OTC Markets Comment Letter Encouraged Secondary Trading of Securities- On January 8, 2018, OTC Markets Group submitted a comment letter to FINRA related to FINRA Rule 6432. Rule 6432 requires that a market maker or broker-dealer have the information specified in Securities Exchange Act Rule 15c2-11 before making a quotation in a security on the over-the-counter market. On February 8, 2018, OTC Markets submitted a second comment letter to FINRA, this one related to FINRA Rule 5250. Rule 5250 prohibits companies from compensating market makers in connection with the preparation and filing of a Form 211 application.
In the last LawCast in this series, I went through OTC Markets suggested changes related to Rule 6432. Following its discussion on the rules and suggested changes, the OTC Markets comment letter turned to the need to encourage secondary trading of securities as an important aspect of encouraging capital formation for smaller companies as a whole. Investors are much more likely to participate in capital raising if they have an exit strategy such as a liquid secondary marketplace where they can reasonably deposit and re-sell freely tradeable securities.
The costs and burdens of being public on a national exchange are a huge disincentive for smaller companies. The decline in the US IPO markets is a constant discussion by SEC top brass, other regulators and politicians. As the OTC Markets comment letter points out, a small company seeking to raise $10 million to finance a promising new software, is in no position to shoulder the costs and burdens of a national exchange listing, but is also stifled by the inability to properly access liquidity for its investors on IDQS’s such as OTC Markets due to antiquated and improperly administered rules such as Rule 6432.
In fact, as of today OTC Markets is the only viable operating secondary marketplace for the trading of non-exchange traded public securities. OTC Markets is comprised of three tiers: the OTCQX; the OTCQB and the Pink Open Market with increasing levels of disclosure and corporate governance requirements.
By implementing OTC Markets suggested changes to Rule 6432 more small companies would access public markets, better information would be made available to investors and the marketplace, and secondary market liquidity would improve.
As mentioned on February 8, 2018, OTC Markets group submitted a second comment letter to FINRA related to Exchange Act 15c2-11 and its implementation by FINRA. The second letter directly addresses Rule 5250, which prohibits a market maker from accepting any payments or other consideration, directly or indirectly, in association or connection with publishing a quotation, acting as a market maker or submitting an application in connection therewith.
As discussed in this LawCast series, a Form 211 goes through an extensive review, comment and response process similar to an SEC review of a filing. The comment and review process is completed when FINRA either clears the Form 211 or refuses to clear the Form. The market maker is required to provide FINRA with a copy of all information and documents in their possession, and FINRA reviews the information for completeness but also reviews the merits of the information using undisclosed subjective standards. In response to comments, a market maker must work with a company to provide information, which can often involve material non-public information that is not, and may never be, made public. This process takes weeks at a minimum and oftentimes much longer.
As a basic premise for the market maker, it must conduct adequate due diligence on the company and properly gather and analyze information prior to submittal to FINRA. The process can be labor-intensive for the market maker.
Furthermore, part of the process involves the market maker’s analysis and backup for the requested pricing of the security in its initial quotation. When a company goes public on a national exchange, a market maker is not restricted from charging for its investment banking services, including the part of the service that involves a valuation and determination of initial offering price. The process of determining valuation for an initial quote on the OTC Markets is substantially similar. The inability to charge for such service acts as a disincentive for a market maker to give adequate thought and attention to the process. #LegalAndComplianceLLC