Addressing the SEC White Paper on OTC Equities
The SEC recently published a paper on OTC equity securities on their website. While I am always happy to see more research around OTC equities, I am surprised by the paper’s overly negative and misinformed conclusions about the growth in OTC dollar volumes.
Moreover, I am concerned that these flawed conclusions, drawn from outdated research and a study of a small group of securities subject to investigative requests by the SEC or FINRA, will be used to develop new regulations that harm capital formation. Regulatory action based on this skewed sample could negatively impact the vast majority of companies that trade successfully on the OTC Markets.
The OTC Markets are More Transparent Today
The SEC’s paper, “Outcomes of Investing in OTC Stocks,” by Joshua White, does not address the improvements in transparency and technology made over the past several years. Instead, it focuses on negative outcomes for investors of Pink companies that provide no information to the market.
Academic studies show that more transparent companies that meet higher market standards have more liquidity and lower share volatility. We have long recognized this to be true. In fact, our mission is to provide investors with the information necessary to intelligently analyze, value and trade 10,000 U.S. and global securities through the broker of their choice.
We have done this by organizing these OTC equities into three tiered markets – OTCQX, OTCQB and Pink – based on the quality and quantity of information the companies make available. OTCQX and OTCQB require companies to make current information available. Within the Pink market, we further divide companies into those that provide “Current Information,” Limited Information” or “No Information.”
This segmentation has been instrumental in driving disclosure by more OTC companies and in providing sufficient information to investors when a company is NOT making adequate current information available, so they can perform additional due diligence or choose not to invest.
And it’s working. Contrary to the paper’s portrayal, OTC trading volumes are no longer concentrated in opaque issuers. In 2016, OTCQX, OTCQB and Pink companies with current financial disclosure comprised almost 99% of the total dollar volume of securities on our markets. In comparison, the dollar volumes in Pink Limited Information and Pink No Information companies that provide delayed or no information to investors have declined 35% and 89%, respectively, since 2014.
We are pleased to see the author acknowledge that securities on OTCQX, our top market with the highest financial and disclosure requirements, deliver positive median holding period and daily returns for investors. This demonstrates that the data-driven standards we have implemented for OTCQX – such as the prohibition of penny stocks, shells and bankrupt companies, material news disclosure requirements and common sense corporate governance – have addressed many of the problems mentioned in earlier studies.
OTCQX Index Performance in 2016
Shortcomings of the SEC’s paper
#1: The paper relies on incomplete data that is inherently negatively biased.
The claim that OTC securities generate negative returns on average is based on an analysis of sample Electronic Blue Sheet (EBS) data that is gathered by the SEC and FINRA as part of investigations into possible federal securities law violations, so it’s no surprise investors lose money when trading these lower quality securities.
Furthermore, the EBS data set the author uses comprises 514 out of 8,900 stock symbols, representing less than 6% of all securities traded on our markets and a mere 1% of the dollar volume of all OTC securities.
The paper also does not mention that the majority of dollar volume in Pink securities in recent years has been in ADRs and F-shares of foreign companies that are listed in good standing on a qualified foreign stock exchange. In fact, of the $200 billion in total dollar volume in 2015 cited in the paper, 88% was in ADRs and F-shares.
#2: The study does not reflect changes to our market structure in 2014.
The paper points to the increase in the number of Pink market securities (which have “no SEC registration or reporting requirements”) since 2012 to imply that the overall quality and transparency of our markets is declining. The fact is the growth of the number of securities on the Pink market is due in large part to the introduction of higher OTCQB Venture Market standards in 2014.
We introduced the new OTCQB standards in part to require more disclosure from SEC reporting companies, precisely because a small minority of SEC reporting companies are the largest source of investor losses related to SEC microcap trading suspensions. Existing OTCQB companies that did not or chose not to meet the new and improved standards, which include management background checks, an annual CEO/CFO certification and a minimum $0.01 bid price, were downgraded to the Pink market where broker-dealers can put the appropriate risk controls around them. As validation for the success of these efforts, SEC reporting companies that chose not to meet the OTCQB standards have seen reduced trading volumes – a fact which merits only a footnote in the paper.
So, while a surface-level analysis of the growth of the Pink market might generate concerns, the fact is this is a result of a growth in the number of Pink ADRs and foreign shares and our increased market standards for SEC reporting companies.
#3: The paper erroneously concludes that OTC Markets is not successful at graduating companies to an exchange.
The number of companies we graduate is an important contribution to financial markets and a benchmark for success, but it should be analyzed in context of the graduation numbers of other global junior markets. Last year, in a time when the IPO market was effectively closed, 44 companies graduated from our markets to an exchange. In comparison, 16 companies graduated from TSX Venture Exchange to the Toronto Stock Exchange and only five companies graduated from London’s AIM market to the London Stock Exchange.
While OTC Markets Group celebrates our graduates, the fact is many OTC companies simply don’t want the regulatory burden and cost of a national exchange listing. These include: ADRs and F-shares of international companies already listed on a foreign exchange, small community banks, closely-held companies and financially-distressed and bankrupt companies.
#4: Manipulative stock promotion is an industry-wide problem that is not limited to companies that do not provide disclosure to investors.
The paper considers OTC stock promotion data obtained from the website www.TheOTCToday.com to claim that OTC stocks “are frequent targets of alleged market manipulation,” yet fails to mention that Nasdaq and NYSE MKT stocks are also listed on that site. In 2016, only one third of the dollar volume of promoted securities, was in OTC equities. The lion’s share, or $11.3, billion, was in Nasdaq and NYSE MKT-listed securities. The vast majority of the promoted securities in 2016 were SEC-registered companies that were current in their reporting. A minority of current SEC-reporting companies are the largest source of questionable activity in our markets.
The paper does highlight the principle that buying any anonymously promoted security, NASDAQ or OTC, for long term investment returns is a bad idea.
We strongly believe public companies should immediately address any fraudulent promotion in their securities, and our OTCQX Rules require that they “act promptly to dispel unfounded rumors which result in unusual market activity or price variations.”
We continuously monitor the market and may require companies subject to stock promotion to provide additional information to the marketplace regarding shareholdings of officers, directors and control persons, as well as company share structure, and issuance history. Securities undergoing extreme promotion are publicly identified with our Caveat Emptor (skull and crossbones) symbol to further alert investors to heightened risk.
We consistently review data and gather feedback from market participants on our promotion rules and policies, and look for ways to use our disclosure and data-driven standards to expose and reduce the market impact of fraudulent promotion.
The OTC markets offer a range of opportunities for investors and an efficient, transparent and less burdensome public markets for companies, from the largest ADR global champions to the smallest entrepreneurial ventures. A study based on biased EBS and stock promotion data does not provide a true picture. To make blanket statements about the characteristics and performance of all OTC stocks and the quality of our markets based on an incomplete examination of our markets does a disservice to the thousands of venture stage, established and international companies that trade here.
We would like to see a more thoughtful approach by regulators that uses the vast amounts of data available today to identify bad actors and accelerate thoughtful enforcement and regulatory changes. Allowing highly visible, fraudulent promotion campaigns to flourish in any market impedes the capital formation process and tars all small companies.
In my next blog post, I will talk about how we believe we can work together with regulators to target fraudulent promotions and illegal share distributions to create better markets and improve capital formation for America’s small companies and their investors.
Jason Paltrowitz is Executive Vice President and Head of Corporate Services at OTC Markets Group. Prior to OTC Markets, Jason served in various roles at JP Morgan and BNY Mellon that covered Clearing, Collateral Management and Depositary Receipts. Jason has an MBA from the NYU Stern School of Business and a BA from Boston University in International Relations.