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by Laura Anthony, Esq.

Once Again, DTC Amends Proposed Procedures for Issuers Affected by Chills and Proposes Subsequent Rule Change

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. 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.  This blog discusses those rule changes and the current status of the proposed rules.

The new rules provide significantly more clarity as to the rights of the DTC and issuers and the timing of the process.  For a complete discussion on background and DTC basics such as eligibility and the evolving procedures in dealing with chills and locks, including a complete discussion of the proposed rules published December 18, 2013, please see my white paper here 12/18/13.

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’).”

In the Matter of the Application of International Power Group, Ltd.

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).

In September 2009, the DTC put a chill on the trading of International Power Group, Ltd. (IPWG) 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.  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. As a result of this process, the DTC imposed a chill on the securities of IPWG.  IPWG was unsuccessful in getting the DTC to be responsive to its inquiries, let alone determine a process for removing the chill. So, although IPWG was clearly and undeniably greatly impacted by the DTC chill, at the time the 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.  In its opinion, the SEC held that an issuer, in this case IPWG, was an Interested Person for purposes of DTC 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 the DTC what the criteria were for determining whether the chill was appropriate or not should be, but only that the issuer is entitled to “fair procedures.”

Moreover, 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.”

Finally, the SEC confirmed that the 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.”

A DTC Chill or Global Lock – General

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, the term of art is 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.

DTC Statement of the Purpose of the Proposed Rule Changes

Once a security is approved as eligible for DTC depository and book-entry services, banks and broker-dealers that 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 freely tradable.  Therefore, in order to be DTC eligible, an issuer’s securities must (i) be issued in a transaction registered with the SEC under the Securities Act of 1933, as amended (“Securities Act”); (ii) be 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) be eligible for resale pursuant to Rule 144A or Regulation S under the Securities Act.

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.  As such, the DTC monitors enforcement actions, regulatory actions and pronouncements and red flags in the securities of DTC-eligible securities.  A red flag includes unusually large deposits of thinly traded, low-priced securities.  DTC Rule 6 allows the DTC to limit certain services to particular deposited securities.  In addition, Section 1.B.2 of the DTC’s Operational Arrangements give the DTC the power to require companies’ outside counsel to provide legal opinions in support of eligibility and free tradability of deposited securities.

In addition, the DTC looks for other red flags, including FINRA’s list of red flags such as the following:

  • A customer of the broker opens a new account and delivers physical certificates representing a large block of thinly traded or low-priced securities;
  • A customer of the broker deposits share certificates that are recently issued or represent a large percentage of the float of the security;
  • The company was a shell company when it issued the shares;
  • A customer of the broker with limited or no other assets under management at the firm receives an electronic transfer or journal transaction of large amounts of low-priced, unlisted securities;
  • The issuer has been through several recent name changes, business combinations or recapitalizations, or the company’s officers are also officers of numerous similar companies;
  • The issuer’s SEC filings are not current, or are incomplete or nonexistent.

Where the DTC’s monitoring raises concerns that securities held at the DTC have been distributed in violation of federal law, the DTC may impose a deposit chill or global lock.  The two main scenarios when this occurs are as follows: (i) Where the DTC detects suspicious, unusually large deposits of a low-priced or thinly traded security, they may and often do impose a Deposit Chill until, in the words of the DTC, “the issuer convincingly demonstrates that the securities are freely transferable.”  (ii) If the DTC determines that there is “definitive evidence” that restricted shares have been deposited, it will impose a Global Lock.  According to the DTC, definitive evidence is established if the SEC or other regulatory agency has brought an enforcement action against any defendant that has deposited the issuer’s securities into the DTC.  The DTC may also impose a Global Lock where the Issuer fails to respond to or adequately resolve a Deposit Chill.

Chart Summary of DTC Proposed Rules

Two Tables (2) (2) Two Tables (3)

DTC Proposed Process for Issuers

The newest amendments to the proposed rules clarify and narrow the DTC’s authority as a protector of the overall marketplace, to just a protector of the DTC system.  Rather than give an explanation of each of the changes from the last version of the proposed rules, this blog explains the proposed rules as they exist today.

The DTC has proposed rules (new Rules 22(A) and 22(B)) such that issuers will be notified in writing of chills and locks, have a set time frame in which to respond, and will have clear guidelines to be met to either prevent a chill or lock or remove same.  The DTC will agree to respond within a set time frame.  Moreover, and importantly, the DTC will agree to keep communication open between the issuer and its counsel, and the DTC and its counsel, throughout the process.

A.Deposit Chills (Rule 22(A)) In general, proposed Rule 22(A) provides companies with an opportunity to establish that they meet the DTC’s eligibility requirements, including by submitting an opinion from independent legal counsel:  “Proposed Rule 22(A) will not apply when DTC impose[s] operational restrictions on deposits or other services in connection with ordinary course of business processing of Eligible Securities.   One example of ‘ordinary course of business processing’ is the processing of corporate actions, including name changes and stock splits.”

Notification of Deposit Chill.  Pursuant to its Proposed Rule, the DTC will notify an issuer of a deposit chill no later than 20 business days prior to imposition of the Deposit Chill, or if the chill has already been imposed, no later than three business days after the chill has been imposed.

The DTC will send the notice via overnight courier to the issuer’s address in its regulatory filings or where it is incorporated. If the DTC cannot locate the issuer with reasonable diligence, it will send it the notice to the issuer’s registered agent for service of process.

The DTC has narrowed and clarified when a deposit chill may be imposed prior to notice.  In particular, the DTC may impose the chill prior to notice “in order to prevent imminent harm, injury or other such consequences to DTC or its Participants” or “if DTC reasonably determines that such action is necessary to protect the prompt and accurate clearance and settlement of securities transactions through DTC.”

The notice will provide an explanation of the specific grounds upon which the restrictions are being or have been imposed including the legal authority upon which DTC relies.  The notice will state the actions that the issuer must take in order to prevent or remove the restrictions, including generally requiring a legal opinion from independent counsel.  It will also provide the date the Deposit Chill was imposed or the date it will be imposed, should the issuer fail to respond to the Deposit Chill notice.

The issuer has 20 days to respond to the notice.  The DTC may extend this deadline for up to an additional twenty business days if the issuer establishes “good cause.” If the issuer demonstrates to DTC’s “reasonable satisfaction” that the issue complies with the DTC’s eligibility requirements and the applicable procedures, the Deposit Chill will be lifted or will not be imposed.

The Proposed Rules provide that the issuer must support its response with a legal opinion, prepared by independent counsel, confirming that the issuer’s securities deposited at the DTC satisfy the DTC’s eligibility requirements, including that they are freely tradable.  In particular, the opinion letter must specify that the securities “(i) are not restricted securities under SEC Rule 144(a)(3), or (ii) are exempt from any restrictions on transferability under the Securities Act.”  The DTC will provide a template for the legal opinion to the issuer.  It is not anticipated that the legal opinion requirements will be different than as in effect today.

DTC Review of Issuer Response.  The DTC may request further or additional information, in which case the issuer will have at least ten (10) days to provide such additional information.  The DTC will respond in writing to the issuer’s submission and legal opinion within twenty business days for pre-chill notices and within ten business days if the chill has already been imposed.

Determination.  An officer of the DTC who did not participate in the decision to impose the chill, together with outside counsel as appropriate, will decide whether the issuer’s response is satisfactory.  If the response from the issuer is sufficient, the chill will either not be imposed or will be lifted.  If a chill was imposed prior to the issuance of a Notice, the determination whether to lift such chill will be provided to the issuer within ten business days after receipt of the issuer’s response.  In the event of a pre-chill notice, the determination will be provided to the issuer within twenty business days after receipt of the issuer’s response.  This timing was not in the prior version of the proposed rules.

If the issuer does not respond in a timely manner (including after extensions) or such response is not sufficient, the chill will remain and a lock may be imposed.  In an adverse decision, prior to imposing a Global Lock, the DTC will give the issuer ten days in which to submit a supplemental response.  The supplemental response will be limited to establishing that either (1) the issuer did timely respond to DTC previously, or (2) that the DTC’s determination was the result of the DTC’s clerical mistake or a mistake arising from an oversight or omission in reviewing the issuer’s response.  This added process will not include an added substantive review.  The DTC will provide a determination within ten (10) days of receipt of the supplemental response.

The Record The record of a proceeding, for purposes of use in an appeal to the SEC, shall include: (i) The Deposit Chill Notice, the Deposit Chill Response, the Deposit Chill Decision, the Supplemental Deposit Chill Response, the Supplemental Deposit Chill Response Decision, the Additional Information Request, and the Additional Information Response; (ii) all documents submitted in connection with (i) and (iii) any written communications created pursuant to the proposed rules as described herein.

DTC reserves authority to modify or lift a chill or to impose a chill after making a favorable determination, with a restart of the proposed procedures.

B.Global Locks. Global locks can be imposed either where (i) an issuer has failed to respond or failed to adequately respond to a deposit chill notice or (ii) the DTC becomes aware that the SEC or other state or federal agency has commenced a judicial or administrative proceeding alleging that DTC-eligible securities have been sold in violation of Section 5 of the Securities Act or other applicable law.

Notification of Global Lock.  Pursuant to its proposed rule, the DTC will notify an issuer of a Global Lock no later than 20 business days prior to imposition of the Global Lock, or if the lock has already been imposed, no later than three business days after the lock has been imposed.  The issuer shall have twenty (20) days to respond.  The DTC may extend the deadline for up to an additional twenty (20) days if the issuer establishes “good cause.”

The DTC will send the notice via overnight courier to the issuer’s address in its regulatory filings or where it is incorporated. If the DTC cannot locate the issuer with reasonable diligence, it will send it the notice to the issuer’s registered agent for service of process.

The notice will provide an explanation of the specific grounds upon which the restrictions are being or have been imposed including the legal authority upon which the DTC relies.  The DTC will impose the lock prior to notice (i) to prevent imminent harm, injury or other such consequences to the DTC or its participants or (ii) if the DTC reasonably determines that such action is necessary to protect the prompt and accurate clearance and settlement of securities transactions through the DTC.  It will also provide the date the Lock was imposed or the date it will be imposed, should the issuer fail to respond to the notice.

The proposed rules differentiate Global Locks based on enforcement proceedings and Global Locks based on an issuer’s failure to respond or adequately respond to a chill.  Where the Lock is imposed as a result of an enforcement proceeding, the notice will provide that a “Global Lock will not be imposed, or, if already imposed, will be released if the issuer demonstrates either (1) that the Eligible Securities were not the intended subject of the Proceeding, or (2) that the Proceeding was withdrawn or dismissed on the merits with prejudice or otherwise resolved in a final, non-appealable judgment in favor of the Defendants.” The DTC will not provide a forum for litigating or re-litigating the allegations or findings in the enforcement proceeding.  As noted above, the notice will give twenty days to respond, with the ability to receive a twenty-day extension.

To be very clear, a DTC Global Lock may be imposed if an action is brought against any shareholder that has deposited the issuer’s securities into the DTC and the DTC reasonably believes that the action relates to the issuer’s securities.  The issuer itself does not have to be a party to the enforcement or legal proceeding.

DTC Review of Issuer Response.  The DTC will respond in writing to the issuer’s submission within twenty business days for pre-lock notices and within ten business days if the lock has already been imposed.    The DTC is cognizant of not providing an alternative forum for an issuer to litigate enforcement proceedings.  Accordingly, where there is a pending enforcement action, it is unlikely that a Global Lock will be lifted and the DTC’s review will be limited.

Determination.  If the response from the issuer is sufficient, the DTC decision will be to either (i) not impose or release the Lock; or (ii) impose or not release the Lock.  Otherwise, the DTC will release the Global Lock upon the eligible securities becoming eligible for free trading status pursuant to Rule 144 – that is, within either one year or six months, depending on whether the issuer is subject to the reporting requirements of the Exchange Act and depending on the company’s Rule 144 eligibility.

In particular, the proposed rules include a provision whereby Global Locks can be lifted and removed after a holding period analogous to Rule 144.  In particular, the DTC’s proposed rules include the lifting of a Global Lock after the following periods have elapsed:

  • For non-reporting issuers – one year after the latest date on which the outstanding litigation or administrative proceeding has been resolved with respect to any defendant that deposited securities at the DTC.
  • For reporting issuers – six months after the latest date on which the outstanding litigation or administrative proceeding has been resolved with respect to any such defendant.
  • Where the Global Lock was imposed for a failure to respond or properly respond to a Deposit Chill issue – for non-reporting issuers – one year after the date the Global Lock was imposed;
  • Where the Global Lock was imposed for a failure to respond or properly respond to a Deposit Chill issue – for reporting issuers – six months after the date the Global Lock was imposed.

The release of the Global Lock as set forth above would only be available to issuers that are not and have never been a “shell company” as defined by Securities Act Rule 144(i), unless the issuer had ceased to be a shell company and filed Form 10 type information.

The record for purposes of an appeal to the SEC will consist of the Global Lock Notice, the Global Lock Response and the Global Lock Decision.  Moreover, the proposed rules give the DTC full discretion to lift or modify a Global Lock on the same grounds for which a Lock can be imposed or lifted as set forth above.

The Author

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

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