Securities and Exchange Commission's Proposed Rule 15c2-6 Re: Sales Practices in Pink Sheet Stocks

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SEC REQUEST FOR COMMENTS

EXECUTIVE SUMMARY

The Securities and Exchange Commission (SEC) has proposed Rule 15c2-6 to address fraudulent, deceptive, or manipulative acts and practices used in connection with high-pressure telephone sales campaigns to sell OTC pink sheet stocks issued by small, little-known companies to unsophisticated investors. Under the conditions set forth in the proposal, this rule would prohibit broker-dealers from selling certain pink sheet securities to customers unless a prior written customer agreement has been executed. Comments must be received by the SEC by April 14, 1989.

BACKGROUND

There has been an increase in the number of NASD members and individuals engaged in the sale of low-priced, speculative penny stocks to the investing public using high-pressure tactics and other fraudulent and deceptive practices. As a result, the NASD has been placing increased emphasis on the examination, surveillance, and enforcement of abusive sales practices involving these non-NASDAQ OTC (NNOTC) securities. In this regard, several disciplinary actions have been taken involving such matters as fraud in the offer and sale of securities, market manipulation, and fraudulently excessive markups. The NASD has levied sanctions including expulsions, bars, suspensions, and substantial monetary fines. There are a number of pending cases that could result in similar types of actions.

Furthermore, since September 1, 1988, members executing principal transactions in non-NASDAQ securities cleared through National Securities Clearing Corporation (NSCC) have been required to electronically report price and volume on a daily basis if their aggregate volume of purchases or sales exceeds 50,000 shares or $10,000. This price and volume information is used for regulatory purposes by the NASD through its Market Surveillance and Anti-Fraud Departments.

In addition to disciplinary actions that are the result of investigations conducted by the NASD, the Association also is engaged in a number of joint investigations with the SEC and various states, and is a major participant in interagency task forces reviewing penny-stock fraud and abuses. This includes cooperative investigations and regulatory efforts with the FBI, United States attorneys offices, and others.

In this regard, to address the serious concerns about the growing incidence of broker-dealer fraud and other abusive sales practices in non-NASDAQ penny stocks, on February 8, 1989, the SEC proposed Rule 15c2-6. The rule is designed to prevent fraudulent, deceptive, or manipulative acts or practices in connection with certain recommended transactions in equity securities ("Designated Securities") that are not registered on a national securities exchange or authorized for listing in NASDAQ. Also exempt are those issuers that meet minimum net income, capital and surplus, or asset standards. These securities are quoted primarily in daily listings of dealers published by the National Quotations Bureau (pink sheets), and often are traded at less than one dollar per share. Proposed Rule 15c2-6 would require a written customer agreement and a documented suitability determination before a broker-dealer may sell certain securities it has recommended. The proposed rule seeks to help address regulatory concerns about abusive sales practices in the sale of "small pink sheet stocks" of issuers that do not meet certain minimum net income, capital and surplus, or asset standards

EXCERPTS FROM PROPOSED SEC RULE 15c2-6

Proposed Rule 15c2-6 would provide that a broker-dealer who recommends to a person the purchase of a Designated Security may not sell that security to such person unless (1) the person was a regular customer of the broker-dealer (i.e., maintains a cash or margin account and has purchased securities of 3 or more different issuers on separate occasions within the preceding two years) or an accredited investor as defined by Regulation D, (2) the broker-dealer's transactions in the security did not exceed an aggregate volume of $5,000 or 10,000 shares during any period of five consecutive business days that ended within the preceding 90 days, or (3) prior to the sale, the broker-dealer had received written agreement to the sale from such person and had approved the person's account for transactions in Designated Securities. In approving an account, the broker-dealer would be required to obtain information concerning the customer's investment objectives, financial situation, experience, and knowledge. The member must also reasonably determine that transactions in Designated Securities were suitable for the customer, and maintain in its files a written statement setting forth the basis for such determination.

The Commission's decision to propose Rulel5c2-6 at this time reflects the Commission's growing concern with the widespread incidence of broker-dealer fraud and other misconduct in the market for small pink sheet stocks. In recent years, the Commission has initiated a number of injunctive and administrative proceedings against individual broker-dealers involved in a wide array of misconduct in connection with transactions in pink sheet stocks. Despite the expenditure of considerable Commission resources in investigating and prosecuting these illegal activities, the Commission's ongoing broker-dealer examination program indicates that broker-dealer misconduct in connection with transactions in pink sheet stocks has continued. Therefore, the Commission believes that additional regulatory action is necessary to deal more effectively with the problem.

The Commission is proposing Rule 15c2-6 in particular to address the indiscriminate use by some broker-dealers of high-pressure telephone sales campaigns to sell pink sheet stocks issued by small, little known companies to unsophisticated investors. Many of these stocks are speculative securities that require purchasers to possess a significant degree of expertise, as well as access to information, before an informed investment decision can be made. The issuers of these securities are rarely followed by professional securities analysts or covered by the financial press. In addition, these small pink sheet issuers often are not subject to Exchange Act periodic reporting requirements, and therefore may not be making publicly available on a regular basis complete information about their operations and financial condition. As a result, investors may have few reliable sources of information on these companies. Moreover, many of these issuers often have few assets and limited operating histories, but nevertheless intend to expand rapidly. Such issuers necessarily have a high risk of failure and corresponding loss of investment for their shareholders. A decision to invest in pink sheet stocks therefore requires diligent investigation and careful analysis of the issuer and its management to determine whether it is a viable operating entity with realizable potential for growth.

The sales practices of some broker-dealers active in this area, however, apparently are designed to preclude careful analysis by investors of the fundamental investment merits of small pink sheet companies. A common means of solicitation is the "cold call" — a telephone call to a person whose name has been drawn from the telephone directory or a membership list, or who has responded to advertisements promoting purchases of small growth companies. Although broker-dealers making cold calls at times may provide prospective buyers with sufficient information and time to make an informed investment decision, more frequently cold calls regarding the stocks of small pink sheet issuers provide investors with little information on the company and little time for reflection before deciding whether to buy.

High pressure cold calls are the predominant means to locate customers used by "boiler room" operations active in the pink sheet market in recent years. These operations involve a concerted, high-intensity effort to sell over the telephone large quantities of little known, speculative stocks to any and all buyers. Salespersons are expected to make hundreds of cold calls per day, and are trained in high-pressure sales tactics frequently involving use of prepared scripts designed to elicit an immediate buy decision from the person called. These tactics usually focus on pink sheet stocks, often where the broker-dealer is the sole or dominant market maker and little information is available about the issuer.

Because these cold call campaigns normally are directed at individuals drawn from a telephone directory or list of names, inevitably many of the persons contacted will have little investment experience and limited financial resources. These individuals may be particularly vulnerable to high pressure sales tactics from salespersons willing to disregard the unsuitability of the recommended security for the purchaser. The potential for mistreatment of investors in cold calls is magnified when the securities being sold are not traded through organized markets and are issued by little known companies, where the risk of loss and the importance of the investment analysis require a careful and unhurried investment decision.

For these reasons, the Commission believes that a serious potential for fraud against investors exists in the unbridled sale of the securities of small pink sheet issuers through the use of cold calls. The Commission is proposing Rule 15c2-6 to help address these problems.

The term "designated security" means any equity security other than NASDAQ or exchange-listed securities, investment company securities, or issuers having (a) annual net income in excess of $300,000 in the most recently completed fiscal year or in two of the last three most recently completed fiscal years; (b) capital and surplus in excess of $8,000,000 at the end of the most recently completed fiscal year; or (c) total assets in excess of $10,000,000 at the end of the most recently completed fiscal year.

NASD members seeking further information or who wish to comment on this proposed rule may obtain a copy of its full text (Release No. 34-26529) at any SEC or NASD office. Comments should be received by the SEC by April 14, 1989, and may be sent to:

Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, NW, Mail Stop 6-9
Washington, DC 20549.

Comment letters should refer to File No. S7-3-89. All comment letters received will be made available for public inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, NW, Washington, DC 20549. For further information, contact Robert L.D. Colby, Chief Counsel, (202) 272-2844; or Daniel M. Gray, Attorney, SEC Division of Market Regulation (202) 272-2848.

Members are requested to send copies of comment letters to:

Lynn Nellius, Corporate Secretary
National Association of
Securities Dealers, Inc.
1735 K Street, NW
Washington, DC 20006-1506.