In two recent administrative decisions, the SEC has upheld FINRA’s broad authority under Rule 6490 to approve and effectuate corporate actions by public companies trading on the OTC Markets. One of FINRA’s mandates is to protect investors and maintain fair and orderly markets and like broker-dealers, it acts as a gatekeeper in the small-cap industry. FINRA exercises its powers though the direct regulation of its member broker-dealer firms, but also through its Office of Fraud Detection and Market Intelligence, which monitors the trading activity and press releases of issues in the marketplace and conducts related investigations. FINRA works with the SEC as a front line in the detection, investigation and assistance with the prosecution of issuers.
Recently, through its power under Rule 6490, as more fully explained below, FINRA has, with the support of the SEC, expanded its impact on the small-cap marketplace by conducting in-depth reviews of issuers in conjunction with the processing of corporate actions, and denying such corporate action requests in record numbers.
On February 2, 2015 and February 5, 2015, the SEC issued administrative decisions following the appeals made to the SEC by MPhase Technologies, Inc. and Positron Corporation to FINRA’s refusal to effectuate their respective corporate actions. The SEC upheld FINRA’s authority in both cases. This blog discusses the SEC’s opinions in both cases.
Neither Positron, MPhase, the SEC nor FINRA raised the issue of the conflict between the state law completed corporate action and public market information as a result of FINRA’s refusal to process, an issue I have previously raised in my blog HERE. Moreover, neither Positron nor Mphase raised the issue of the FINRA review process itself which I discuss below. As the issue was not raised with the SEC by the companies, it was not addressed in its rulings.
Effective September 27, 2010, the SEC approved FINRA Rule 6490 (Processing of Company Related Actions). Rule 6490 Rrequires that corporations whose securities are trading on the over-the-counter market (OTCQX, OTCQB, or OTCPink) notify FINRA in a timely manner of certain corporate actions, such as dividends, forward or reverse splits, rights or subscription offerings, and name changes. The Rule grants FINRA discretionary power when processing documents related to the announcements.
Rule 6490 works in conjunction with Exchange Act Rule 10b-17. Rule 10b-17provides that “it shall constitute a manipulative or deceptive device or contrivance as used in section 10(b) of the Act for any issuer of a class of securities publicly traded… to fail to give notice in accordance with paragraph (b) of this section of the following actions relating to such class of securities: (1) a dividend or other distribution in cash or in kind… (2) a stock split or reverse split; or (3) a rights or other subscription offering.” Section (b) requires that notice be given to FINRA “no later than 10 days prior to the record date involved.”
FINRA also issues trading symbols to over-the-counter traded issuers and maintains a database of trading symbols for issuers. When FINRA completes the processing of a corporate action, OTC Markets is notified of such change. Most commonly, changes include the re-pricing of securities after a forward or reverse split and the issuance of a new trading symbol following a name change or merger and the appearance of the new name on the company’s quotation page.
Prior to 2010, FINRA’s role has been predominantly ministerial due to their limited jurisdictional ability to impose informational or other regulatory requirements, and fundamental lack of power to reject requested changes. However, since the SEC began expressing concern that entities were using FINRA to assist in fraudulent activities, Rule 6490 was created.
The Rule codifies FINRA’s authority to conduct in-depth reviews of company-related actions and equips the staff with discretion to refuse the processing of such actions in situations when the information or requisite forms are incomplete or when certain indicators of potential fraud exist. FINRA staff now possesses broad discretion to request additional documents and supporting evidence to verify the accuracy of submitted information.
Rule 6490(d)(3) provides:
“(3) Deficiency Determination
In circumstances where an SEA Rule 10b-17 Action or Other Company-Related Action is deemed deficient, the Department may determine that it is necessary for the protection of investors, the public interest and to maintain fair and orderly markets, that documentation related to such SEA Rule 10b-17 Action or Other Company-Related Action will not be processed. In instances where the Department makes such a deficiency determination, the request to process documentation related to the SEA Rule 10b-17 Action or Other Company-Related Action, as applicable, will be closed, subject to paragraphs (d)(4) and (e) of this Rule. The Department shall make such deficiency determinations solely on the basis of one or more of the following factors: (1) FINRA staff reasonably believes the forms and all supporting documentation, in whole or in part, may not be complete, accurate or with proper authority; (2) the issuer is not current in its reporting requirements, if applicable, to the SEC or other regulatory authority; (3) FINRA has actual knowledge that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected to the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action are the subject of a pending, adjudicated or settled regulatory action or investigation by a federal, state or foreign regulatory agency, or a self-regulatory organization; or a civil or criminal action related to fraud or securities laws violations; (4) a state, federal or foreign authority or self-regulatory organization has provided information to FINRA, or FINRA otherwise has actual knowledge indicating that the issuer, associated persons, officers, directors, transfer agent, legal adviser, promoters or other persons connected with the issuer or the SEA Rule 10b-17 Action or Other Company-Related Action may be potentially involved in fraudulent activities related to the securities markets and/or pose a threat to public investors; and/or (5) there is significant uncertainty in the settlement and clearance process for the security.” (emphasis added)
Exchange Act Rule 10b-17 appears to be limited to notice and allows the SEC to pursue an enforcement action for the failure to give such notice in a timely manner. Rule 6490 goes further, stating a corporation action “will not be processed” if FINRA makes a “deficiency determination.” Clearly subsections (3) and (4) give broad discretionary authority to FINRA to render such a deficiency determination and refuse to process an action.
On the Matter of Positron Corporation
On February 5, 2015, the SEC issued an Order dismissing Positron Corporation’s (“Positron”) request for review of FINRA’s denial of a corporate action request. FINRA had refused to process Positron’s reverse split and change of corporate domicile because Positron’s then CEO was the subject of a settled regulatory action involving security law violations and was involved in a current SEC administrative proceeding. FINRA, relying on its authority under Rule 6490, found that it was not in the public interest to process the change with the OTC trading markets.
Positron’s CEO had consented to a federal court injunction prohibiting further violations of the antifraud and disclosure provisions of the federal securities laws and was also the subject of a then pending SEC administrative proceeding wherein the SEC was seeking to bar him from the securities industry. Positron argued that the requested corporate action was in the best interest of the shareholders and that the CEO’s regulatory proceedings were not related to his role with or at Positron.
Positron had filed a Company Related Actions application with FINRA requesting that it process a 1:100 reverse split and a change in corporate domicile from Texas to Delaware. Positron asserted that if it did not complete the reverse split, it would be required to increase its authorized shares into the billions to “account for full dilution of securities and future investor participation.” The Company noted that an increase in authorized shares would “bring Positron’s total to six billion authorized shares, a number that is clearly extraordinary and not respectable…” In addition, without the reverse split the share price would be and remain very low and would “undermine its credibility with investors, joint venture partners and potential employees.”
FINRA denied the corporate action request, citing “the protection of investors” as a result of the prior and pending actions against the CEO. Positron appealed to FINRA, arguing that the denial was “detrimental to the interests of Positron’s shareholders and the investing public.” Positron also noted that it had already completed the corporate actions by obtaining the necessary board and shareholder approvals and making all state corporate filings, which would all have to be unwound at great company expense.
FINRA denied the appeal, once again citing “the protection of investors and the public interest.” Moreover, in its denial of the appeal FINRA acknowledged that Positron had asserted valid business reasons for the corporate actions but that it “places primary importance on [FINRA’s] responsibility to protect investors when an issuer’s officers or directors are defendants and respondents in pending actions that allege fraud and securities violations.” FINRA continued that although Positron itself was not the subject of any actions, the CEO asserted significant control over the company and therefore provided a sufficient basis for the denial.
Positron then appealed to the SEC under Exchange Act Section 19(f). Under Section 19(f) the SEC must refuse Positron’s request if, as cited in the SEC order, “(i) the specific grounds on which FINRA based its denial exist in fact; (ii) the denial was in accordance with FINRA rules; and (iii) those rules are, and were applied in a manner, consistent with the purposes of the Exchange Act.” The SEC found that FINRA met these criteria and denied Positron’s entreaty.
In this case the SEC found that the three review factors under Section 19(f) supported FINRA’s denial of Positron’s action. As noted above, Rule 6490 states that where FINRA determines a corporate action is deficient, based on one of the enumerated considerations, it “may determine that it is necessary for the protection of investors, the public interest and to maintain fair and orderly markets” to refuse to process the requested action. The SEC found that the Rule’s use of the “may” “vests FINRA with discretionary authority in deciding whether to process and announce” a corporate action. The SEC continued that the discretion is FINRA’s and that the SEC “will not substitute our judgment for FINRA’s unless its decision is unsupported by the record.”
In this case the grounds cited by FINRA were factually accurate. The SEC reviewed the record and the actions against the CEO, from a factual perspective, supported FINRA’s concerns. The SEC noted that in passing Rule 6490 in the first place, it had “specifically highlighted the value of FIRNA’s authority under the Rule to ‘conduct in-depth reviews of requests to process Company Related Actions and to provide FIRNA staff the discretion not to process… requests for which there are certain indicators of potential fraud.”
The SEC also found that FINRA’s denial of Positron’s request was supported by FINRA rules. FINRA is authorized to adopt rules that are “designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling and processing transactions in securities” and to “protect investors and the public interest.” Citing these principles, the SEC approved the passage of Rule 6490 and now approves its use by FINRA to exercise its discretion and authority.
Finally, the SEC found that FINRA applied the rule consistently with the intent of the Exchange Act. In its ruling, the SEC notes that Rule 6490 furthers the objectives of the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 to curb “the pervasive fraud and manipulation of the penny stock market.” For more on the Penny Stock Reform Act of 1990, see by blog HERE.
The SEC continues with its support of FINRA, noting the “critical role that FINRA occupies in regulating the OTC Markets” and that “FINRA has direct authority for the activities related to OTC trading.” The SEC goes further, stating that investors in OTC Markets, which is a high-risk market, take on the risk of the entire marketplace and not just the single issuer they invest in, and that part of that overall risk is the potential that FINRA will exercise its authority against a single issuer, such as it did with Positron.
Further, the SEC downplayed the final impact of FINRA’s action as nothing more than a “prophylactic measure designed to prevent potential fraud or abuse from occurring” from FINRA’s processing of such action. The SEC noted that the CEO could continue as CEO and that Positron’s stock continued to trade.
Regarding the Matter of MPhase Technologies, Inc.
On February 2, 2015, the SEC issued an Order dismissing MPhase Technologies, Inc.’s (“MPhase”) request for review of FINRA’s denial of a corporate action request. FINRA had refused to process MPhase’s reverse split because the company’s CEO and COO were the subject of a settled regulatory action involving securities law violations and, in particular, Section 5 violations. Like Positron, FINRA, relying on its authority under Rule 6490, found that it was not in the public interest to process the change with the OTC trading markets.
In this case the CEO and COO actions had been settled in 2007. However, in this case, the actions against the company officers were five years old, did not involve any industry-related bars, did not involve fraud-related claims, and neither officer had any issues since that time. Moreover, in this case, FINRA engaged in a more intensive back-and-forth with MPhase regarding the proceedings against the CEO and COO, providing MPhase an opportunity to explain and defend against FINRA’s concerns. FINRA ultimately denied the corporate action, and appeals ensued.
As with Positron, the SEC supported FINRA’s position based on the same Section 19(f) three-part analysis. Despite the factual differences between this case and Positron, the SEC’s analysis is substantially the same and unwavering in its support of FINRA’s broad discretionary authority under Rule 6490.
Consideration of State vs. Federal Authority over Corporate Law
Neither Positron, MPhase, the SEC nor FINRA raised the issue of the conflict between the state law completed corporate action and public market information as a result of FINRA’s refusal to process, an issue I have previously raised in my blog HERE.
In that blog I explained that as a result of FINRA’s refusal to effectuate a reverse split by Ecolocap Solutions, Inc. (“ECOS”), the Company legally had approximately 3.4 million shares issued and outstanding; however, according to the OTC Markets, the company has approximately 6.8 billion shares outstanding. At the time, the discrepancy led to ECOS filing an 8-K taking a strong stance against FINRA, stating that pricing information published by FINRA is inaccurate.
FINRA’s exercise of its power under Rule 6490 to refuse to effectuate a corporate action, such as a reverse split or name change, can lead to a discrepancy between a change that has been legally effectuated on the state level through board and shareholder approval and the filing of amended articles of incorporation and that which appears on the OTC Markets trading platform and any other quotation source that publishes such quotes (such as Yahoo and Bloomberg).
Further exacerbating the conflict between the application of state and federal law is the fact that FINRA requires that a Company submit the file-stamped amendments to its corporate charter as part of their review process. Simply stated, the FINRA corporate action process requires that a Company legally complete the corporate action (reverse split, name change, etc.) on the state level prior to issuing a determination as to whether it will process the already-completed change with the marketplace.
A company whose corporate action has been denied by FINRA following state law processing has the ability to reverse the action through additional board and shareholder consents and additional state filings. However, what happens when shareholder consents to reverse the action cannot be obtained? What if the shareholders at large hold the controlling interest and refuse to vote in favor of a reversal of the action?
Where shareholder consents cannot be obtained to reverse the action, a company can make full public disclosure of the discrepancy and the investing public would be acting at its own peril in making investing decisions regarding that issuer. ECOS did just that, filing an 8-K that took a strong stance against FINRA, stating that pricing information published by FINRA is inaccurate.
Clearly it is problematic when state and federal rules and regulations cause a conflicting result, leaving a board of directors, shareholders and the investing public in a state of flux. As an attorney the clear potential for an ongoing discrepancy between legally effectuated facts, such as a name change or change of domicile, and that which is published on the OTC Markets is troublesome and should be addressed by either FINRA, the SEC or both.
Consideration of Due Process During the FINRA Rule 6490 Review Process
Although not addressed by any of the parties discussed in this blog, as a practitioner I advocate a requirement that FINRA establish and publish minimal procedures and timelines for the in-depth review process utilized under Rule 6490 more analogous to an SEC comment process. Currently upon notice from FINRA that a file raises one or more red flags and will be subject to an in-depth review, a company has no reference or reasonable expectation as to the timeline of such review and no ability to converse or communicate with the reviewing parties. FINRA can take several months in between comments, which are all filtered through a single reviewer that is not an attorney and that has no independent authority. It is believed that a panel that is comprised of some number of individuals, including legal counsel, reviews submissions and answers to comments and ultimately makes a decision. The front-line reviewer that communicates with the company is not a part of this panel. Following the last comment, several (3 or more) months can pass without any communication between FINRA and the applicant company.
Although it is certainly understandable that a comment process, like with the SEC, can continue for an extended period of time, I would advocate for a limit on the time period in which FINRA must submit comments or follow up on comments, and in which it must render a decision. I would suggest that no more than thirty (30) days should pass in which FINRA submits comments or additional comments following responses from the company. I would also suggest that a time limit, perhaps sixty (60) days, be set between the last comment and the rendering of a decision.
Moreover, as with the SEC, which allows and facilitates attorney-to-attorney and accountant-to-accountant communication, I would advocate that FINRA do the same and allow and even encourage communication between counsel for a company and counsel to FINRA in this process, which process has a substantial impact on OTC Market companies and their shareholders.
In the cases presented, the SEC has firmly supported FINRA and its broad discretion to consider the public interest and the bigger picture of overall regulation of the OTC Markets with a view toward preventing potential fraud where indicators or red flags exist. However, the potential conflict and issues that could arise between state and federal corporate law have not been addressed. A factual scenario has not been presented wherein the board of directors did not have voting control and the shareholders at large, following an annual or special meeting, have voted on a particular action and have refused to vote to unwind or undo a particular action following FINRA’s refusal to process such action. I believe this issue still requires attention.
Moreover, as discussed, I advocate for additional parameters, vis-à-vis due process, be added to the Rule 6490 review process.
Attorney Laura Anthony
Founding Partner, Legal & Compliance, LLC
Corporate, Securities and Business Transaction Attorneys
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size OTC issuers as well as private companies going public on the over-the-counter market, such as the OTCBB, OTCQB and OTCQX. For nearly two decades Ms. Anthony has structured her securities law practice as the “Big Firm Alternative.” Clients receive fast, personalized, cutting-edge legal service without the inherent delays and unnecessary expenses associated with “partner-heavy” securities law firms. Ms. Anthony’s focus includes, but is not limited to, registration statements, including Forms 10, S-1, S-8 and S-4, compliance with the reporting requirements of the Securities Exchange Act of 1934, including Forms 10-Q, 10-K and 8-K, 14C Information Statements and 14A Proxy Statements, going public transactions, mergers and acquisitions including both reverse mergers and forward mergers, private placements, PIPE transactions, Regulation A offerings, and crowdfunding. Moreover, Ms. Anthony 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 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 host of SecuritiesLawCast.com, the securities law network.
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