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    15c2-11 Application

    SEC Rule 15c2-11 was designed to allow companies to list their securities on The Financial Industry Regulatory Authority’s (FINRA) Over-the-Counter Markets and Bulletin Board by filing disclosures to FINRA.

    Companies seeking to obtain a new listing on OTC Markets must be “fully reporting” with the SEC.  Companies that file a registration statement with the SEC using a Form S-1 will become a reporting company when the SEC declares the registration statement effective. Once a company is reporting, it is eligible to have a market maker file a Form 211 with FINRA. The 211 must be approved by FINRA, which normally takes three to six months before the company can trade its stock on the OTC Markets.  FINRA will require a certain number shareholders, sufficient public float, and an operating entity that meets its financial statement requirements to approve the 211 application.  After FINRA receives the application, an auditor can review it.  They will reply with a letter setting forth their questions and comments on your application and filing. The stated and un-stated listing requirements are as follows:

    • The company must be fully reporting with the SEC
    • It must have a minimum of ~30-40 stockholders of record holding at least 100 shares each
    • Finally, it must have a market maker submit 15c2-11 (Form 211) application to FINRA and agree to act as market maker for the company’s securities

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    15c2-11 Red Flag Issues

    The following are examples of red flags that require additional scrutiny by the broker-dealer to comply with Rule 15c2-11. These examples are not exhaustive. The presence of these or other red flags is not necessarily an indication of microcap fraud or even inaccurate issuer information. The red flag simply means that the broker-dealer should question whether the issuer information is accurate or reliable.

    • Commission Trading Suspensions. As indicated above, commission trading suspension orders generally raise significant red flags regarding the credibility of 15c2-11 information. Broker-dealers publishing quotes once a trading suspension terminates must satisfy the rule’s requirements. These may include seeking verification from the issuer or soliciting the views of an independent professional.
    • Foreign Trading Suspensions. A trading suspension by a foreign regulator may indicate that the issuer information is unreliable or inaccurate. However, a trading suspension in a foreign market may be imposed because the issuer did not meet stock exchange listing standards. If the broker-dealer learns of a foreign trading suspension, it should first attempt to determine the basis for the suspension order. Then it should assess whether the issuer information is still accurate and from a reliable source.

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    Advise you regarding potential red flags

    Explore potential red flags that suggest fraudulent activity which doesn’t comply with Rule 15c2-11

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    More Financial Red Flags

    While not necessarily problematic, these are material events involving the issuer. The change in control of the issuer, merger, acquisition, or business combination, acquisition or disposition of significant assets provides unscrupulous issuers with an opportunity to artificially overvalue the issuer’s assets and manipulate of the issuer’s worthless stock.  An increase in the issuer’s equity securities provides the assets necessary for such manipulation. Bankruptcy proceedings or a delisting from an exchange or the Nasdaq Stock Market may also  lead the broker-dealer to conclude that the issuer’s financial information is inaccurate.

    • Concentration of ownership of the majority of outstanding, freely tradable stock. Concentration of ownership of freely tradable securities is a prominent feature of microcap fraud cases. When one person or group controls the flow of freely tradable securities, they can more easily manipulate stock price, compared to when the securities are widely held. In a “pump and dump” scheme, retail interest is stimulated, and the price of the securities is manipulated upward. Often, other broker-dealers that are not intentionally participating in improper activities publish quotations in response to an escalating demand for the security. The promoters of these companies, company insiders, and unscrupulous brokers make substantial profits when they sell their shares at inflated prices. When the scheme is over, the security’s price plummets. This leaves innocent investors who paid a premium price holding worthless shares.
    • Large reverse stock splits. Microcap fraud schemes can involve the substantial concentration of the publicly-traded float through a reverse stock split. The subsequent issuance of large amounts of stock to insiders increases their control over the issuer and the stock trading process.
    • Companies that have large assets and minimal revenue without any explanation. A red flag exists when the issuer assigns a high value to certain assets on its financial statements. These statements are often ones that are often unrelated to the company’s business, which were recently acquired in a non-cash transaction. In this situation, the company’s revenues often are minimal. There appears to be no valid explanation for such large assets and minimal revenues. Also, a red flag is present when the financial statements of a development stage issuer list, as the principal component of the issuer’s net worth, an asset wholly unrelated to the issuer’s line of business. For example, from a review of Rule 15c2-11 submissions, art collections, or other collectibles that are unrelated to the issuer’s business apparently have been overvalued on the financial statements of some issuers. While assets unrelated to the business of the issuer are not always an indication of potential microcap fraud, some unscrupulous issuers have overvalued these types of assets to inflate their balance sheets.
    • Shell corporation’s acquisition of private company. A shell corporation is characterized by no business operations and little or no assets. In a fraud scheme, a reporting company with a large number of shares controlled by one person or a small number of persons often merges with a non-reporting company that has some business operations. The new public company is then used as the vehicle for “pump and dump” and other fraudulent schemes. Broker-dealers placing quotes for these issuers’ securities should be aware of the potential for abuse. Offerings under Rule 504 of Regulation D where one or more of the following factors are present:
    • Little capital is raised in the Rule 504 offering. There appears to be no business purpose except to provide some shareholders with free-trading shares
    • The Rule 504 offering is preceded by an unregistered offering to insiders or others for services at prices well below the price in the subsequent offering
    • Sales immediately following the Rule 504 offering are at substantially higher prices than those paid in the Rule 504 offering
    • A shell company and an operating company merge, which results in the operating entity becoming the surviving entity. The surviving entity goes public by issuing shares pursuant to Rule 504. Rule 504 of Regulation D allows non-reporting companies to raise up to $1 million per year in seed capital without complying with Securities Act registration requirements. The freely tradable nature of securities issued in Rule 504 offerings has facilitated a number of fraudulent schemes through the OTCBB Display Service or the Pink Sheets published by the National Quotation Bureau, Inc. (NQB). Broker-dealers should be alert to information in the Rule 15c2-11 materials where an active trading market is being promoted for securities issued solely in a Rule 504 transaction. A registered or unregistered offering raises proceeds that are used to repay a bridge loan made or arranged by the underwriter where:
    • The bridge loan was made at a high interest rate for a short period
    • The underwriter received securities at below-market rates prior to the offering
    • The issuer has no apparent business purpose for the bridge loan. Broker-dealers have given small issuers bridge loans at high interest rates for short time periods. In exchange for this bridge loan, the broker-dealer receives a significant number of shares of the issuer’s common stock at a price substantially below market rates. The broker-dealer then engages in a scheme to manipulate the stock’s price. Ultimately, it benefits when it dumps the stock at an artificially high price.
    • Significant write-up of assets following the acquisition of a patent or trademark for a product. This technique is used by issuers to engage in microcap fraud to inflate their balance sheets.
    • Significant asset consists of OTC Bulletin Board or pink sheet companies. There have been cases of microcap fraud schemes involving issuers whose major assets are substantial amounts of shares in other OTC Bulletin Board or pink sheet companies.
    • Assets acquired for shares of stock when the stock has no market value. In microcap fraud cases, the issuer’s financial statements often indicate that they acquired assets with substantial value in exchange for its essentially worthless stock.
    • Significant write-up of assets in a business combination of entities under common control. Those engaged in microcap fraud often use a business combination such as a merger to falsify financial statements.  There have been cases of microcap fraud schemes in which unscrupulous issuers use purchase method accounting to write up the historical value of an asset to an artificially high value. They often do this in situations when the entities involved in the business combination are under common control or otherwise have a high degree of common ownership. For example, Generally Accepted Accounting Principles (GAAP) requires that the acquisition of one entity by another entity be accounted for at historical cost in a manner similar to pooling of interests accounting, when these entities are under common control.
    • Unusual auditing issues: auditors refuse to certify financial statements or they issue a qualified opinion
    • Change of accountants.  Rule 15c2-11 does not state that the broker-dealer should scrutinize the issuer’s financial statements with the expertise of an accountant. The above red flags, however, do not require accounting expertise and have appeared in several microcap fraud schemes.  An accountant’s resignation or dismissal occurs in some microcap fraud cases. If a broker-dealer sees any of these red flags, it should confirm the auditor’s credentials with the appropriate state licensing authority, question the circumstances of the change in accountants, and carefully scrutinize the rule’s required information.
    • Extraordinary items in notes to the financial statements, such as unusual related party transactions. Unusual related party transactions are sometimes found in microcap fraud schemes. For example, an issuer’s financial statements may show a related party transaction between two companies, which later merge and inflate the worth of their assets by using purchase method accounting.
    • Suspicious documents: inconsistent financial statements,altered financial statements, or altered certificates of incorporation.
    • Altered or facially inconsistent issuer documents. At a minimum, broker-dealers should contact issuers if financial documents have been altered.
    • The broker-dealer receives substantially similar offering documents from different issuers with the following characteristics: the same attorney is involved; the same officers and directors are listed; and/or the same shareholders are listed. It is not uncommon for the same individuals to be involved in multiple microcap fraud schemes. If a broker-dealer realizes that the same individuals are involved with these entities, it should determine the accuracy of the issuer’s information.
    • Extraordinary gains in year-to-year operations.  In microcap fraud cases, the issuer may show extraordinary gains in its year-to-year operations. This may be accomplished by assigning an artificially high value to certain assets or through other manipulative devices that are red flags.
    • A reporting company fails to file an annual report. This suggests that the company is not in good standing with the SEC.
    • Disciplinary actions against an issuer’s officers, directors, general partners, promoters, or control persons. The following types of disciplinary actions should trigger further investigation by a broker-dealer: indictment or conviction in a criminal proceeding; an order permanently or temporarily enjoining, barring, suspending or otherwise limiting an officer, or controlling a person’s involvement in any type of business, securities, commodities, or banking activities;adjudication by civil court of competent jurisdiction, the Commission, the Commodity Futures Trading Commission or a state securities regulator to have violated federal or state securities or commodities law; or, anorder by a self-regulatory organization permanently or temporarily suspending involvement in any type of business or securities activities. Many microcap fraud cases involve recidivist securities law violators.  If a broker-dealer has information or could reasonably discover information about the above types of violations, it should question whether it has a reasonable basis to believe that the issuer’s information is accurate and complete.
    • Significant events involving an issuer or its predecessor, or any of its majority owned subsidiaries. The following types of significant events should prompt further investigation by a broker-dealer: change in control of the issuer; substantial increase in equity securities; a merger, acquisition, or business combination; acquisition or disposition of significant assets; bankruptcy proceedings; delisting from any securities exchange or the Nasdaq Stock Market.
    • Request to publish bid and ask quotes on behalf of a customer for the same stock. The highly unusual request from a customer for the broker-dealer to publish bid and ask quotes is a red flag that calls for appropriate inquiry by the broker-dealer.
    • The issuer or promoter offers to pay a “due diligence” fee. It is illegal for an issuer to pay a due diligence fee in connection with making a market in the issuer’s security. Specifically, it violates NASD Rule 2460. If the broker-dealer receives any consideration in connection with publishing a quotation, the reproposed rule requires them to disclose any such compensation. They must also disclose any other significant relationship information between the issuer and the broker-dealer publishing the quotation.
    • Regulation S transactions of domestic issuers.  Regulation S provides a safe harbor from the registration requirements of the Securities Act of 1933. We recently adopted amendments to Regulation S designed to prevent the abuses related to offshore offerings of equity securities from domestic issuers.  Prior to the recent amendments, large Regulation S transactions in the U.S. were particularly vulnerable to fraud.  The perpetrators of the fraud sold the securities to U.S. investors after the 40-day holding period expired. Little information was available to investors about the issuers.
    • Under the amendments, equity securities of U.S. issuers that are sold offshore under Regulation S are classified as “restricted securities” within Rule 144 under the Securities Act. The period during which these securities cannot be distributed in the United States is lengthened from 40 days to one year. These amendments make Regulation S abuses less likely, but broker-dealers should be alert to any questionable activities once the one-year holding period expires.
    • Form S-8 stock. Form S-8 is the short-form registration statement for offers and sales of a company’s securities to its employees. The form has been abused by unscrupulous issuers to register on Form S-8 securities nominally offered and sold to employees or, more commonly, to so-called consultants and advisors. These persons then resell the securities in the public markets, at the direction of the issuer or a promoter.  In a typical pattern, an issuer registers on Form S-8 securities underlying options issued to so-called consultants. These consultants resell the underlying securities in the public market. Then, they either remit the proceeds from selling the shares to the issuer ,or apply the proceeds to pay debts of the issuer that are not related to any services provided by the consultants.  In some cases, these consultants perform little to no other service for the issuer. In other microcap fraud cases, the issuer uses Form S-8 to sell securities to “employees” who act as conduits. They sell the securities to the public and remit the proceeds (or their economic benefit) to the issuer.  This public sale of securities has not been registered, although the Securities Act requires registration. The failure to register this sale of securities deprives public investors of the protections afforded by the Securities Act.

    Form S-8

    To prevent these abuses, Form S-8 and related rules impose certain restrictions on the sale of securities using this form.

    • “Hot industry” microcap stocks.  Another characteristic of microcap fraud cases is that they often involve stocks that are in vogue.  In the past, oil and gas ventures and mining operations, have been popular in frauds involving low-priced stocks. The stocks of issuers with purportedly innovative products have also attracted fraud.
    • Unusual activity in brokerage accounts of issuer affiliates, especially involving “related” shareholders. Many microcap frauds begin with the deposit and sale of large blocks of an obscure stock. New, unfamiliar customers who are often is affiliated with an issuer conduct these deposits.  At the same time, the broker-dealer is encouraged to make a market in the stock by the issuer.
    • Companies that frequently change names.  Frequent name changes are another characteristic seen in microcap fraud cases.
    • Companies that frequently change their line of business.  Besides companies that frequently change their names, companies that frequently change their line of business are common to microcap fraud cases.

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