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by Steve Letzler

DTCC has been cracking down on potential fraud caused in so-called “microcap” securities and, as a result of its unique perspective on the market, has been able to contribute substantially to efforts focused on shutting down that fraud.

Microcaps are stocks that are thinly traded, at a low price – often for less than a penny a share – and generally outside major market exchanges. The low price and small volume means relatively small numbers of trades can move the price substantially up or down, making them ripe for manipulation. In some cases, unscrupulous issuers leverage certain exemptions from registration of securities with the Securities and Exchange Commission (SEC) to issue large blocks of securities that will dilute the issue.

DTCC began its efforts as a result of expanding its Anti-Money Laundering Program to monitor microcap security transactions, in line with regulatory guidance to financial institutions regarding the risks associated with these securities. DTCC’s depository, The Depository Trust Company (DTC), is a limited purpose trust company, and is regulated under New York State banking rules. It is therefore bound by the same requirements as other banks.

Under the microscope

Through its Office of Corporate and Regulatory Compliance (OCRC), DTCC monitors unusual large share deposits of microcap securities issues at DTC for signs of potential fraudulent behavior such as “pump and dump” schemes. This is when a small company’s stock price is “pumped up” by false press releases or chatter on the Internet and then insiders “dump” all their stock on unsuspecting investors when the price increases.

When monitoring turns up potential trouble spots, DTC has a number of options. It can refer the activity to the relevant regulatory or law enforcement agency. Or, if DTC develops concerns about the eligibility status of newly issued shares of a security, or if there’s an indication of fraudulent activity, it can place compliance “chills,” or processing restrictions, on the issue in question. It can also deny DTC eligibility to companies applying for DTC membership and services.

In some circumstances, DTCC obtains additional information from the issuer regarding the underlying activity and may choose to not place any restrictions on the issue or remove or change an existing processing restriction. This is typically accomplished in concert with DTC participants’ involvement, depending on the specific facts and circumstances for that issue.

Mihal Nahari, DTCC’s chief compliance officer, noted that DTCC is careful to take action against microcaps only when there is a verifiable reason. In fact, DTC has placed chills on only 500 issues to date for compliance-related concerns, out of 3.6 million issues held at DTC. “Those 500 issues also represent less than 1% of the stocks worth under $1 in the depository,” Nahari said.

Similarly, DTC has denied eligibility to just five issues out of more than 2,400 that applied in 2011 through October.

SEC forum

Nahari and Susan DeSantis, DTCC’s deputy chief compliance officer, were recently invited by the SEC to participate in a roundtable discussion about microcap fraud in Washington, D.C. About 100 people attended the event and more watched a live webcast (also archived on the SEC website) of the panel discussions.

“The discussions gave DTCC an opportunity to educate the investment and regulatory communities about our role in this area,” said Nahari. The roundtable, moderated by SEC officials, consisted of three panels, and included representatives of transfer agents, brokerage firms, law firms, brokers, clearing firms and investors.

SEC Chairman Mary Schapiro, who sat in during the discussions, asked the panelists what the SEC could do to help address issues of microcap fraud.

Nahari noted that most of the problems seemed to occur in stocks that claimed exemption from registration with the SEC. She urged the commission to take steps to tighten the exemption and require more information to be made available by issuers claiming such an exemption.

She also said that while DTCC could place restrictions on clearing and settlement of issues held at its depository, trading could continue at a broker’s discretion if a customer held physical certificates either directly or through a Direct Registration position. “It would be much better if microcap fraud could be stopped before the trade takes place, rather than at the clearance and settlement level,” Nahari stated.

AML focus

DeSantis participated in a panel focused on anti-money laundering (AML). She noted that while DTCC has the same obligations as any bank or brokerage to report suspicious activity, unlike those institutions, it does not deal directly with investors and therefore is not in a position to conduct due diligence in the same way the broker/dealer can.

In discussing ways to deter money laundering, DeSantis said the SEC could help either by limiting exemptions for stock registration or by placing more requirements for the disclosure of unregistered share issuances, such as requiring audited financial numbers, and by extending the Know-Your-Customer duediligence requirements to transfer agents.

Transfer agents, which maintain the books and records for an issuer, are regulated by the SEC and are best positioned to validate that shares are issued in accordance with securities laws, DeSantis noted. However, most stand-alone transfer agents are not currently “covered financial institutions” under the Bank Secrecy Act, and are not required to have an AML program in place.

“If the transfer agents had a transaction monitoring and suspicious activity report filing obligation, they would be much better positioned to prevent and detect securities fraud,” DeSantis said. @