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-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 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
| DTC/Issuer Action | Chill | Global Lock |
| Notice by the DTC – pre-imposition notice | No set time | No set time |
| Notice by the DTC – post-imposition notice | No later than 3 business days after imposition | No later than 3 business days after imposition |
| Grounds for imposition | (i) court order; (ii) to prevent imminent harm or material adverse consequences to the DTC or its participants | (i) court order; (ii) SEC trading suspension or FINRA trading halt |
| DTC grounds for imposing Chill/Lock prior to providing notice | In order to prevent imminent harm, injury or other such consequences to the DTC or its participants | In order to prevent imminent harm, injury or other such consequences to the DTC or its participants |
| Notice content | (i) basis for DTC action; (ii) date chill was/will be imposed; (iii) that company may respond; and (iv) date response required | (i) basis for DTC action; (ii) date chill was/will be imposed; (iii) that company may respond; and (iv) date response required |
| Method of delivery of notice | Mailed to company’s last known address and transfer agent | Mailed to company’s last known address and transfer agent |
| Issuer time to respond | 20 business days | 20 business days |
| Response requirements | Not specified | Not specified |
| DTC ability to request additional info | Yes | Yes |
| DTC review | By independent DTC officer | By independent DTC officer |
| Supplement by company following decision | Within 10 business days of DTC decision | Within 10 business days of DTC decision |
| DTC reservation of authority to amend or change decision | Yes | Yes |
| Decision appealable to SEC | Yes | Yes |
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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