA) and non-SRO standard-setting entities (for example, DTC) in the financial services sector. In addition, the SEC works with international regulators and markets cooperating with over 115 foreign jurisdictions.

Clayton specifically points to the regulations of over-the-counter derivatives – including security-based swaps for which the SEC shares regulatory functions with the CFTC (for more on this, see HERE). Clayton is committed to working with the CFTC to improve this particular area of financial regulation and reduce unnecessary complexity and costs.

In addition, cybersecurity is an important area requiring regulatory coordination. Information sharing is essential to address potential and respond to actual cyber threats.

Putting Principles into Practice

After laying out his eight principles for the SEC, Chair Clayton addressed some specific areas of SEC policy.

Enforcement and Examinations

Clayton is committed to deploying significant resources to enforcement against fraud and shady practices in areas where Main Street investors are most exposed, including affinity and micro-cap fraud. He indicates that the SEC is taking further steps to find and eliminate pump-and-dump scammers, those that victimize retirees, and cyber criminals. As a practitioner in the small- and micro-cap market space, I welcome and look forward to initiatives that work to reduce fraud, while still supporting the honest participants and the necessary small-business ecosystem.

Clayton also recognizes that the markets also have more sophisticated issues requiring enforcement attention related to market participants. The SEC is “committed to making our markets s fair, orderly, and efficient – and as liquid – as possible.” Although prior Commissioners and Chairs have made similar statements, the addition of “and as liquid” by this regime continues to illustrate a commitment to supporting business growth and not just enforcement.

Finally on this topic, Clayton stresses the importance of cybersecurity in today’s marketplace. Public companies have an obligation to disclose material information about cyber risks and cyber events (see HERE for more on this topic). However, cyber criminals, including entire nations, can have resources far beyond a single company, and companies should not be punished for being a victim where they are being responsible in face of cyber threats. To bring proportionality to the topic, Clayton points out that cyber threats go beyond capital markets but affect national security as well.

Capital Formation

Consistent with his pro-business attitude, Jay Clayton advocates enhancing the ability of “every American to participate in investment opportunities, including through public markets.” Of course, the flip side is the ability for businesses to raise money to grow and create jobs. Clayton is also consistent with the message that he and other Commissioners have been relaying that the U.S. public markets need to grow and become more attractive to businesses (without damaging the private marketplace).

As a first step, the SEC recently expanded the ability to file confidential registration statements for all Section 12(b) Exchange Act registration statements, initial public offerings (IPO’s) and for secondary or follow-on offerings made in the first year after a company becomes publicly reporting, to all companies. Previously only emerging growth companies (EGC’s) were allowed to file registration statements confidentially. For more on this, see my blog HERE. Clayton believes that allowing companies to submit sensitive information on a non-public basis for initial staff review, will make the going public process more attractive to earlier-stage entities.

As a last point on capital formation, Chair Clayton encourages companies to request waivers or modifications to the financial reporting requirements under Regulation S-X, where the particular disclosure or reporting is overly burdensome and not material to the total mix of information presented to investors.

Market Structure

Clayton suggests shifting the focus of the conversation on market structure to actions. He recommends proceeding with a pilot program to test how adjustments to the access fee cap under Rule 610 of the Securities Exchange Act of 1934 would affect equities trading. The pilot would provide the SEC with more data to assess the effects of access fees and rebates on market makers, pricing and liquidity. Clayton is open to that and further suggestions from the SEC’s Equity Market Structure Advisory Committee.

Clayton believes the SEC should broaden its review of market structure to also include the fixed-income markets, to provide stable investment options for retirees. In that regard the SEC is creating a Fixed Income Market Structure Advisory Committee.

Investment Advice and Disclosure to Investors

Chair Clayton addresses both the fiduciary rule and improving disclosures to investors. Related to the fiduciary rule, Clayton states that it is important for the SEC to bring clarity and consistency to the area. In that regard, in June the SEC issued a statement seeking public input and comment on standards of conduct for investment advisers and broker-dealers.

Related to disclosures, as with all other areas of disclosure, investment advisors must provide potential investors with easily accessible and meaningful information. Clayton refers to the SEC’s ongoing Disclosure Effectiveness initiative, the progress in which is summarized at the end of this blog.

Resources to Educate Investors

A priority for the SEC is to provide more information to investors through technology and other means.

Further Reading on Disclosure Effectiveness Initiative

I have been keeping an ongoing summary of the SEC’s ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. I note that we have not seen any regulatory changes since the election and new regime at the SEC, but certainly significant changes are expected in light of Chair Clayton’s, and the Commissioners’, publicly disclosed priorities.

On August 31, 2016, the SEC issued proposed amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The proposed amendments would require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the proposed amendment would also require that all exhibits be filed in HTML format. See my blog HERE on the Item 601 proposed changes.

On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE.

On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE.

That proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.

As part of the same initiative, on June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE.

As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the reporting requirements in general, see my blog HERE.

In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.

In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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SEC Adopts The T+2 Trade Settlement Cycle

Posted by Securities Attorney Laura Anthony | April 18, 2017 Tags: Conforming Stock Exchange Rule Amendments, DTC, DTC Process, Exchange Act Rule 15c6-1, SEC Adopts The T+2 Trade Settlement Cycle, T+2 amendment, T+4 settlement cycle

Introduction and brief summary of the rule

On March 22, 2017, the SEC adopted a rule amendment shortening the standard settlement cycle for broker-initiated trade settlements from three business days from the trade date (T+3) to two business days (T+2). The change is designed to help enhance efficiency and reduce risks, including credit, market and liquidity risks, associated with unsettled transactions in the marketplace.

Acting SEC Chair Michael Piwowar stated, “[A]s technology improves, new products emerge, and trading volumes grow, it is increasingly obvious that the outdated T+3 settlement cycle is no longer serving the best interests of the American people.” The SEC originally proposed the rule amendment on September 28, 2016. My blog on the proposal can be read HERE. In addition, for more information on the clearance and settlement process for U.S. capital markets, see HERE.

The change amends Rule 15c6-1(a) prohibiting a broker-dealer from effecting or entering into a contract for the purchase or sale of a security that provides for payment of funds and delivery of securities later than T+2, unless otherwise expressly agreed to by the parties at the time of the transaction. This means that when an investor buys a security, the brokerage firm must receive payment from the investor no later than two business days after the trade is executed. Also, when an investor sells a security, the investor must deliver the investor’s security to the brokerage firm no later than two business days after the sale.

The rule does not apply to private exempt transactions such as private placements. The rule also allows a managing underwriter and issuer to agree to a trade settlement cycle other than T+2 as long as the agreement is express and reached at the time of the transaction. Firm commitment offerings are also exempted. In particular, Rule 15c6-1(c) allows registered firm commitment underwritten transactions that price after 4:30 p.m. ET to use a T+3 or T+4 settlement cycle.

The reduction of the settlement cycle to T+2 will also assist in aligning global clearing of securities as many markets, including the United Kingdom and many European countries, are already on the T+2 schedule.

Compliance with the new rules is effective on September 5, 2017.

Background

DTC provides the depository and book entry settlement services for substantially all equity trading in the US. Over $600 billion in transactions are completed at DTC each day. Although all similar, the exact clearance and settlement process depends on the type of security being traded (stock, bond, etc.), the form the security takes (paper or electronic), how the security is owned (registered or beneficial), the market or exchange traded on (OTC Markets, NASDAQ…) and the entities and institutions involved.

All securities trades involve a legally binding contract. In general, the “clearing” of those trades involves implementing the terms of the contract, including ensuring processing to the correct buyer and seller in the correct security and correct amount and at the correct price and date. This process is effectuated electronically.

“Settlement” refers to the fulfillment of the contract through the exchanging of funds and delivery of the securities. In 1993, Exchange Act Rule 15c6-1 was adopted, requiring that settlement occur three business days after the trade date, commonly referred to as “T+3.” Delivery occurs electronically by making an adjusting book entry as to entitlement. One brokerage account is debited and another is credited at the DTC level and a corresponding entry is made at each brokerage firm involved in the transaction. DTC only tracks the securities entitlement of its participating members, while the individual brokerage firms track the holdings in their customer accounts. Technology, of course, plays an important role in the process and ability to efficiently manage settlements.

There may be two brokerage firms between DTC and the customer account holder. Brokerage firms that are direct members with DTC are referred to as “clearing brokers.” Many brokerage firms make arrangements with these DTC members (clearing brokers) to clear the securities on their behalf. Those firms are referred to as “introducing brokers.” A clearing broker will directly route an order through the national exchange or OTC Market, whereas an introducing broker will route the order to a clearing broker, who then routes the order through the exchange or OTC Market.

The Dodd-Frank Act added a definition of, and responsibilities associated with, a “financial market utility” or FMU. Clearing brokers are FMU’s. FMU’s provide the actual functions associated with clearing trades through the DTC system. As part of that process, a division of DTC, the National Securities Clearing Corporation (“NSCC”), becomes the buyer and seller of each contract, netting out and settling all brokerage transactions each day, making one adjusting entry per day. The net entry debits or credits the brokerage firm’s account as necessary. When one of the counterparties in the process does not fulfill its settlement obligations by delivering the securities, there is a “failure to deliver.” Overall, failures to deliver are less than 1% of all transactions.

Likewise, a cash account is maintained for each brokerage firm, which is netted and debited and/or credited each day. These accounts can be in the billions. Clearing firms can either settle each day or carry their open account forward until the next business day. Because all transactions are netted out, 99% of all trade obligations do not require the exchange of money, which helps reduce some risk. NSCC’s role in this process is referred to as a central counterparty or CCP. This process is continuous.

Looking at the process from the top down, the CCP carries the risk that the clearing firm (or FMU) will not have the financial resources to perform its obligations. In turn, the clearing firms have risks from their customers, including introducing brokers, who in turn ultimately have risks from the individual account holders. The risks are compounded by changing values of the securities being traded, during the settlement process. The faster a trade settles, the lower the cumulative risk at each level of the process.

This is a very simplified high-level description of the process. Technically, the roles of DTC and its subsidiaries, CEDE and NSCC, as well as clearing agencies and introducing brokers involve a complex set of regulations, with different definitions, obligations and roles for the different hats the entities wear depending on the type of security being traded (stock, bond, etc.), how the security is owned (registered or beneficial), the form the security takes (paper or electronic), the market or exchange traded on (OTC Markets, NASDAQ…) and the entities and institutions involved (retail or institutional).

Exchange Act Rule 15c6-1

Exempted securities include government and municipal securities, insurance products, commercial paper, limited partnership units that are not listed on an exchange or automated quotations system (OTC Markets), and sales in a firm commitment underwritten offering that are priced after market close. Firm commitment offerings can rely on an extended T+4 settlement cycle. The new rule does not amend the exemptions or the settlement cycle for firm commitment underwritten offerings.

One of the SEC’s roles is to enhance the resilience and efficiency of the clearance and settlement process such that the system itself does not add to, but rather subtracts from, the risks associated with trading in securities. To further this goal the SEC has amended Rule 15a6-1(a) to shorten the settlement cycle to T+2. The SEC believes this change will reduce various risks in the marketplace, including: (i) the credit risk that one party will be unable to fulfill its delivery obligations (of either cash or the securities) on the settlement date; and (ii) the market risk that the value of the securities will change between the trade and settlement such as to result in a loss to one of the parties.

To drill down further on the summary of the settlement and clearing process described in the background section of this blog, the following is a high-level description of what happens following the execution of a trade. When a trade is submitted to an exchange or alternative trading system (such as OTC Markets), it is matched with a counterparty. That is, a buy order is electronically matched to a sell order. As long as there is a match, the trade is locked in and sent to NSCC.

On the trade date (T), NSCC validates the trade data and communicates receipt of the transaction. At that moment the parties are legally committed to complete the trade. Before the new amendment, at midnight on the first day (T+1), NSCC substitutes itself as the legal buyer and legal seller. Technically, the first buy/sell contract is replaced by two new contracts, one between NSCC and the buyer and the other between NSCC and the seller. The NSCC substitution will now occur at the point of trade comparison and validation.

Historically, on the second day (T+2), NSCC would issue a trade summary report to its members which summarizes all securities and cash to be settled that day, and show the net positions for each. NSCC also sends an electronic instruction to DTC to process the net security and cash settlements. This will now occur on T+1. Finally, on the third day (T+3), DTC process the electronic settlement by transferring cash and securities between the broker-dealer accounts and the broker-dealers, in turn, put the securities and/or cash in their customer accounts. With implementation of the rule change, this final step will be completed on the second day (T+2).

Although institutional trading is similar, there are unique aspects and there can be additional participants. For example, an institution may have a custodian of its securities in addition to its broker, may use a matching provider and may avail itself of different netting and settling processes within the brokerage and DTC systems. Although the detailed process may differ, ultimately both retail and institutional trades will now fully settle in the new T+2 timeline.

As mentioned, the length of the settlement cycle impacts the exposure to credit, market and liquidity risks for the participants. The participants, including NSCC, take measures to reduce these risks, including by requiring funds to be kept on deposit by clearing and brokerage firms effecting such participants’ liquidity. Even then, however, all participants are exposed to market risk during the settlement process, including a decline in value of the traded securities and the risk that such decline could exceed the broker’s capital deposit or result in a failure to deliver.

A reduction in risks would reduce the necessity to mitigate such risk, including reducing the funds that must be kept on deposit by participants. It is undisputed that reducing the settlement cycle reduces these risks. Firms may pass these benefits on to other market participants, including retail investors in the form of reduced margin charges. Also, obviously if funds are tied up for three days pending a settlement of a transaction, whether you are the retail investor or clearing agency, there is a lack of available liquidity to participate in other transactions during that time.

The SEC also believes that shortening the standard settlement cycle will promote technological innovation and changes in market infrastrucutres and operations, incentivizing market participants to make work further to make the markets more efficient.

The rule amendment requires the SEC to conduct a study no later than September 5, 2020, on the impact of the T+2 amendment and the potential impact of further reducing the trade settlement cycle to T+1.

Conforming Stock Exchange Rule Amendments

On February 10, 2017, the SEC approved rulemaking proposals submitted separately by the New York Stock Exchange, the NASDAQ Stock Market and the NYSE MKT that will conform stock exchange rules to the amendments to Rule 15c6-1, with the amendments to become operative concurrently with the SEC compliance date.

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The Author

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SEC Proposes Shortening Trade Settlement

Posted by Securities Attorney Laura Anthony | December 27, 2016 Tags: DTC, DTC Process, SEC, SEC Proposes Shortening Trade Settlement

On September 28, 2016, the SEC proposed a rule amendment to shorten the standard broker-initiated trade settlement cycle from three business days from the trade date (T+3) to two business days (T+2). The change is designed to help reduce risks, including credit, market and liquidity risks, associated with unsettled transactions in the marketplace. Outgoing SEC Chair, Mary Jo White was quoted as saying that the change “is an important step to the SEC’s ongoing efforts to enhance the resiliency and efficiency of the U.S. clearance and settlement system.” I have previously written about the clearance and settlement process for U.S. capital markets, which can be reviewed HERE.

Background

“Settlement” refers to the fulfillment of the contract through the exchanging of funds and delivery of the securities. In 1993, Exchange Act Rule 15c6-1 was adopted requiring that settlement occur three business days after the trade date, commonly referred to as “T+3.” Delivery occurs electronically by making an adjusting book entry as to entitlement. One brokerage account is debited and another is credited at the DTC level and a corresponding entry is made at each brokerage firm involved in the transaction. DTC only tracks the securities entitlement of its participating members, while the individual brokerage firms track the holdings in their customer accounts. Technology, of course, plays an important role in the process and ability to efficiently manage settlements.

Exchange Act Rule 15c6-1

Exchange Act Rule 15c6-1 prohibits a broker-dealer from effecting or entering into a contract for the purchase or sale of a security, subject to certain exemptions, that provides for the payment of the funds or delivery of the securities later than the third business day after the contract (i.e., trade) date unless expressly agreed upon by both parties at the time of the transaction. Exempted securities include government and municipal securities, commercial paper, limited partnership units that are not listed on an exchange or automated quotations system (OTC Markets), and sales in a firm commitment underwritten offering that are priced after market close.

Firm commitment offerings can rely on an extended T+4 settlement cycle. It is unclear what impact the proposed rule change will have on this exception. The SEC rule release has sought comment on the question.

One of the SEC’s roles is to enhance the resilience and efficiency of the clearance and settlement process such that the system itself does not add to, but rather subtracts from, the risks associated with trading in securities. The SEC is proposing to amend Rule 15a6-1(a) to shorten the settlement cycle to T+2. The SEC believes this change will reduce various risks in the marketplace, including: (i) the credit risk that one party will be unable to fulfill its delivery obligations (of either cash or the securities) on the settlement date; and (ii) the market risk that the value of the securities will change between the trade and settlement such as to result in a loss to one of the parties.

To drill down further on the summary of the settlement and clearing process described in the background section of this blog, the following is a high-level description of what happens following the execution of a trade. First, when the trade is submitted to an exchange or alternative trading system (such as OTC Markets), it is matched with a counterparty. That is, a buy order is electronically matched to a sell order. As long as there is a match, the trade is locked in and sent to NSCC.

On the trade date (T), NSCC validates the trade data and communicates receipt of the transaction. At that moment the parties are legally committed to complete the trade. At midnight on the first day (T+1), NSCC substitutes itself as the legal buyer and legal seller. Technically, the first buy/sell contract is replaced by two new contracts, one between NSCC and the buyer and the other between NSCC and the seller. On the second day (T+2), NSCC issues a trade summary report to its members which summarizes all securities and cash to be settled that day, and shows the net positions for each. NSCC also sends an electronic instruction to DTC to process the net security and cash settlements. Finally, on the third day (T+3), DTC process the electronic settlement by transferring cash and securities between the broker-dealer accounts and the broker-dealers, in turn, put the securities and/or cash in their customer accounts.

Also, obviously if funds are tied up for three days pending a settlement of a transaction, whether you are the retail investor or clearing agency, there is a lack of available liquidity to participate in other transactions during that time.

The reduction of the settlement cycle to T+2 will also assist in aligning global clearing of securities as many markets including the United Kingdom and many European countries are already on the T+2 schedule.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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DTC Again Proposes Procedures For Issuers Subject To Chills And Locks

Posted by Securities Attorney Laura Anthony | August 30, 2016 Tags: DTC, dtc chill, dtc chills, DTC Eligibility, dtc global lock, dtc global locks, Finra

On June 3, 2016, the DTC filed a new set of proposed rules to specify procedures available to issuers when the DTC imposes or intends to impose chills or locks. The issue of persistent and increasing chills and global locks which once dominated many discussions related to the small- and micro-cap space has dwindled in the last year or two. The new proposed rule release explains the change in DTC procedures and mindset related to its function in combating the deposit and trading of ineligible securities.

Background

On October 8, 2013, I published a blog and white paper providing background and information on the Depository Trust Company (“DTC”) eligibility, chills and locks and the DTC’s then plans to propose new rules to specify procedures available to issuers when the DTC imposes or intends to impose chills or locks (see my blog HERE). On December 5, 2013, the DTC filed these proposed rules with the SEC and on December 18, 2013, the proposed rules were published and public comment invited thereon. Following the receipt of comments on February 10, 2014, and again on March 10, 2014, the DTC amended its proposed rule changes (see my blog HERE).

Then on August 14, 2014, the DTC quietly withdrew its proposed rules and was silent until the release of new proposed rules on June 3, 2016.

A DTC chill is the suspension of certain DTC services with respect to an issuer’s securities. Those services can be book entry clearing and settlement services, deposit services (“Deposit Chill”) or withdrawal services. A chill can pertain to one or all of these services. In the case of a chill on all services, including book entry transfers, deposits, and withdrawals, it is called a “Global Lock.”

From the DTC’s perspective, a chill does not change the eligibility status of an issuer’s securities, just what services the DTC will offer for those securities. For example, the DTC can refuse to allow further securities to be deposited into the DTC system or while an issuer’s securities may still be in street name (a CEDE account), the DTC can refuse to allow the book entry trading and settlement of those securities.

The proposed rule change would add new Rule 33 to address: (i) the circumstances under which the DTC would impose and release a restriction on deposits (“Deposit Chill”) or on book entry services (a “Global Lock”); and (ii) the fair procedures for notice and an opportunity for the company to challenge the Deposit Chill or Global Lock.

As stated in the rule release, the current proposed rules “specify procedures available to issuers of securities deposited at DTC when DTC blocks or intends to block the deposit of additional securities of a particular issue (‘Deposit Chill’) or prevents or intends to prevent deposits and restrict book-entry and related depository services of a particular issue (‘Global Lock’).”

Background and Purpose for the Rule

The DTC serves as the central securities depository in the U.S. facilitating the trading and operation of the country’s securities markets. I’ve written about the DTC on numerous occasions, including recently in this blog HERE – on the settlement and clearing process, which provides basic background and history on the role and function of the DTC in the clearing of trillions of dollars in securities on a daily basis.

Once a security is approved as eligible for DTC depository and book-entry services, banks and broker-dealersthat are participants with the DTC (which is almost all such entities) may deposit securities into their DTC accounts on behalf of their respective clients. Securities deposited into the DTC may be transferred among brokerage accounts by book-entry (electronic) transfer, facilitating quick and easy transactions in the public marketplace. Eligible securities are registered on the books of a company in the DTC’s nominee name, Cede & Co.

A basic premise to use of the DTC is that securities be fungible. To be fungible all deposited securities must be freely tradable and devoid of unique characteristics or features such as restrictions on transfer. Since deposited securities are in fungible bulk, the deposit or existence of any illegally or improperly deposited securities (restricted securities) taints the bulk of all securities held by the DTC for that company.

Previously, upon detecting suspiciously large deposits of thinly traded securities, the DTC imposed or proposed to impose a Deposit Chill to maintain the status quo while it contacted the company and required such company to provide a legal opinion from independent counsel confirming that the securities met the eligibility requirements. As a reminder, the basic eligibility requirements that counsel confirmed were that the company’s securities were (i) issued in a transaction registered with the SEC under the Securities Act of 1933, as amended (“Securities Act”); (ii) issued in a transaction exempt from registration under the Securities Act and that, at the time of seeking DTC eligibility, are no longer restricted; or (iii) eligible for resale pursuant to Rule 144A, Regulation S or other applicable resale exemption under the Securities Act.

The Deposit Chill could, and often did, remain in place for years due to a company’s non-responsiveness, refusal or inability to submit the required legal opinion. As a practitioner that wrote such opinions, I can say that they were very expensive for a company. In order to satisfy the obligations as an attorney, we would be required to review each questionable deposit, including all paperwork, and satisfy ourselves that the securities qualified for deposit. In other words, for each deposit we would review the documents as if we were writing the initial opinion letter. Many times the company did not have all the records available and the shareholder that had made the deposit was not available, non-responsive or no longer had any supporting records. Sometimes the list of questionable deposits was in the hundreds and reviewing each and every one was extremely time-consuming. On more than one occasion, a company would spend significant funds attempting to comply only to realize that they fell short and no opinion could be rendered.

Regarding Global Locks, the DTC monitored enforcement actions, regulatory actions and pronouncements alleging Section 5 violations and would impose a Global Lock upon learning of such proceedings. At the time, the DTC had the policy to release the Global Lock when the action was withdrawn, dismissed on the merits with prejudice or otherwise resolved in favor of the company or shareholder defendants. However, over time this system was problematic as many enforcement proceedings are only resolved after several years and often without any definitive determination of wrongdoing.

On March 15, 2012, the Securities and Exchange Commission (SEC) issued an administrative opinion stating that an issuer is entitled to due process proceedings by the DTC as a result of a DTC chill placed on an issuer’s securities (In the Matter of the Application of International Power Group, Ltd. Admin. Proc. File No. 3-13687). The SEC stated, “DTC should adopt procedures that accord with the fairness requirements of Section 17A(b)(3)(H), which may be applied uniformly in any future such issuer cases”; “Those procedures must also comply with Section 17A(b)(5)(B) of the Exchange Act, which requires clearing agencies when prohibiting or limiting a person’s access to services, to (1) notify such person of the specific grounds for the prohibition or limitation, (2) give the person an opportunity to be heard upon the specific grounds for the prohibition or limitation, and (3) keep a record.”

At the time, the SEC confirmed that the DTC could still put a chill on an issuer’s security prior to giving notice and an opportunity to be heard to that issuer, in an emergency situation, stating, “[H]owever, in such circumstances, these processes should balance the identifiable need for emergency action with the issuer’s right to fair procedures under the Exchange Act. Under such procedures, DTC would be authorized to act to avert imminent harm, but it could not maintain such a suspension indefinitely without providing expedited fair process to the affected issuer.”

Following International Power, the DTC filed proposed rules on December 5, 2013, which were withdrawn on August 14, 2014.

In the time since International Power, the DTC has determined that its proposed procedures for imposing Deposit Chills and Global Locks are more appropriately directed to current trading halts or suspensions imposed by the SEC, FINRA or a court of competent jurisdiction. In fact, the DTC seems to think that the Deposit Chill and Global Lock process they were using only created more problems. In the proposed rule release, DTC states, “DTC believes that wrongdoers have seemingly taken into account DTC’s Restriction process, and have been avoiding it by shortening the timeframe in which they complete their scheme, dump their shares into the market and move on to another issue.”

Moreover, imposing Global Locks in response to an SEC enforcement action did nothing to curtail the behavior which had already occurred. As the DTC notes, “by the time of an enforcement action, the wrongdoers had long since transferred the subject securities.” Further, neither the Deposit Chill nor the Global Lock affected the trading in the security. In short, the DTC realized that its methods were not working.

New Proposed Rule 33

Imposing Chills and Locks

The proposed new Rule is dramatically simplified from the early 2014 proposals. Under the proposed new Rule 33, the DTC will establish the basis for the imposition of Deposit Chills and Global Locks premised directly on current judicial or regulatory intervention or the threat of imminent adverse consequences to the DTC or its participants.

In particular, if FINRA or the SEC halts or suspends trading in a security, the DTC will impose a Global Lock. The DTC will also impose a restriction (Chill or Lock) if ordered to do so by a court of competent jurisdiction. The DTC, however, recognizes that FINRA and the SEC may issue a trading halt or suspension for other reasons than fraud or wrongdoing, such as due to a technical glitch. Accordingly, if the DTC reasonably determines that a Global Lock will not further its regulatory purposes.

The DTC will also impose a Chill (or Lock) when it becomes aware of a need for immediate action to avert an imminent harm, injury, or other material adverse consequence to the DTC or its participants. It is expected that these circumstances will be rare, but an example would be if the DTC becomes aware that persons were about to deposit securities at the DTC in connection an ongoing corporate hijacking, market manipulation, or in violation of the law, or if a company notifies the DTC of stolen certificates. In support of its ability to impose such as Chill or Lock, the DTC quotes the SEC’s opinion in International Power, as discussed above.

Releasing Chills and Locks

New Rule 33 also address the release of Chills and Locks. From a high level, a Chill or Lock can be released if it was imposed in error in the first instance, such as based on clerical error.

Where a Global Lock has been imposed as a result of an SEC or FINRA trading suspension or halt, the Global Lock will be lifted when the suspension or halt is lifted. Where a Global Lock or Chill is imposed based on court order, the DTC will release it when also ordered to do so by a court.

Where a Chill or Lock is imposed as a result of imminent adverse consequences, it would be lifted when the DTC reasonably determines that lifting such Chill or Lock would not pose a threat of imminent adverse consequences such that the original basis for imposition has passed. Examples of when such a Chill or Lock could be lifted include: (i) the perceived harm as passed or is significantly remote; (ii) when the basis for the issue no longer exists (for example, lost certificates found); or (iii) there is a prior Global Lock based on an SEC enforcement action, but there is no current indication that illegally distributed securities are about to be deposited.

Proposed Fair Procedures

The DTC has established procedures to give a company timely notice of the imposition of a Chill or Lock, an opportunity to respond or object in writing, and a review and determination by an independent DTC officer. The DTC will also maintain complete records of all actions and proceedings. The DTC will send the initial written notice to the company’s last known business address and to the company’s transfer agents, if any, on record with the DTC.

The notice will be sent within 3 days of the imposition of the Chill or Lock. The company will have 20 business days to respond. An independent DTC officer will review the file. The independent DTC officer may request additional information from the company. Once the review is complete, a final written decision will be sent to the company. The company will then have 10 business days to submit a supplement; however, the supplement will only be reviewed if the objection is based on a clerical mistake or clear oversight or omission. If a supplement is submitted, the DTC must respond within 10 business days.

The Rule change will not modify of affect the DTC’s current ability to (i) lift or modify a Chill or Lock; (ii) restrict services in the ordinary course based on other rules not associated with Chills or Locks; (iii) communicate with the company, its transfer agent, or its representative as long as communications are memorialized in writing; or (iv) send out a restriction notice in advance of imposing a Chill or Lock.

Chart Summary of DTC Proposed Rules

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

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