Decoding the 211 Regulations and Shell Companies: A Legal Perspective
The Securities and Exchange Commission (SEC) introduced significant amendments to the 15c2-11 rules back in September 2020. The revised regulations, better known as the 211 rules, came into force on September 28, 2021, with a broad scope that reshapes the securities landscape. At a macro level, the updated 211 rules (i) demand the availability of current and public data about the issuing entity and its security to initiate or maintain a quote for the security; (ii) constrain certain exemptions, such as the piggyback exception, where the issuer’s data isn't accessible to the public or isn't up-to-date; (iii) restrict the exceptions where a firm becomes and stays a shell company for 18 months; (iv) lessen regulatory burdens for quoting securities less prone to potential fraudulent activities and manipulation; (v) enable OTC Markets to determine and verify eligibility for reliance on the rules; and (vi) streamline the regulations, removing outdated provisions. Detailed discussions on the 15c2-11 rules can be found HERE and HERE.
The 211 rules encapsulate unique provisions regarding shell companies. They allow broker-dealers to depend on the piggyback exception to publish quotes for shell companies for 18 months after the initial priced quotation on OTC Markets. This period commences from the enforcement date of the revised regulations - September 28, 2021. Essentially, it provides a shell company with an 18-month window to finalize a reverse merger with a functioning business or alternatively, to begin operations organically. If a company has retained its shell status since September 28, 2021, the deadline to maintain 211 eligibility will be March 28, 2023 – just a month away from today. This impending deadline has triggered anxiety among OTC Markets shell companies, which this article hopes to alleviate.
Understanding a Shell Company
The definition of a shell company in the revised 15c2-11 rule parallels Securities Act Rules 405 and 144, along with Exchange Act Rule 12b-2. Still, it includes a "reasonable basis" qualifier to assist broker-dealers and OTC Markets in their determinations. Specifically, a shell company refers to an issuer, not linked to a business combination related shell company as defined in Rule 405 or an asset-backed issuer, that possesses: (i) minimal or no operations; and (ii) no or nominal assets, or assets composed solely of cash, cash equivalents, or nominal other assets. A start-up or a company with a limited operating history does not automatically qualify as a shell company. For a reasonable basis of determination, broker-dealers or OTC Markets can refer to public filings, financial statements, business descriptions, etc.
In preparation for the upcoming 18-month deadline, OTC Markets has included FAQs for shell companies on its 15c2-11 resource center page and established a surveillance team to monitor shell status. Typically, OTC Markets deems a company as a shell when it identifies itself as such in its SEC periodic reports or reports filed with OTC Markets through the alternative disclosure system.
However, the “shell risk” designation that occasionally appears on a company’s quote page is different. As part of its ongoing review, OTC Markets may label a company with a shell risk flag, indicating a potential risk of shell company characteristics. The designation does not necessarily mean that the company has self-identified as a shell (that would result in a firm shell flag, not a “shell risk” one). The shell risk review evaluates factors like asset composition, operational expenditures, and income-related metrics. When a company receives a shell risk flag, in order to successfully regain the piggyback exception, the onus is on the company to prove that they are no longer a shell company and meet the criteria required by OTC Markets or a broker-dealer. Of course, this means the company must take necessary actions to move beyond their shell status, such as merging with a company that's fully operational or initiating their own business operations.
Let's make it clear that these actions should be pursued with genuine intent. Undertaking a business transaction as a temporary measure to evade the shell status, if not fully disclosed, can be considered a fraudulent activity. A number of firms, in a bid to avoid the shell status, may contemplate initiating temporary business transactions, but I must emphasize that any such actions should be transparently disclosed to avoid allegations of fraud.
One only has to recall the surge in the creation of shell companies that transpired when newly public companies were offered for sale just after filing an S-1 and acquiring a ticker symbol. The act of not disclosing in the S-1 and subsequent periodic reports that the business being taken public was a placeholder, with the true intention being to find a new buyer and business for the new public company, was identified as securities fraud. This resulted in a wave of enforcement actions and numerous prison sentences for the participants.
When a company on the OTC Markets suddenly manifests a temporary change in its shell status, although it may not file an S-1 immediately, any false statement could violate Exchange Act Rule 10b-5. This rule states that it is illegal for any person, in connection with the purchase or sale of any security, to engage in fraudulent activities, make any false statement of a material fact, or omit to state a material fact necessary to prevent the statements made from being misleading.
In the event that a shell company loses piggyback eligibility, they would need a new 15c2-11 review to be undertaken by either a broker-dealer or OTC Markets under the initial quotation standards when they cease being a shell company. OTC Markets will only carry out a 211 current information review for a company that applies to the OTCQB or OTCQX tier of trading on OTC Markets.
In today's regulatory environment, with the need to adhere to increasingly stringent disclosure requirements, a target company should really only contemplate going public through a reverse merger with a public shell company if it meets the requirements for trading on the OTCQB or OTCQX tiers of OTC Markets. This includes the obligation to obtain audited financial statements.
In summary, the updated 15c2-11 rules bring significant changes for companies and securities, especially in the case of shell companies on the OTC Markets. Understanding the details of these changes and knowing how to navigate them effectively is crucial for broker-dealers, investors, and companies alike. As always, legal and regulatory advice should be sought when in doubt. The impact of these changes will continue to unfold, and we'll keep you updated with new developments and insights.
Revisiting the Requirements for Current Information
The primary tenet of Rule 15c2-11 is the availability of current and adequate information when a security is launched in the market. Exchange Act Rule 15c2-11 specifies the information a broker-dealer is required to maintain when initiating a quotation. This includes: (i) a prospectus such as a Form S-1 filed under the Securities Act of 1933 that became effective less than 90 days prior, (ii) a Regulation A offering circular qualified less than 40 days prior, (iii) the company's latest annual report filed under Section 13 or 15(d) of the Exchange Act or Regulation A, along with subsequent quarterly reports, (iv) information published according to Rule 12g3-2(b) for foreign issuers, or (v) particular information resembling that in items (i) through (iv).
Moreover, a broker-dealer needs to have a reasonable basis to believe in the accuracy and reliability of the information provided. As per the 211 rules, public information must be current and must be timely filed, or filed within 180 days from a specific date, based on the company's category. The 180-day period commences from the end of a reporting period.
Take for example an SEC reporting issuer with a December 31 year-end, who has filed a report for that period. Quotations from January 1 to June 29 would be covered by the piggyback exception. If the issuer subsequently filed quarterly reports for March 31, June 30, and September 30, the 180-day period would extend from each of those dates. However, if the issuer failed to file its September 30 10Q, the piggyback exception could not be relied on starting from December 28 (180 days post-June 30) as there would be no current and publicly available information for any reporting period ending 180 days before the quotation's publication or submission.
For alternative reporting (catch-all) companies, a broker-dealer must ascertain that current information is within 12 months of the quotation's publication and the balance sheet is not older than 16 months. Thus, for instance, if such a company with a December 31 year-end filed its annual report for December 31, 2020, including all required data (with a balance sheet dated post-September 1, 2019, and profit and loss for the preceding 12 months), a broker-dealer could rely on the piggyback exception until December 31, 2021.
Of course, current information maintenance involves more than just financial statements. As discussed further below, when SEC or other regulatory standards dictate the information to be reported (such as for a foreign private issuer), Rule 15c2-11 does not require different information. The rule does prescribe the information required by a catch-all company. The OTC Markets has revised its current information reporting requirements to include all of the new Rule's information and requirements.
The rule allows for a 15-day conditional grace period from the date it's publicly determined that a company no longer possesses current information within the specified 180-day period. This grace period is meant to inform the markets of the company's potential exit from quotation, providing investors an opportunity to liquidate positions.
To leverage the grace period, three conditions must be fulfilled: (i) OTC Markets or FINRA must publicly determine that current public information is no longer available within four business days of the information becoming unavailable (i.e., the chart time periods expiry); (ii) all other piggyback exception requirements must be met; and (iii) the grace period ends either when the company once again makes current information publicly available or on the 14th calendar day after OTC Markets or FINRA make the public determination in the first condition.
The SEC does not consider a late-reporting issuer as a part of the "catch-all" category for piggyback exception qualification. Instead, the updated rule provides a grace period for Exchange Act reporting companies that are behind on their reporting responsibilities. A broker-dealer can rely on the piggyback exception for quotations for up to 180 days following the end of the reporting period. Given that most OTC Markets companies are not accelerated filers, the due date for an annual Form 10-K is 90 days post fiscal year-end, and for a quarterly Form 10-Q, it is 45 days post quarter-end. As a result, a company can delay filing its Form 10-K up to 90 days or its Form 10-Q up to 135 days before losing piggyback eligibility. Companies reporting under Regulation A and Regulation Crowdfunding are not given a grace period, but must file their reports in a timely manner to maintain piggyback eligibility.
The below summarizes the time frames for which 15c2-11 information must be current and publicly available, timely filed, or filed within 180 calendar days from the specific period:
Exchange Act reporting company: Filed within 180 days following the end of a reporting period. Regulation A reporting company: Filed within 120 days of the fiscal year-end and 90 days of the semi-annual period end. Regulation Crowdfunding filer: Filed within 120 days of the fiscal year-end. Foreign Private Issuer: Since the first day of the most recent completed fiscal year, has filed information required by the laws of the home country or principal exchange traded on. Catch-all company: Current and publicly available annually, except the most recent balance sheet must be dated less than 16 months before the submission of a quote and profit and loss and retained earnings statements for the 12 months preceding the date of the balance sheet.
Please note that the requirement to include financial information for the previous two years does not become effective until approximately two years and two months after the effective date. A catch-all company must provide all other current information specified in the rule to qualify for the piggyback exception, beginning on the compliance date.
A company that fails to meet the current information requirements will be moved to the Expert Market. Quotes in the Expert Market are restricted from public viewing. Only broker-dealers and sophisticated or professional investors are allowed to view quotes in Expert Market securities. Although viewing restrictions apply, the Expert Market does not limit who can trade securities. Rule 15c2-11 regulates a broker's ability to submit, publish, or distribute quotations (i.e., bids and offers) in OTC securities. It does not, however, apply to the underlying transactions or an investor's ability to buy or sell a security.
A company on the Expert Market will still have a quote page on the OTC Markets website, but the quotes will not be visible to the public. The quote page will display two black diamonds and contain the following message:
Warning! This security is traded on the Expert Market.
The Expert Market serves broker-dealer pricing and investor best execution needs. Quotations in Expert Market securities are restricted from public viewing. OTC Markets Group may designate securities for quoting on the Expert Market when it is not able to confirm that the company is making current information publicly available under SEC Rule 15c2-11, or when the security is otherwise restricted from public quoting.