Commentary: How The Sec Is Passing The Buck On Microcaps

At first glance, it seems like a perfectly intelligent, common-sense way of dealing with microcap fraud. Simply beef up the rules governing "market makers" who trade over-the-counter stocks, and require them to learn about the stocks they trade. They should study the companies' financial statements and keep an eye peeled for fraud. And if they find evidence of chicanery? Well, they should drop such cruddy stocks, and fast.

This little-publicized proposed change in securities law is a crucial component of the Securities & Exchange Commission's campaign against microcap fraud. It targets a vast, trouble-plagued segment of the market--8,600 stocks trading on the OTC Bulletin Board and Pink Sheets, which include stocks too small to be traded on the stock exchanges or NASDAQ. Such stocks account for $20 billion in volume a year. Traders have long noted that OTC stocks, many little more than fictitious "shells" disguised as legitimate companies, are a hotbed of fraud and manipulation by shady "chop house" brokers (BW--Dec. 15, 1997).

Comments have begun to pour into SEC files in recent days, and the reaction is predictable: Wall Street hates it. Critics include the Securities Industry Assn. and the National Quotation Bureau, which publishes the Pink Sheets. Major Street firms are expected to weigh in against the proposal in coming days.

CRUSHING LIABILITY. Proponents, mainly state regulators, say the idea is a major step forward in the war against securities fraud. But Street critics argue that the proposal is overly broad--covering bonds, closely held corporations, and foreign issues as well as small stocks. They say it would curtail liquidity in the market for microcap stocks. Downplayed in the comment letters is the Street's primary concern--potentially crushing liability from lawsuits by disgruntled investors.

The securities industry's opposition is, of course, self-serving. But this time, the Street is right. The agency's proposal is an awful idea. It would indeed reduce liquidity and would do painfully little to fight microcap fraud. The proposal would even play into the hands of scamsters--by discouraging short-selling of scuzzy stocks.

Market makers can't be lumped together with the brokerages that clear trades for microcap firms, who often are the first to see the "red flags" of stock fraud, such as massive commissions and markups. Regulators are--correctly--working on ways to force clearing firms to pass on evidence of stock fraud. But in this proposal, the agency seems to be trying to pass the buck--shifting onto brokers the SEC's responsibility to halt trading in shady OTC stocks. Asserts R. Cromwell Coulson, chairman of the National Quotation Bureau: "Market makers should make markets. Regulators should regulate markets."

At issue is Rule 15c2-11, adopted in 1971 as a way of curtailing traffic in outwardly bogus OTC stocks. The regulation requires a market maker to peruse a company's financials if it is the first firm to trade that stock over-the-counter. The SEC now wants the rule extended to all brokers who make a market in OTC stocks--not just the first to begin trading such stocks. After reviewing financials, says the SEC, "responsible broker-dealers should refrain from publishing quotations for questionable securities."

MANIPULATION. That's just what the scamsters want. When shady brokers dominate the market for a stock, they don't want "responsible broker-dealers" horning in. They want their stocks traded by fellow "chop-house" brokers, whom they can count on to manipulate prices. And since the rule would prevent market makers from issuing quotes if they think the stock is fraudulent, it would discourage, if not prohibit, short-selling--the bane of stock scamsters. (Most short-sellers of OTC stocks are market makers.) "Why do they want us to investigate stocks? Why doesn't the SEC pass a rule requiring themselves to do that?" one short-seller/market maker asks caustically.

Why indeed. The way to stamp out OTC stock fraud is for the SEC to work more closely with federal and local prosecutors and put scamsters behind bars. The SEC should also act more vigorously to halt trading in shady OTC stocks, and extend that authority to the National Association of Securities Dealers--a move supported by state regulators. Shifting that burden to market makers is more than just an ill-conceived idea. It actually would lend a hand to the scamsters the SEC is trying to fight.