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From: Testimony of Arthur Levitt,, Chairman, U. S. Securities and Exchange
Time: 7:38:04 AM
ARTHUR LEVITT, CHAIRMAN U.S. SECURITIES AND EXCHANGE COMMISSION
CONCERNING FRAUD IN THE "MICRO CAP" MARKET BEFORE THE PERMANENT SUBCOMMITTEE ON INVESTIGATIONS, COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE
Chairman Collins and Members of the Subcommittee:
I appreciate this opportunity to appear before the Permanent
Subcommittee on Investigations on behalf of the Securities and Exchange
Commission ("Commission"), to discuss fraud in the micro capital ("micro
cap") and "penny stock" markets and the Commission's efforts to combat such
We are living in an era of tremendous expansion in our capital
markets. Last year, the Dow broke 6,000, and then 7,000, and this year
broke 8,000. Daily volume on the New York Stock Exchange and Nasdaq is
also at an all-time high, and initial public offerings are running at a
record pace -- as shown in 1996, $50 billion was raised for new businesses.
It is not surprising then that public participation in our securities
markets has grown to record levels. Mutual fund assets ($135 million in
1980) are now a record $3.7 trillion, surpassing the $2.6 trillion that
Americans have on deposit at commercial banks. As recently as 1980, only
one in 16 households invested in mutual funds; today that number is more
than one in three, as we have evolved from a nation of savers into a nation
With this vast expansion in our markets and in public participation in
those markets, we would expect to see an increase in the incidence of
fraud. We have particularly seen an increase in abuses in the market for
micro cap securities, which provides opportunity for small businesses to
raise capital, but also provides opportunity for fraudsters to prey on
innocent investors. Despite the record-setting pace of our markets, the
Commission's resources have remained relatively constant. We must,
therefore, rely increasingly on innovative and efficient ways of minimizing
fraud and of maximizing the deterrence achievable with the Commission's
The Commission's campaign against fraud in the micro cap market is an
example of such innovation. The three parts of our strategy are
prevention, enforcement and regulatory initiatives.
Prevention Obviously, the Commission recognizes that preventing
securities fraud is far more effective than seeking to punish wrong-doers
after the fact. We prevent fraud through our programs involving broker-
dealer inspections, market and Internet surveillance, and investor
Enforcement The Commission's Division of Enforcement has been working
in partnership with the criminal authorities to lock up recidivist brokers
and deter wrongdoers. Indeed, in the past year alone, at least 80
individuals have been charged or prosecuted through the coordinated efforts
of the Commission and the Department of Justice. The Commission has also
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coordinated its activities with other securities regulators to maximize our
resources and stop micro cap fraud at its earliest stages.
Regulatory Initiatives Over the last several months, the Commission's
staff has worked with the New York Stock Exchange, Inc. ( NYSE ) and the
National Association of Securities Dealers, Inc. ( NASD ) to develop rules
that address the vulnerabilities in this sector of the market, such as a
rule that increases the responsibility of clearing firms for notifying
regulators of problems with introducing firms. The Commission is also
studying how best to increase the amount of public information available
regarding companies that are quoted on the NASD's over-the counter ("OTC")
Bulletin Board and in the National Quotation Bureau's "Pink Sheets."
The terms "micro cap" stock and "penny stock" have been used to
describe a particular segment of the securities market. As both terms
suggest, these stocks are generally low-priced securities issued by small
companies. A penny stock is generally a security that is priced at less
than $5 per share and is not traded on Nasdaq or listed on a stock
exchange.<(1)> "Micro cap" stock generally describes a somewhat
<(1)> Under the federal securities laws, penny stock is defined generally as: an equity security that is not listed on Nasdaq or a national securities exchange and either (a) has a price per share that is less than $5 or (b) whose issuer has net tangible assets that are less than $2 million, if the issuer has been in continuous operation for at least three years; or that are less than $5 million, if the issuer has been in continuous operation for less than three years; or whose average revenues are less (continued...)
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broader universe of stocks than "penny stocks" -- the stock of any company
with comparatively low capitalization, regardless of its price or where it
is traded.<(2)> Thus, the term "micro cap" often includes "penny
stock" as defined by the Commission.
Fraud in the "micro cap" stock market follows a fairly predictable
pattern. We find two different, but often related problems:
* The first problem is aggressive, and sometimes fraudulent, sales
practices, such as unauthorized trading in a customer's account.
<(1)>(...continued) than $6 million for the last three years. See Section 3(a)(51) of the Securities Exchange Act of 1934, 15 U.S.C. 78c(a)(51), and Rule 3a51-1, 17 C.F.R. 240.3a51-1, promulgated thereunder.
When the Commission adopted the $5 threshold for penny stocks it cited three reasons: 1) the perceived difficulty of manipulating higher valued stocks; 2) the fact that $5/share was the threshold for the ULOR/SCOR -- a uniform, streamlined state registration form for companies raising less than $1 million under the Rule 504 exception under Regulation D; and 3) the perception that legitimate small businesses could still raise capital and the liquidity for their shares would not be impaired. Exchange Act Release No. 30608 ("Penny Stock Rule Release"), 57 Fed. Reg. 18,004 (Apr. 28, 1992).
<(2)> The term "micro cap" is not a term defined under the federal securities laws. Lipper Analytical Services, a mutual fund rating organization, generally categorizes micro cap companies as companies with market capitalizations of less than $300 million. Lipper-Directors' Analytical Data, Investment Objective Key, 2d ed. 1997. In general, securities of micro cap companies are quoted on Nasdaq's OTC Bulletin Board, in the National Quotation Bureau's Pink Sheets and on the Nasdaq Small Cap Market.
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* The second problem involves manipulation of micro cap stocks by
brokers, issuers and promoters to benefit themselves while
harming innocent investors.
Micro cap stock fraud presents a difficult challenge: to control the
fraud without damaging the market for securities issued by legitimate small
businesses. In this effort, the Commission is guided by three principles:
* First, we must try to prevent fraud before it happens through
early intervention and investor education.
* Second, we must vigorously enforce the securities laws against
con men and criminals who take advantage of investors.
* Finally, we must continue to encourage legitimate capital
formation through flexible regulation, especially for small
A. What is Micro Cap Stock Fraud?
Before expanding upon the Commission's response to micro cap fraud, it
may be useful to briefly consider the nature of the problem. Stock
manipulators need stock. They usually get it in one of two ways. One way
is to find a "shell" company that already has issued publicly trading
securities. This shell company typically has little or no operating
history; few assets; few, if any, employees; and slim prospects for
financial success. The shell is sometimes merged with a privately-held
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company. The other vehicle for these individuals to get stock is to take
advantage of exemptions from the federal registration requirements.
The securities involved are usually traded in portions of the OTC
market where public information is limited and a small number of brokers
control the market. The securities are usually sold through hype or high
pressure tactics, often involving "boiler room" operations where a small
army of sales personnel cold call potential investors using scripts to
induce them to purchase the "house stocks" -- those stocks in which the
firm makes a market or has a large inventory. The information conveyed to
investors often is at best exaggerated and at worst completely fabricated.
Increasingly, stocks also are being touted on the Internet by unregistered
promoters who work to raise interest in the stock.
Once they have lured investors, the unscrupulous brokers employ a
variety of inappropriate practices, from "bait and switch" tactics,
unauthorized trading, "no net sales" policies (where investors are
discouraged or actually prevented from selling their stocks) to churning
(excessive trading in their accounts in order to generate commissions for
the broker). The firm often charges excessive, undisclosed
markups<(3)> and issues arbitrary stock quotations. Even if investors
complain to the brokerage firm, it rarely disciplines its registered
representatives or reports the investor complaints.
<(3)> Excessive mark-ups in boiler room operations typically occur when a broker-dealer acquires a supply of stock at low cost and resells it at a substantially higher price to retail customers.
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The promoters of these companies, and often company insiders,
typically hold large amounts of stock and make substantial profits when the
stock price rises following intense promotional efforts. Once the price
rises, the promoters, insiders and brokers sell, realizing their profits,
and the promoters cease their promotional efforts. After the manipulation
of the stock ceases, the stock price plummets and innocent investors not
only incur large losses, but may also lose their initial investments
B. The Commission's Previous Response to Micro Cap Fraud
The last major outbreak of micro cap stock fraud occurred during the
bull market of the 1980s. The Commission formed a Penny Stock Task Force
in 1988 to coordinate its response to the problem. In 1989, the Commission
adopted Exchange Act Rule 15c2-6, which requires brokers to obtain relevant
financial information about their customers, document their penny stock
recommendations and obtain written agreements from the customer for the
first three penny stock purchases.<(5)> The intent of the rule is to
require and document customer suitability when penny stocks are
recommended. Armed with this new rule, the Commission devoted substantial
resources to policing "penny stock" fraud, bringing 86 penny stock
<(4)> This type of manipulation frequently is referred to as a "pump and dump" scheme.
<(5)> In 1993, the Commission redesignated Rule 15c2-6 as Rule 15g-9, joining it with the other Penny Stock Rules. Exchange Act Release No. 32576 (July 2, 1993), 58 Fed. Reg. 37,413 (July 12, 1993).
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enforcement actions in 1990 alone that represented 28% of all enforcement
actions brought that year.<(6)>
In 1990, the Commission approved the NASD's pilot project to bring
more accurate and current information to the OTC market,<(7)> where
micro cap stocks generally trade. The vast majority of micro cap stocks
are not listed on exchanges or traded on Nasdaq. Before 1990, the National
Quotation Bureau's "Pink Sheets" were the primary source of information
about the stocks for this large group of smaller companies. The Pink
Sheets are daily lists of stocks, published by a private financial
information vendor, advertising the brokerage firms that make markets in
these stocks. They sometimes include indications of interest or non-firm
bid and offer prices for small quantities of stock. The Pink Sheets are
not widely distributed and often contain stale information. In order to
provide more public information about these stocks, the NASD created the
OTC Bulletin Board, a centralized, automated alternative to the Pink Sheets
that can provide real-time price and volume information. The pilot project
was made permanent in 1997.<(8)> The OTC Bulletin Board has
strengthened the NASD's ability to monitor those quotes that are displayed.
<(6)> 1990 Annual Report of the U.S. Securities and Exchange Commission, at 6 and 156.
<(7)> Exchange Act Release No. 27975 (May 1, 1990), 55 Fed. Reg. 19,123 (May 8, 1990) [Corrected Order, Exchange Act Release No. 27975-A (May 30, 1990), 55 Fed. Reg. 23,161 (June 6, 1990)].
<(8)> Exchange Act Release No. 38456 (Mar. 31, 1997), 62 Fed. Reg. 16,635 (Apr. 7, 1997).
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Congress also has previously worked to address micro cap fraud. In
1990, the Subcommittee on Telecommunications and Finance of the House
Commerce Committee took up the issue of penny stock fraud,<(9)> and
ultimately Congress enacted the Penny Stock Reform Act of 1990 ("Penny
Stock Act") as part of the Securities Enforcement Remedies Act ("Remedies
Act").<(10)> The Penny Stock Act expanded the Commission's authority
over such previously unregulated persons as promoters who associate with
broker-dealers to sell penny stocks, and it required the creation of a
toll-free hotline investors could call to obtain the disciplinary history
of brokers. The Act also placed significant restrictions on so-called
"blank check" offerings and required broker-dealers to disclose more
information to customers when selling penny stocks. Finally, the Act
called for the creation of an automated quotation system for OTC stocks,
which the NASD and Commission already had underway with the OTC Bulletin
After the enactment of the Penny Stock Act, the Commission adopted new
rules to implement the statute.<(11)> Among the requirements are
rules requiring brokers to give customers specific information before the
sale about the market for penny stocks and the broker's compensation.
After the sale, the broker must provide clients with monthly statements
<(9)> Penny Stock Market Fraud: Hearings on H.R. 4497 Before the Subcommittee on Telecommunications and Finance of the House Committee on Energy and Commerce, 101st Cong. 27 (1990) (Statement of Richard C. Breeden, Chairman of the Commission).
<(10)> Securities Enforcement Remedies and Penny Stock Reform Act of 1990, Pub. L. No. 101-429, 104 Stat. 931.
<(11)> Penny Stock Rule Release, supra, at fn. 1.
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reporting the market value of the client's penny stocks. The goal of these
rules is to provide information to investors and provide prospective
investors with an opportunity to consider whether to make a purchase
without the pressure of boiler room tactics.
In 1991, the Commission amended Exchange Act Rule 15c2-11. That rule
requires a broker-dealer to review financial and other issuer information
before publishing a quotation in the issuer's stock in a quotation media
such as the OTC Bulletin Board or the Pink Sheets. The rule also requires
brokers to have a reasonable basis for believing the information is
accurate. Finally, the amended rule requires broker-dealers to obtain a
copy of any trading suspension order in the issuer's stock for the previous
In 1993, the Commission conducted an extensive examination sweep with
the NASD and state regulators to determine whether firms were complying
with the Penny Stock Rules. The sweep found widespread adherence to the
Penny Stock Rules, along with generally diminished activity in stocks
covered by the Penny Stock Rules.<(13)>
C. How Micro Cap Fraud Has Changed
<(12)> Exchange Act Release No. 29094 (Apr. 17, 1991), 56 Fed. Reg. 19,148 (Apr. 25, 1991).
<(13)> Joint Regulatory Penny Stock Examination Sweep (June 1994). Only 14 of the 129 broker-dealer examinations disclosed violations serious enough to warrant consideration of enforcement or disciplinary action.
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Although the Penny Stock Act and Rules and the creation of the OTC
Bulletin Board have by and large curbed certain abuses in the market for
securities priced under $5, we are now finding that promoters and broker-
dealers have adjusted their schemes so that the securities fall outside
these measures. The simplest way around the Penny Stock Rules, for
example, is to offer or sell securities that do not meet the technical
definition of "penny stocks". The Commission today sees more fraud in
mostly lower-priced Nasdaq-listed securities and in securities valued at $5
In addition, the Internet is being used as a new vehicle to perpetrate
securities fraud, especially in the micro cap market (including touting in
"chat rooms", bulletin boards and on e-mail). The Commission has already
brought enforcement actions involving fraudulent securities offerings,
stock manipulations,<(14)> and investment advisers fraud through
Internet newsletters.<(15)> The fraudulent securities offerings
often promise unreal returns and include everything from interests in an
eel farm,<(16)> an ethanol plant,<(17)> gold and diamond mining
<(14)> SEC v. Huttoe, Litigation Release No. 15237 (Jan. 31, 1997), 63 SEC Docket 2383 (Mar. 4, 1997).
<(15)> SEC v. Chelekis, Litigation Release No. 15264 (Feb. 25, 1997), 63 SEC Docket 2900 (Mar. 25, 1997).
<(16)> SEC v. Odulo, Litigation Release Nos. 14591 (Aug. 7, 1995), 59 SEC Docket 3105 (Sept. 5, 1995), and 14616 (Aug. 24, 1995), 60 SEC Docket 122 (Sept. 19, 1995).
<(17)> SEC v. Spencer, Litigation Release Nos. 14856 (Mar. 29, 1996), 61 SEC Docket 1960 (Apr. 30, 1996), and 15042 (Sept. 12, 1996), 62 SEC Docket 2409 (Oct. 8, 1996).
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enterprises<(18)> and a coconut chip enterprise,<(19)> to more
sophisticated offerings of sham
<(18)> SEC v. Wye Resources, Inc., Litigation Release No. 15073 (Sept. 26, 1996), 62 SEC Docket 2762 (Oct. 22, 1996).
<(19)> SEC v. Frye, Litigation Release Nos. 14720 (Nov. 15, 1995), 60 SEC Docket 2123 (Dec. 12, 1995), 15139 (Oct. 29, 1996), 63 SEC Docket 422 (Nov. 26, 1996).
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promissory notes<(20)> and bonds purportedly issued by a nonexistent
offshore company.<(21)> The Internet can be used for scams because
it provides anonymity, broad circulation and the appearance of legitimacy
at low cost. Accordingly, the Commission has been developing an effective
surveillance strategy for the Internet.<(22)> However, the
Commission is committed to the legitimate use of the Internet by honest
III. The Commission's Program to Prevent
Fraud in the Micro Cap Markets
The Commission's program to prevent fraud in the micro cap market
* early detection and intervention; and
* investor education.
A. Early Detection and Intervention
The Commission's program of early detection and intervention includes:
(1) regular examination of broker-dealers; (2) surveillance of the Internet
and the markets; (3) imposition of trading suspensions; and (4) an
<(20)> SEC v. Sellin, Litigation Release No. 15012 (Aug. 12, 1996), 62 SEC Docket 1749 (Sept. 10, 1996).
<(21)> SEC v. Octagon Tech. Group, Inc., Litigation Release No. 14942 (June 11, 1996), 62 SEC Docket 377 (July 9, 1996).
<(22)> See discussion at pp. 14-15.
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increasing resort to emergency litigation to stop active and on-going
The Commission's Office of Compliance Inspections and Examinations
("OCIE") examines broker-dealers and oversees the examinations which the
Self Regulatory Organizations ("SROs") -- the national securities exchanges
and the NASD -- conduct of their members. Over the past several years,
OCIE has focused its review of broker-dealers on their sales and trading
practices. About 20% of examinations lead to referrals to the Commission's
Division of Enforcement. OCIE is currently working closely with the NASD
to focus on micro cap fraud through intense examination of broker-dealers.
The examination staff also periodically conducts "sweeps" to determine
if particular violations are widespread and then it issues recommendations
and reports. For instance, in 1994 the Commission staff with the NYSE and
NASD conducted a review of the hiring, retention and supervisory practices
of nine of the largest brokerage firms. Two years later, the Commission,
together with the NASD, NYSE and the North American Securities
Administrators Association, Inc. ("NASAA") conducted a joint sweep to
review the sales practices of selected registered representatives employed
by small and medium-sized firms as well as the hiring, retention and
supervisory practices of the brokerage firms that employ them.
The second sweep revealed that some firms employ registered
representatives with a history of disciplinary actions and customer
complaints, use only minimal hiring procedures, and have supervisors in
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branch offices who fail to review customer transactions adequately to
detect sales abuses. We also found that almost one-half of the branches
that engage in cold calling violated federal cold-calling
rules.<(23)> As a result of the sweep, the Commission, NYSE, NASD
and NASAA prepared a public report making specific recommendations designed
to correct these problems.<(24)> For example, the report recommends
more stringent hiring procedures for registered representatives; heightened
supervision of registered representatives with a history of customer
complaints, disciplinary actions or arbitrations; and training and
supervision of cold-calling techniques.
These joint sweeps have resulted in greater coordination among the
regulatory authorities. The Commission's compliance staff meets quarterly
with the NASD and NYSE to discuss how to improve our combined examination
procedures. In addition, the Commission's regional examination staff meet
regularly with their state counterparts and local NASD offices to determine
how to better craft regulatory solutions.
To combat securities fraud on the Internet, the Commission's Division
of Enforcement, with the assistance of other Commission staff, has
<(23)> In 1991, Congress passed the Telephone Consumer Protection Act, Pub. L. No. 102-243, 105 Stat. 2394 (1991), codified at 47 U.S.C. 227. The Federal Communications Commission enacted rules which, among other things, restrict the hours unsolicited calls can be made and require telemarketing firms to have "do-not-call" lists. 47 C.F.R. 64.1200.
<(24)> Joint Regulatory Sales Practice Sweep, A Review of the Sales Practice Activities of Selected Registered Representatives and the Hiring, Retention, and Supervisory Practices of the Brokerage Firms Employing Them (Mar. 1996).
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assembled a group of professionals who devote more and more resources to
Internet surveillance. These professionals use the latest browsing
software to monitor the Internet, including such message areas as
newsgroups and bulletin boards. The on-line Division of Enforcement
Complaint Center also provides an easy means for investors to send
complaints to the Commission staff. Currently, the Commission receives
between 50 and 70 on-line investor complaints a day. Suspicious activities
are investigated, with enforcement action initiated where appropriate. In
addition, the Commission staff has helped states develop their own Internet
surveillance programs and meets regularly with the states, both
individually and as part of regional and national conferences, to
coordinate our surveillance and investigations.
The Commission recently implemented a pilot program in our Florida
regional office to intervene as soon as a potential sham micro cap offering
is identified, which has already resulted in six trading
suspensions.<(25)> The staff reviews regulatory filings for
irregularities, or "red flags", that suggest the company may not be
legitimate. After determining that the public interest and protection of
<(25)> In the Matter of Amquest International, Ltd., Exchange Act Release No. 38695 (May 30, 1997), 64 SEC Docket 1862 (July 1, 1997); In the Matter of Green Oasis Environmental, Inc., Exchange Act Release No. 38588 (May 9, 1997), 64 SEC Docket 1395 (June 10, 1997); In the Matter of Genesis International Financial Services, Inc., Exchange Act Release No. 38565 (May 1, 1997), 64 SEC Docket 1259 (May 27, 1997); In the Matter of Historic Hotel Holdings, Inc., Exchange Act Release No. 38492 (Apr. 10, 1997), 64 SEC Docket 761 (May 6, 1997); In the Matter of OmniGene Diagnostics, Inc., Exchange Act Release No. 37966 (Nov. 19, 1996), 63 SEC Docket 709 (Dec. 17, 1996); In the Matter of Home Link Corp., Inc., Exchange Act Release No. 37292 (June 10, 1996), 62 SEC Docket 288 (July 9, 1996).
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investors require it, the Commission can suspend trading in the stock.
Trading suspensions can be a very potent remedy because:
* Investors are put on notice of a potential fraud, hopefully
encouraging more informed decision-making; and
* Promoters and brokers are hit where it hurts most: in the
pocketbook. The financial reward of a micro cap scheme depends
on selling all the stock at the height of the manipulation. A
trading suspension often leaves the promoters holding worthless
stock before they are able to dump it on unsuspecting investors.
Although a trading suspension only halts trading for a ten-day period, the
suspension triggers application of Exchange Act Rule 15c2-11, which
requires a market maker to have current and accurate financial information
about the issuer before trading resumes. In other words, it is difficult
for a broker-dealer to lawfully resume trading.
B. Investor Education
The Commission continually works to educate investors about how to
avoid and report securities fraud through its Office of Investor Education
and Assistance (OIEA). A well-educated investor is one of the most
important defenses against securities fraud. Through Investor Alerts, an
Internet Web Site<(26)> and a toll-free information line,<(27)>
OIEA provides investors with practical tips on how to spot securities
<(27)> (800) SEC-0330
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fraud. Numerous pamphlets and brochures have been developed to warn
investors about scams, stating in "plain English" what every investor
should know about investing. All of our publications are available free of
charge on the Commission's website as well as through our toll free number.
To educate investors and listen to their concerns, the Commission has
coordinated -- and will continue to hold -- Investors' Town Meetings
throughout the country. The town meetings are typically well-attended
(often over 1,000 investors attended each meeting) and feature a series of
seminars for investors on a wide variety of topics. We have also leveraged
the modest resources required for these meetings by asking the securities
industry to participate (we believe that investor education is among its
most important responsibilities) and by recording some of the meetings so
that they might reach audiences in the millions through television
The Commission receives over 44,000 letters and inquiries from
investors annually. Some investors simply want information. Others have
complaints. Where the OIEA can help, it attempts to resolve the disputes,
although it cannot act as lawyer or judge. Through its efforts, investors
recovered more than $1.2 million last year. Sometimes the complaints are
referred to the other divisions and offices of the Commission. Last year,
nearly one-fifth of all investigations undertaken by the Division of
Enforcement and "for cause" broker-dealer examinations were initiated, at
least in part, in response to investor complaints. The Office tracks
trends in complaints in order to identify problem brokers and practices, so
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that the Commission's limited resources can be targeted at the areas of
The most significant trend is the rapid increase in complaints about
cold calling. In 1995, the Office received 265 complaints primarily
alleging cold calling. In 1996, the number of cold calling complaints
doubled, rising to 427. As of July 28th of this year, the Office had
already received 231 such complaints.
IV. The Commission's Enforcement Program to
Combat Fraud in the Micro Cap Market
The Commission's enforcement program works in conjunction with state
regulators, the SROs and criminal authorities to make life as difficult as
possible for the con men and criminals who prey on American investors. The
Commission has brought significant enforcement actions against micro cap
stock brokers, such as A.R. Baron & Co., and micro cap stock issuers, such
as Comparator Systems. The following enforcement actions recently brought
by the Commission help illustrate some of the trends I have discussed
A. A.R. Baron & Co.
In 1996, the Commission brought an emergency administrative action
against a broker-dealer, A.R. Baron & Co., Inc., and two of its principals
for fraudulent sales practices, including rampant unauthorized trading in
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customer accounts.<(28)> The Commission alleged that Baron and these
principals manipulated the market for the stocks of two companies.
Customers lost nearly $17 million as a result of these practices before the
enforcement staff was able to shut the firm down. The brokerage firm
consented to the entry of an order revoking its registration, and the
Manhattan District Attorney s office subsequently indicted several
principals. The Commission has so far recovered approximately half a
million dollars in connection with the Baron case, and actions are still
B. Global Financial Traders, Ltd.
The Commission alleged that Global Financial Traders, Ltd., an
investment newsletter publisher, and certain affiliated entities and
individuals: (1) obtained a large undisclosed position in the stock of
American Image Motor Company, an OTC Bulletin Board security; (2) carried
out a concerted telemarketing campaign and made recommendations in one of
its newsletters to promote the stock, making material misrepresentations
concerning the market in the stock; (3) sold large amounts of the stock
from their own accounts; and (4) maintained the market price through stock
manipulation. Early this year, the Commission obtained a temporary
<(28)> In the Matter of A.R. Baron & Co., Inc., Exchange Act Release No. 37240 (May 23, 1996), 61 SEC Docket 2869 (June 18, 1996), Exchange Act Release No. 37248 (May 29, 1996), 62 SEC Docket 11 (June 25, 1996).
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restraining order, an asset freeze and a preliminary injunction against the
firms and its principals.<(29)>
C. Comparator Systems Corp.
The ability to artificially inflate the price of a stock, in this
instance using the Internet, was showcased in the dramatic rise and fall of
the stock of Comparator Systems Corp. The Commission brought an action
against Comparator and three of its officers and directors, alleging that
the defendants sold tens of millions of shares of the company's stock while
falsely representing that they owned certain fingerprint
technology.<(30)> Moreover, the company's financial statements had
been falsified, allowing Comparator to remain listed on the Nasdaq Small
Cap Market and avoid classification as a penny stock. Due to touting on
the Internet, the company's stock price rose from $0.06 to $1.88 over three
days, setting Nasdaq trading volume records. Prior to filing its complaint
against Comparator, the Commission issued a trading suspension.<(31)>
Comparator's former auditor has agreed to the entry of an order to cease
and desist from further violations of the securities laws and to a bar from
<(29)> SEC v. Global Financial Traders, Ltd., Litigation Release Nos. 15291 (Mar. 14, 1997), 64 SEC Docket 402 (Apr. 15, 1997), and 15338 (Apr. 17, 1997), 64 SEC Docket 969 (May 13, 1997).
<(30)> SEC v. Comparator Systems Corp., Litigation Release Nos. 14927 (May 31, 1996), 62 SEC Docket 236 (July 2, 1996), and 15056 (Sept. 19, 1996), 62 SEC Docket 2593 (Oct. 15, 1996).
<(31)> Exchange Act Release No. 37209 (May 14, 1996), 61 SEC Docket 2759 (June 11, 1996).
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appearing or practicing before the Commission. Actions against other
participants are pending.
D. Repeat Offenders
Once a fraudulent broker-dealer firm is put out of the securities
business, it is important to prevent the staff that perpetrated that fraud
from migrating to other securities firms. The presence of repeat offenders
in the industry (commonly referred to as "rogue brokers") has concerned the
Commission for several years. The Commission and other regulators can
impose severe sanctions, including bars and suspensions, against those
persons identified as serious securities law violators. The Commission has
worked to ensure that a permanent bar from the industry is truly
permanent<(32)> and that barred brokers do not "slip" back into the
system. In less egregious cases, we can limit the securities activities of
offenders, or impose other sanctions such as fines or injunctions to deter
The Commission and the Justice Department have worked together to
address the problem of rogue brokers. In November 1995 and again in May
1997, the Commission and the Justice Department announced the filing of
charges against rogue brokers throughout the country. The brokers
allegedly had engaged in a wide range of fraudulent conduct, including
forging investor checks, engaging in unauthorized transfers of client
<(32)> Exchange Act Release No. 34720 (Sept. 26, 1994), 57 SEC Docket 1941.
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funds, selling securities of nonexistent issuers and creating false or
fictitious account statements.<(33)>
Under the federal securities laws, much of the responsibility for
identifying and monitoring problem registered representatives lies with
each individual firm and its supervisory staff. In April of this year, the
SROs admonished the securities industry of its responsibility to be
particularly aggressive in policing problem registered
representatives.<(34)> The SROs' message -- echoing that of the
Commission -- is that firms must maintain strong hiring procedures that
either exclude or carefully evaluate applicants having records containing
disciplinary actions, customer complaints, or adverse arbitration
decisions. It also reminds firms that they must supervise such registered
representatives closely, at both the branch manager and firm levels.
E. Criminal Prosecutions
In addition to our work with the state regulators and the SROs, the
Commission coordinates its efforts to combat fraud with criminal
authorities. Coordination with criminal authorities has produced some of
the Commission's most dramatic efforts in combating fraud in the micro cap
<(33)> "Second Set of Charges in Broker Case," New York Times, May 23, 1997, p.2; Attorney General and SEC Chairman Announce Nationwide Prosecution of Unscrupulous Investment Brokers, Department of Justice Release (Nov. 30, 1995).
<(34)> The Joint Regulatory Sales Practice Sweep; Heightened Supervisory Procedures. Joint NASDR/NYSE Memorandum to Members and Member Organizations (Apr. 15, 1997).
======END OF PAGE 23======
market. The Commission will continue working to enhance these efforts.
For example, in October 1996, the U.S. Attorney for the Southern District
of New York, the Commission and the NASD announced the results of a year-
long joint undercover operation in which FBI agents posed as brokers in a
small Manhattan brokerage firm who were willing to accept payoffs to sell
OTC Bulletin Board and Nasdaq stocks to their customers.<(35)> The
payments were generally made by and through promoters, working with
officers of the companies whose stocks were being touted. Payoffs were as
high as 40% of the value of the stock. The FBI arrested 45 people,
including promoters, brokers and company officials. Twenty-eight of those
people have already been charged in Commission administrative proceedings
for allegedly making undisclosed payments to brokers to sell stock.
In November 1996, the U.S. Attorney for the District of Nevada
announced indictments against 30 individuals for their roles in an alleged
scheme involving, variously, undisclosed payments to brokers for sales of
the securities of three small issuers, money laundering, conspiracy and
racketeering. To date, 20 guilty pleas have been entered, including eleven
individuals named in the indictments. Three Commission staff attorneys
were designated as Special Assistant U.S. Attorneys in this matter and have
played leading roles in the criminal investigation and litigation. The
NASD staff also has substantially assisted in the investigations. In a
<(35)> Criminal and Public Administrative and Cease-and-Desist Proceedings Announced Against 45 in Connection with Kickback Schemes, Exchange Act Release No. 37807 (Oct. 10, 1996), 62 SEC Docket 3027 (Nov. 5, 1996).
======END OF PAGE 24======
related matter, the Commission has instituted four administrative
proceedings against 17 respondents.
Successful coordination between the Commission and criminal
authorities also resulted in the termination of a massive and on-going
manipulation of the stock of Systems of Excellence, Inc., a manufacturer
and distributor of video teleconferencing equipment with offices in
Virginia and Florida. On November 7, 1996, after an expedited
investigation, the Commission filed a civil injunctive action in federal
district court against the former CEO of Systems of Excellence, the
publisher of a daily stock newsletter that touted Systems of Excellence and
was disseminated over the Internet, and eleven other individuals and
entities. That same day, the Court ordered temporary restraining orders
against all of the defendants, asset freezes, and other emergency relief,
which effectively ended the scheme. The Commission also provided evidence
it obtained to the Department of Justice, which opened a criminal
investigation that now has resulted in guilty pleas by the former CEO and
the newsletter publisher, who are both incarcerated, and a former auditor
of Systems of Excellence.
V. Regulatory Initiatives
A. Modifications to Rule 15c2-11 Governing
Initiating and Resuming Quotations
======END OF PAGE 25======
As noted above, Rule 15c2-11 is intended to prevent the publication of
stock quotations in the OTC Bulletin Board, the Pink Sheets and similar
media that may be used in fraudulent schemes. Before publishing the
initial quotation for a particular stock, or after a trading halt, brokers
must review such information as the issuer's most recent balance sheet,
profit and loss, and retained earnings statements; the nature of the
issuer's business; the nature of the products or services offered; the
nature and extent of the issuer's facilities; and any relationship between
the broker-dealer and company insiders. As a result of the recent rise in
micro cap fraud, the Commission's staff is studying how to amend the rule;
these amendments might take the form of requiring market makers to review
additional financial information about the issuer or obtain updated
information more regularly.
B. Modifications to the Penny Stock Rules
The Commission staff is also considering whether to recommend
amendments to the Penny Stock Rules, such as broadening the definition of
"penny stock" to include securities with a price greater than $5 per share
and prohibiting a broker-dealer from recommending any non-Nasdaq OTC equity
security without reviewing current information about the issuer.
C. Regulation of the Relationship
Between Introducing and Clearing Brokers
The federal securities laws permit brokers that are often minimally
capitalized -- with as little as $5,000 -- to "clear" their trades through
======END OF PAGE 26======
a more substantially capitalized firm (a "clearing broker"). These small
brokers (an "introducing broker" or "correspondent") generally handle the
"retail" relations with the customer -- opening accounts, taking orders,
and making recommendations -- while the clearing broker clears and settles
the trade by exchanging money and securities, handles the back office
paperwork (primarily, providing trade confirmations and monthly
statements), and delivers securities. The clearing broker may also execute
the trade for the introducing broker.
Clearing firms perform a valuable function by financing customer
trades and smaller market makers, centralizing recordkeeping and
safekeeping customer funds. Moreover, they help maintain competition in
the securities industry by lowering the cost for new, small brokerage firms
to enter the market. Unfortunately, some of these small introducing firms
end up cheating the investing public. I have personally expressed the
Commission's concerns in this area to Richard Grasso, Chairman of the NYSE,
and Frank Zarb, Chairman of the NASD, and have encouraged them to develop
rules to address this issue. The NYSE Board has already approved a rule
that would, among other things, require clearing firms to send copies of
customer complaints about introducing firms to the introducing firm's
regulator. The Commission will consider this proposal carefully. The
Commission's own examination staff is also conducting a series of
examinations to look at the procedures of clearing firms, particularly
those that clear for broker-dealers that make markets in OTC Bulletin Board
and Nasdaq Small Cap stocks.
======END OF PAGE 27======
D. Listing Standards
Because of concerns regarding micro cap fraud, the Commission has
recently approved stronger Nasdaq listing standards.<(36)> Nasdaq
and the national exchanges have established listing and maintenance
standards, setting forth financial and other criteria that a company must
satisfy to include its securities in Nasdaq or list its securities on an
exchange. Listing on Nasdaq or the exchanges raises the visibility of a
company and provides greater liquidity for its shares. Listing comes with
a cost: companies are subjected to greater regulation, such as periodic
financial reporting and rules on corporate governance. Higher listing
standards should be studied to determine whether they would make
manipulation and other fraudulent schemes even more difficult, as companies
without substantial assets or expectations of revenues would be prevented
from obtaining a listing for their securities. Raising the standards will
result, however, in the de-listing of some companies from Nasdaq, forcing
their shares to trade in markets that require less information. The
Commission carefully weighs the balance between the cost of providing the
information necessary to deter fraud and the need for a marketplace where
the stock of legitimate small companies can trade.
<(36)> Exchange Act Release No. 38961 (Aug. 22, 1997), 62 Fed. Reg. 45,895 (Aug. 29, 1997).
======END OF PAGE 28======
Within the last three years, the Commission approved new SRO
telemarketing rules that impose "hour-of-the-day" restrictions, disclosure
requirements and "do not call" lists.<(37)> These rules have since
been incorporated into the examination modules of the Commission and the
SROs. The Municipal Securities Rulemaking Board ("MSRB") has also adopted
telemarketing rules for the municipal securities market.<(38)>
Other SRO measures currently under consideration include:
* implementing new Internet technology to identify potential
* taping sales calls at broker-dealers that have hired sales
personnel from firms that were expelled from the securities
* increasing SRO examinations targeted at sales practice abuses.
F. The Role of State Regulation
The Commission supports the states' authority to license broker-dealers and their associated persons. State regulators are justly concerned about who is doing business in their backyard. Furthermore, as the "local cop on the beat," a state regulator is well positioned to monitor and respond to the numerous, but relatively small, abuses that
occur daily in their state. These are abuses that the SEC and SROs, with
limited resources and staff in certain jurisdictions, may not be able to
respond to as promptly. In the aggregate, state regulators recover
substantial sums of money for small investors.
To address the need of broker-dealers and issuers for a predictable,
uniform regulatory system, the states have already taken substantial steps
to unify their regulatory schemes. The states, through NASAA, have worked
effectively with the SROs, industry associations, and the Commission to
develop more uniform requirements and procedures for the registration of
broker-dealers and the licensing of associated persons.
For example, NASAA and the states helped develop standardized forms
such as the U-4 for licensing associated persons. NASAA and the NASD
created the Series 63 examination to provide associated persons with a
single, uniform examination relating to state securities laws, reducing the
burden that had resulted from multiple state law examination requirements.
Further, NASAA and the NASD were instrumental in developing the Central
Registration Depository ("CRD"), the computer system that processes
licensing applications and holds disciplinary records. Certain
technological limitations in the CRD system have been identified -- the
system relies on 1981 technology which sometimes makes conducting searches
and producing reports difficult -- and we are working with the NASD and
NASAA to improve the system and to make it more widely and readily
available. NASAA and the NASD have also developed the Temporary Agent
Transfer ("TAT") program, which allows registered representatives without
disciplinary histories to transfer from one firm to another without an
interruption in business. More recently, NASAA created the Task Force on
the Future of Shared State and Federal Securities Regulation as well as the
MultiState License Committee, which are both exploring additional ways in
which to make state regulation more uniform.
In the National Securities Markets Improvement Act of 1996
("NSMIA"),<(39)> Congress made the financial responsibility,
recordkeeping and reporting requirements imposed on broker-dealers uniform
at both the federal and state levels.<(40)> Congress also directed
the Commission to study the impact of disparate state licensing
requirements on associated persons of registered broker-dealers and to
identify methods for the states to make licensing requirements more
uniform. The Commission is consulting with state securities regulators,
SROs, broker-dealers, and other industry participants to determine how best
to work together without duplication. Because the Commission is in the
process of completing this study and will submit a report to Congress by
October 11, 1997, it would be premature to report the final conclusions of
the study at this time. I can say, however, that the study does not call
for the federal preemption of state licensing powers.
<(39)> Pub. L. No. 104-290, 110 Stat. 3416 (1996).
<(40)> Exchange Act Release No. 34-37850 (Oct. 22, 1996), 61 Fed. Reg. 555,930 (Oct. 28, 1996).
The Commission is dedicated to fighting fraud in the micro cap market
through early intervention and prevention of harm, coordinated and strong
enforcement, and regulatory initiatives that balances the need to
facilitate capital formation with the elimination of fraud. This fight
requires a unified front of federal and state regulators, prosecutors, and
investors to make the costs of perpetrating a fraud in the microcap markets
much greater than the benefits. We are completely committed to achieving
this result, and we are deeply grateful for the support of Congress.
Before closing our discussion of fraud in the micro cap market, it is
important to remember that legitimate small businesses are the lifeblood of
the United States economy. The Commission is proud of its efforts to
reduce the regulatory burdens imposed on small businesses over the last
* Companies can raise up to $1 million dollars a year in seed
capital, without complying with the registration requirements of
the federal securities laws.
* Companies can raise up to $5 million dollars a year through
exempt public sales of securities using an offering document
that, though reviewed by the Commission staff, includes unaudited
financial statements, which cost substantially less than audited
statements. Companies can "test the waters" for offerings up to $5 million
dollars, allowing the company to determine whether there is
public interest in its securities before being required to
prepare documents for the offering.
* Non-public companies can issue securities without registration to
compensate their employees.
Together, these initiatives permit small businesses to raise adequate
capital without the cost of full federal registration.<(41)> We do
not plan to turn back these efforts, however, we are concerned about any
abuse of these measures and the harm that may cause not only investors, but
also those businesses the rules were designed to help.<(42)> The
Commission will continue to work in earnest to help legitimate small
businesses gain access to the public capital markets while aggressively
rooting out fraud among those that are not legitimate.
Thank you for this opportunity to address the Subcommittee.
<(41)> The federal securities laws are based on full and fair disclosure. Thus, companies that wish to raise capital in the national securities markets generally must register their securities with the Commission and file annual audited financial statements. The cost of preparing and distributing this information may affect the ability of some legitimate small companies to raise capital in the public securities markets.
<(42)> For example, while not a small business initiative, the Commission recently modified Regulation S -- which permits United States companies to raise capital overseas without registering the stock with the Commission -- to better monitor the extent to which the stock was re-entering United States public markets. Exchange Act Release No. 37801 (Oct. 10, 1996), 61 Fed. Reg. 54,506 (Oct. 18, 1996). The Commission is currently considering additional modifications to restrict such re-entry of Regulation S stock. Securities Act Release No. 7392 (Feb. 20, 1997), 62 Fed. Reg. 9,258 (Feb. 28, 1997).