Sign-up for our Free Newsletter, Whitepaper and SEC and FINRA Updates as they occur.

by Laura Anthony, Esq.

DTC Chills, Due Process and Rule 22

Back in October and November of 2011 I wrote a series of blogs regarding DTC eligibility for OTC (over the counter) Issuers.  OTC Issuers include all companies whose securities trade on the over the counter market, including the OTCBB, OTCQB and Pink Sheets.  Many OTC Issuers have faced a “DTC chill” without understanding what it is; let alone how to correct the problem.  In technical terms, a DTC chill is the suspension of book-entry clearing and settlement services with respect to an Issuer’s securities.  In layman’s terms it means your stock can’t clear or trade electronically.  Since all trading in today’s world is electronic, it really means your stock doesn’t trade.

The SEC’s Stance

As noted in the SEC opinion:

“…DTC provides clearance, settlement, custodial, underwriting, registration, dividend, and proxy services for a substantial portion of all equities, corporate and municipal debt, exchange traded funds, and money market instruments available for trading in the United States.  In 2010, DTC processed 295,000,000 book entry transfers of securities worth $273.8 trillion.”

If DTC doesn’t process and settle trading in your securities, it just doesn’t happen.

My previous blogs discussed how to become DTC eligible.  From the DTC perspective, a chill does not change the eligibility status of an Issuer’s securities, just what services the DTC will offer for those securities.  So while an Issuer’s securities may still be in street name (a CEDE account), DTC can refuse to allow the book entry trading and settlement of those securities.

International Power Group, Ltd.

On March 15, 2012 the Securities and Exchange Commission (SEC) issued an administrative opinion that sheds some light, though not much, on the DTC process (In the Matter of the Application of International Power Group, Ltd. Admin. Proc. File No. 3-13687).  As further discussed herein, the SEC ultimately issued an opinion stating that an Issuer is entitled to due process proceedings by DTC as a result of a DTC chill placed on an Issuers securities.

In the Matter of the Application of International Power Group, Ltd. (IPWG), in September 2009, DTC put a chill on the trading of IPWG’s securities following the initiation by the SEC of an action against certain defendants, not IPWG, for improper issuance and trading in certain OTC securities, including IPWG and 3 other Issuers.  Neither IPWG nor any of its officers or directors was a party to the SEC proceeding.

The portion of the SEC action related to IPWG indicated that about 80,000,000 shares of IPWG stock was sold in the public markets without proper registration or an exemption from registration.  In May 2010 the SEC settled with the Defendants related to IPWG for the usual penalties and permanent injunctions, which settlement did not address the already issued securities.

DTC Hearings and Rule 22

Upon learning of the DTC chill, IPWG requested that DTC provide a hearing in accordance with its Rule 22, the only DTC rule that allows for some sort of hearing process.  Rule 22 provides an opportunity for Interest Persons to be heard on any determination by DTC that an Issuer’s security is no longer an eligible security.  DTC denied IPWG’s request for a hearing stating that IPWG’s securities were still eligible and that it would lift the chill “once the matter of the unregistered IPWG shares is resolved with the SEC.”  DTC suggested IPWG take the matter up with the SEC.

IPWG was in a quandary.

There was no action pending with the SEC within which IPWG was a party and the SEC action related to IPWG shares had been settled, without addressing the “matter of the unregistered IPWG shares.”

No Clear Way Out

There was no clear way to take the matter up with the SEC.  In addition, there was no clear way to take the matter up with DTC.  DTC works through Participants – i.e. licensed broker-dealers not Issuers.  (See my previous blog on DTC eligibility).  Moreover, the shares it actually holds and trades are already issued and belong to shareholders, not the Issuer.  So, although IPWG was clearly and undeniably greatly impacted by the DTC chill, DTC took the position that it didn’t have any particular obligation to IPWG for its actions.

IPWG filed an administrative appeal with the SEC looking for assistance.  A discussion of jurisdiction and the rules vis a vie getting this matter in front of the SEC is beyond the scope of this blog, but suffice it to say, after much legal wrangling and a realization by all involved that there was no precedent to look upon, the SEC agreed to take the matter on.

Definition of Interested Person

In its opinion, the SEC held that an Issuer, in this case IPWG, was an Interested Person for purposes of Rule 22 and was impacted by the DTC chill such that they are entitled to due process and fair proceedings. The SEC did not tell DTC what the criteria for determining whether the chill was appropriate or not should be, only that the Issuer is entitled to “fair procedures”.  However, prior to the March 15, 2012 opinion, DTC could affect a chill on the trading of an Issuer’s security for an indefinite time, at its sole discretion, without recourse.  In fact, the way Rule 22 was written, prior to the March 15, ruling, not even a Participant broker dealer could appeal a chill.

Moreover, and importantly, the SEC held that in the future, an Issuer who is negatively impacted by DTC action can avail itself of the SEC administrative proceedings process for appeal following a negative decision in a DTC hearing and proceeding.

Emergency Chills and Fair Practice

Finally, the SEC confirmed that DTC can 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.”

The Author

Attorney Laura Anthony,
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions

Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public Companies as well as private Companies intending to go public on the Over the Counter Bulletin Board (OTCBB), now known as the OTCQB. For more than a decade Ms. Anthony has dedicated her securities law practice towards being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.

Ms. Anthony’s focus includes but is not limited to compliance with the reporting requirements of the Securities Exchange Act of 1934, as amended, (“Exchange Act”) including Forms 10-Q, 10-K and 8-K and the proxy requirements of Section 14. In addition, Ms. Anthony prepares private placement memorandums, registration statements under both the Exchange Act and Securities Act of 1933, as amended (“Securities Act”). Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of the Exchange Act, state law and FINRA for corporate changes such as name changes, reverse and forward splits and change of domicile.

Contact Legal & Compliance LLC for a free initial consultation or second opinion on an existing matter.

© Legal & Compliance, LLC 2012