Reversing Market Perceptions

• As the CEO of OTC Markets Group, I have witnessed first-hand the transformation of the OTC market – from an opaque, paper-based system to a fully regulated market designed to meet the needs of global companies, community banks and early-stage venture companies. Frustratingly though, an outdated narrative still exists. One where the OTC market is portrayed as the Wild West or the Wolf of Wall Street and everything that is traded on an exchange is deemed “safe.“  

  
  

  OTC Markets By the Numbers: Today, there are over 2,600 securities of companies over a billion-dollar market cap traded on the OTC Market. They traded $238 billion in dollar volume through the end of Q3, representing 88.35% of overall dollar volume. International Company ADRS and Ordinary shares are now 77% of the securities quoted and over 85% of the dollar volume in OTC trading in the first nine months of this year. These numbers contradict a standard narrative that OTC Markets is primarily for smaller companies or speculative penny stocks.

  
  

  Nasdaq’s Wolf of Wall Street

  
  

  Many still remember the narrative of Stratton Oakmont, the infamous firm portrayed in Martin Scorsese’s “The Wolf of Wall Street.” While this story is often wrongly associated with the OTC “Pink Sheets,” in actuality, all 27 of Stratton Oakmont IPOs were listed on the Nasdaq Stock Market. It was the blanket of credibility that listing on Nasdaq provided that allowed Stratton Oakmont boiler rooms to peddle these speculative offerings as “investable.” The brand halo of a Nasdaq Stock Market listing left investors blind to the risk.

  
  

  Unfortunately, the belief that all exchange-listed securities are investment-grade companies and safe from stock manipulation is a risky misconception. This point was made clear in a 2022 FINRA regulatory notice to member firms entitled Heightened Threat of Fraud: FINRA Alerts Firms to Recent Trend in Small-Capitalization IPOs.

  
  

  Today, investors can find a vast trove of microcap companies, with hundreds trading for pennies, under the exchange brand. In fact, there are currently over 2,400 microcap stocks listed on Nasdaq and NYSE; 600 stocks are priced under a dollar and over 200 securities that would meet the SEC’s criteria for a “Penny Stock” if there was not an exemption for exchange-listed securities.

  
  

  Understanding Risk: For an investor, risk is the probability of a permanent capital loss. It can come from many sources. While many focus on fraud risk, professional investors understand that the more significant permanent losses in their portfolios come from the overvaluation risk – meaning paying too much for assets and, in the case of companies raising capital, the dilution risk of having your ownership interest shrink. If a value investor, as taught by Ben Graham, seeks to buy assets worth $1 for 50 cents, a trickster tries to reverse the equation and sell quarters, dimes, and nickels for a dollar. Efficient markets require public availability of information and disclosure that highlights material risk factors, allowing all types of risks to be understood so they are considered in the investment decision process and reflected in the market pricing.

  
  

  Destroying Cap Tables with Costly Financing Structures

  
  

  A recent example of risky activity is highlighted by an SEC enforcement case against an investment advisor and their fund for alleged manipulative short-selling as part of private financing activities in multiple exchange-listed issuers.  

  
  

  This case has all the hallmarks of a pump-and-dump scheme – with small issuers desperate for capital, SEC rules blatantly disregarded, and sophisticated players selling tens of millions of shares, all ending with a collapsing share price. The activity was facilitated by optimistic news releases puffing hot sectors, multiple reverse splits, toxic financing terms, and ballooning share counts in the market. All were set into motion by intermediaries that, while not registered or regulated as broker-dealers, reaped vast profits by dumping discounted shares into the market.  

  
  

  One of the Nasdaq-listed companies highlighted, “Issuer 1,” was part of the Blockchain frenzy in early 2018. The stock closed between $1.58 and $1.08 in March 2018. In the weeks and months that followed, the share price declined, closing at 93 cents on April 18th and 61 cents on the 19th. An 8-K announcing a private financing revealed steep share discounts and dilution of existing shareholders. The stock closed at 40 cents on the 20th. The financing terms allowed conversion at 80% of the calculated price and had an 8% Placement Agent fee. As part of the private financing terms, ahead of a ‘conversion price reset’ scheduled for mid-June, the SEC alleges the toxic financier sold short millions of shares before converting their shares. By making large, short sales ahead conversion, they locked in profits and lowered the calculated price. This again cut the stock price in half, to as low as 12 cents on the dollar.

  
  

  This financing essentially sold shares at a significant discount to the market via an unregulated intermediary with a prior record of regulatory infractions. This type of activity, as Matt Levine at Bloomberg said when writing about the case, “is kind of a scammy way to make a stock offering: You are basically able to lock in a big profit by selling the stock to the company’s public shareholders before you buy it from the company, and it seems a bit unfair.” All told, 90% of the stock price disappeared in four months, and outstanding common shares exploded from 16 million to over 43 million according to Issuer 1’s quarterly SEC filings.

  
  

  Continued Non-Compliance with Exchange Listing Standards

  
  

  At the time of its April 2018 offering, Issuer 1 was non-compliant with exchange listing standards regarding stockholders’ equity and minimum bid price. The issuer’s shares have remained listed on Nasdaq, and they continue to be on the non-compliant list today. They are not alone, as over 700 still-listed companies are currently marked as noncompliant with Nasdaq or NYSE  exchange listing standards. 

  
  

  A Cycle of Reverse Stock Splits

  
  

  The case of Issuer 1, and others like it, involves continuous dilution of shareholder interest facilitated by a series of reverse splits. In 2017 there was a one-for-fifteen reverse split. In 2018, there were two reverse splits: a one for thirty in February before the offering, and a one for forty in November. Between those two reverse splits in 2018, when the offering and alleged illegal activities took place, the stock price went from $4.79 to 19 cents, as over 800 million shares were traded. A shareholder who started 2018 with 1,000 shares ended the year with less than one share. It continued with a one-for-forty-five split in 2020 and one-for-seventy-five in 2022. An investment of 10 million shares in 2017 would have been reduced to less than one share today.

  
  

  The story of Issuer 1 is not uncommon, and the press has covered other egregious serial convertible distributions and reverse split cases on exchanges. Reverse splits continue to grow in prevalence. In a recent Rule filing with the SEC designed to enhance the ability for market participants to accurately process reverse splits, Nasdaq stated “As of June 23, 2023, Nasdaq has processed 164 reverse stock splits, and projects significantly more throughout 2023.” In contrast, OTC Markets has calculated approximately 83 reverse splits on NYSE, 11 on our OTCQX Market, and 83 on our OTCQB Venture Market in 2022. On our Pink Market, where the riskiest and most financially stressed companies trade, there were 162. Some companies use reverse splits to recover from toxic financing, but many use them to meet initial requirements to uplist to a national exchange. While these financings may be attractive because they offer a lower-cost way to recapitalize outside of bankruptcy courts, companies need to understand this is a dangerous step that dilutes current shareholders.

  
  

  It is also surprising that while exchanges used to quickly delist companies that fail to publish financial reports or file for bankruptcy quickly, they now seek to retain these companies for as long as possible. In comparison, we quickly remove delinquent reporting or bankrupt companies from our OTCQX market, as well as penny stocks and companies that fail to meet our ongoing financial standards. 

  
  

  The sheer number of reverse splits and the hundreds of companies not in compliance with listing standards should be a wakeup call that unscrupulous activities are taking place in exchange-listed securities. As notices and cases mount, broker-dealer compliance procedures and AML practices will need to treat similar-sized OTC and exchange listed securities the same.

  
  

  The Role of the SRO

  
  

  FINRA, the self-regulatory organization (SRO) regulating the OTC market, is separate from the commercial operations of our market. This is different from exchanges in that they are both an SRO and a commercial market operator. The advantage is that FINRA has no conflicts in pursuing its role as a regulator. FINRA has built an aggressive Market Fraud Team, with most of their efforts looking for market manipulation or fraud in OTC trading.

  
  

  OTC Markets Group has made a substantial investment in our own compliance and market integrity teams, which play a supportive role for regulators, working to improve company disclosure and providing hundreds of referrals to SEC enforcement.  This separation of roles has worked well to improve the OTC market. However, FINRA’s focus on the OTC market has left a blind spot for problematic activities in exchange-listed securities.

  
  

  With SEC rules soon requiring every broker-dealer to be a FINRA member firm, it is worth considering if market-wide fraud and manipulation surveillance should be split off from exchange SRO’s and consolidated with FINRA. Expanding the mandate of FINRA’s Market Investigation Team would let a regulator without conflicts chase bad guys. Exchange SRO activities can focus on regulating trading on their systems and overseeing issuers’ compliance with listing and disclosure standards.

  
  

  Fostering Capital Formation and Flagging Risk

  
  

  Regulation can also help enhance the capital formation process. Current SEC rules only allow the largest public companies, or Well-Known Seasoned Issuers, to benefit from ‘at the market’ shelf offerings, where a public company can directly sell shares into the market. Smaller public companies are prohibited from this more efficient, cost-effective way to raise capital and are instead forced to consider private offerings through unregulated intermediaries. This creates market inefficiencies with large gaps between the public market price and private capital raising. It also imposes huge costs on companies seeking capital and incentivizes bad practices as intermediaries skirt through regulations. Regulators and lawmakers need to change this paradigm.

  
  

  An Alternative Approach

  
  

  At OTC Markets Group, we have spent the last two decades transforming our markets with technology and transparency. The OTC markets, with its broad range of securities, from global blue chips to smaller, more speculative stocks, has never shied away from flagging risks based on disclosure, stock promotion, bankruptcy and other potential public interest concerns. By providing a tiered market structure and data distribution, our platform empowers public companies to supply disclosure, demonstrate compliance, and share governance with investors. 

  
  

  Most recently, we have enhanced our issuer disclosure requirements to ensure that companies clearly disclose each outstanding convertible note, the names of the noteholder beneficiaries, and note conversion terms. This step is above and beyond what is required for SEC reporting and listed companies. This allows investors and broker-dealers to identify potentially toxic financings more easily and better interpret dilution risk as part of their investment decisions. 

  
  

  We introduced the Transfer Agent Verified Shares Program to provide investors and broker-dealer with current and reliable share data on OTCQX and OTCQB securities in a more timely and trusted manner than quarterly filing cycles provide. The program requires issuer’s stock transfer agents to report their clients’ share data, including authorized and outstanding shares, to OTC Markets Group on a regular basis via a secure, electronic file transfer.

  
  

  At OTC Markets Group, we give public companies a platform to own and earn their individual reputation. As market operators, we focus on improving the market pricing process and capital formation by incentivizing issuer disclosure and flagging risks. This allows investors to decide on the merits of investments. By shining a light on the corners of the market, we empower investors with the information to analyze, value and trade securities regardless of whether they trade on our markets or on the exchanges.