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Re: Penny Stock Fraud, Letter to Congress, John Dingell
Chapman, Spira & Carson - Disscusion

From: National Association of Securities Administrators Association, Inc, NASAA
Date: 4/30/99
Time: 6:38:27 AM
Remote User:


The voice of Reason Chapman Spira and Carson

February 6, 1998

The Honorable John D. Dingell Ranking Member Committee on Commerce 2322 Rayburn HOB Washington, DC 20515

Dear Congressman Dingell:

Of the many issues confronting state securities regulators today, micro-cap fraud is one of our top priorities. The North American Securities Administrators Association, Inc. ("NASAA").1 appreciates the attention you are bringing to the issue of fraud in this market segment, and thanks you for the opportunity to outline our perspective, our remedial efforts to date and our suggestions and plans for corrective measures yet to come. We look forward to working with you and the U.S. General Accounting Office to provide whatever information we have on this issue.

Micro-cap fraud is not a new problem for state regulators; in one form or another, it has plagued investors in the more speculative markets for many years. Most recently, its roots can be traced to the penny stock scams prevalent in the seventies and eighties; though in many respects, the problems in the micro-cap markets of today have grown more grave because of savings and investment patterns and market conditions.

This letter outlines what we believe to be the problem, its origins, and the states' responses. We will set forth the remedial actions states have undertaken, both individually and collectively, through NASAA, that pertain to micro-cap fraud.


First, what do we mean by the "micro-cap" market? "Micro-cap," includes penny stocks, and generally describes the low-priced securities of small companies with market capitalizations of less than $300 million. Most of the micro-cap stocks we are concerned about are thinly-traded, risky stocks issued by start-up companies with little or no earnings. The vast majority trade on the Nasdaq Small-Cap Market, the Over-The-Counter Bulletin Board, or in the "pink sheets," a market data service previously printed daily on pink paper, and now available on electronic data feeds from private vendors.

Micro-cap fraud stems from the systemic employment of abusive sales practices by firms marketing low-priced and highly speculative securities over the telephone. These firms may be easily distinguished from their legitimate Wall Street counterparts by their inattention to compliance matters and their disregard for the financial welfare of their customers. NASAA's investigations revealed that in many cases the brokers of the penny stock firms of the eighties are now the head traders, principals or chief executives of the micro-cap firms of today.

Problem firms creating the fraud generate a significant percentage of their revenues by underwriting initial public offerings ("IPOs") in micro-cap stock. The IPOs they structure are often positioned to present opportunities for manipulation. Additionally, transactions in the securities in which these firms make markets are often characterized by heavy mark-ups, sometimes as high as 30%. This results in extreme transaction costs even though customers are routinely told they will not be charged commissions. Often, when customers experience a dramatic price decline and place sell orders, these orders are ignored, leaving the investor with significant losses.

Abusive and high-pressure sales practices appear to be part of the corporate culture at these firms. Long-term customer relationships are rare. Formal compliance training and substantive schooling in sound market techniques and customer service are replaced by sophisticated cold-calling methods. Scores of unlicensed solicitors, employing elaborate scripts, persistently call their prospects until they agree to invest in the micro-cap stock du jour. Often there is no expectation of servicing the account beyond that initial trade.

Lastly, though geographic location of these firms is diverse, there seems to be a concentration of these firms in the New York City metropolitan area. In sales scripts seized by state regulators and taped transcripts of actual cold-calls, the firms located in this area take every advantage of their "Wall Street" proximity, trading on the name of the Street to bolster their credibility and reputation. We have also discovered that the potential investor is lured into a false sense of comfort by the frequent use of names of well-respected and recognized Wall Street firms. In their affiliation with these micro-cap firms, the clearing firm performs nothing more than administrative services and has no supervisory responsibilities for the activities of the introducing brokers.

All the above characterizes the problem we have come to know as micro-cap fraud.


We believe the fundamentals are in place for a bull market in fraud. There are several reasons. Today one in three households invests in securities. An even more telling statistic: 31% of U.S. household financial assets are invested in equities, either directly, or indirectly through mutual funds, up from 17% at the end of 1990.2 To an extent this has helped fuel the bull market itself.3 Of course, these waves of new market participants have, in part, fueled dramatic market performance of recent years (the Dow Jones Industrial Average doubled in two and a half years, from 4,000 in February, 1995 to 8,000 in July, 1997).

As a practical matter this shift in savings patterns has resulted in an ever-growing number of less sophisticated investors entering the marketplace. At the same time, investors are seeking ever-increasing returns on investment without a careful analysis of the risk/reward balance. In October of 1997, Montgomery Asset Management reported results of an investor survey that found that investors expected their portfolios to produce average returns of 34% annually over the next ten years.4 This number appears to NASAA to suggest that individual investors are placing heavy emphasis on returns at the expense of risk tolerance.

Therefore, we have parallel trends of an aggregate lower level of sophistication in the market coupled with unrealistically high expectations on return on investment. This creates the perfect environment for fraud and abuse.

What's more, millions of new individuals investing in the markets create a greater demand for salespersons. A five-year review indicates the number of representatives registered with the NASD jumped from 426,979 in 1992 to over 565,000 in 1997.5 And it is our belief that regulatory resources have not kept pace with this growth.


In 1997, many states received an increasing number of complaints from the investing public compared to 1996 levels. State securities regulators, we should note, act as a kind of "early warning radar" tracking brokers and underwriters engaging in abusive sales tactics. NASAA finds the increasing number of complaints in certain states revealing because a burgeoning stock market with high returns generally means investors are content and refrain from logging complaints with their state regulators.

The most frequent complaints received involve high-pressure calls from brokers, brokers who refuse to sell a stock when directed, brokers who make unauthorized trades and brokers who make unsuitable recommendations. A sampling of states reporting higher numbers of investor complaints to the state securities agencies include:

STATE 1996 1997 Connecticut 219 238 Georgia 563 620 Idaho (investigations and inquiries) 565 803 Illinois 800 1221 Massachusetts 372 526 New Jersey (requests for assistance) 1527 2012 New York (inquiries and complaints) 3100 4300 Pennsylvania 111 133


At the NASAA Annual Conference in September of 1996, these complaints became an informal topic of conversation among state regulators; it was apparent a systemic problem was developing.

Later that fall, NASAA's Board of Directors authorized a special project to address the issue of fraudulent sales practices in the micro-cap marketplace. In January of 1997, NASAA created a task force made up of representatives from 12 states. The task force was then divided into teams, each targeting a particular micro-cap firm. Branch offices and additional firms in other states were scheduled for audits as well.

In February, 1997, audit teams from these states examined five firms in the New York metropolitan area. Concurrently, other states conducted similar investigations. Ultimately 20 states participated in taking actions, with NASAA serving as the coordinator for this nationwide examination of dealers selling micro-cap stocks.

At a May 29, 1997 news conference with the New York and New Jersey Attorneys General, NASAA announced that 20 state securities agencies had filed 36 actions against 14 micro-cap firms-the largest-ever coordinated state enforcement initiative aimed at a particular market sector.

What the NASAA team found was a disturbing cottage industry of cold-callers, boiler rooms and nonexistent analyst reports used to hype micro-cap stock.



All of the firms relied on high-pressure, scripted telephone cold-calling practices. Many operations were classic boiler rooms with long tables and up to seven phone stations per table. Unregistered cold-callers were found in all of the firms. The scripts seized demonstrate the nature of the problem. Here is a quote from a script used by cold-callers at Investors Associates, Inc., "Perhaps a 100% return in 20 minutes sounds a bit unrealistic, but I assure you that's exactly how all of our IPOs ("Initial Public Offerings") trade."


Unauthorized trading was rampant at all the firms examined by the states. Examiners found that firm and branch records were falsified. In order to mask unregistered sales by cold-callers, customer account forms were marked with a number from a registered representative with whom investors insist they never dealt. The firms systematically failed to execute customer sell orders, made unsuitable recommendations, employed unethical high-pressure sales tactics and displayed a general disregard for the accepted role of compliance procedures which the securities industry is required to maintain. For example, at one firm all the cold-callers were on the first floor with no supervision at all.


State examiners found hundreds of unreported customer complaints. Most of the firms failed to maintain centralized procedures for handling and reporting customer complaints to regulators, as required by law. Unauthorized trades were so common that state examiners found fill-in-the-blank forms these firms used to respond to customer allegations. The forms contained blanks for the stock name; its value; and the reason for the unauthorized trade. One firm had reported just one complaint to the NASD Regulation, Inc. ("NASDR") from 7/96 through 2/97 but examiners uncovered over 90 unreported complaints on site.


Brokers and firms are required to register in the states in which they transact business. This requirement is absolute unless an exemption is available. When firms are transacting unregistered business it is a sure sign of problems--including avoidance of certain record-keeping requirements relied on by state regulators to protect their citizens. Examiners found that some firms claimed their branches were "franchises" in order to evade the state supervisory and record-keeping requirements.


Other actions continue to follow as a result of this project. The 20 original states were joined by 13 more and, to date, have together filed 81 final actions and have an additional 11 actions pending. A complete list of the actions taken against six of the firms is included as Tab 2.

Later in the summer of 1997, The New York State Attorney General convened a series of public hearings to gather additional facts regarding the scope of this problem. The hearing panel received testimony from 27 witnesses and interviewed approximately 12 others. The following state regulators submitted written testimony and is included as Tab 3: California, Delaware, Hawaii, Illinois, Indiana, Maryland, New Hampshire, Ohio, Oklahoma, Pennsylvania, South Carolina, Tennessee, Texas, Vermont, and Washington.

The hearings showed that some micro-cap firms specifically target unsophisticated investors. The victims are often the elderly, who are more likely to be home when the phone rings, less likely to hang up, and more apt to fall prey to high-pressure telemarketing techniques.

Many of the firms targeted, employ brokers who frequently move from one micro-cap firm to another. It is not uncommon for these brokers to have a history of regulatory actions and numerous customer complaints. The hearings also found problems with unregistered cold-calling.6



State securities agencies are often the first contacted when individual investors have questions or concerns. Consequently, much of our focus is placed on the individual investor. While our federal counterparts are well-equipped to focus on broad national market issues, state regulators specifically focus on the protection of individual investors.


State agencies devote an ever-increasing level of resources to the function of screening out problem brokers. This is detailed in the NASAA submission to the Securities and Exchange Commission ("SEC") in connection with a mandated study under the National Securities Markets Improvement Act of 19967 on the uniformity of state licensing requirements of associated persons of registered brokers and dealers8. The dual roles of cracking down on fraudulent brokerage houses and screening out problem brokers often go hand in hand.


The micro-cap stocks sold by these firms are subject to state registration and review. Unlike mutual funds and stocks trading on the AMEX, Nasdaq NMS and NYSE, these predominantly regional stock offerings must be registered in order to be offered or sold in a state. As discussed above, all the sales personnel of these micro-cap dealers also must be licensed and reviewed. Therefore, this lower tier of the market receives the greatest amount of state regulatory scrutiny.


State regulators combine a variety of tools and procedures in their anti-fraud efforts, both at the front-end through licensing, review of securities offerings and other investor protection efforts and after-the-fact through enforcement actions. In addition, states are making administrative changes and restructuring their operations to more effectively target the problem of micro-cap fraud. Many states have developed model programs in these areas. The programs represent various methods and procedures that have been developed and tailored to the specific state needs and resources. The cumulative effect is a critical national framework of local regulation. What follows is a brief description of several such efforts from a few select states.



In 1988, Maine instituted a program to increase the scrutiny of all broker-dealer applications, particularly applications where the firm or any of its owners, officers or directors had been involved with penny stock firms that had exhibited a propensity for sales practice abuses. Over the years this policy has shielded Maine investors from well-known micro-cap firms such as First Jersey Securities, Blinder Robinson, Stratton Oakmont and H. J. Meyers & Co. Maine's program includes reviewing the types of products the firm has sold in the last year, how those products are selected, who in the firm is responsible for researching the products to be sold, and the policies the firm has in place to ensure that the products are only sold to suitable investors. In addition, if the sales force is going to conduct cold-calls, the state has insisted that all callers be licensed before placing calls into Maine.

Of firms subject to the NASAA sweep last spring, Maine licensed only five of the 14 firms (see page 4). One of the remaining five was subject to a conditional licensing agreement. A revocation has been filed against another.

In 1997, Maine received 161 broker-dealer applications and received 57 requests from broker-dealer applicants to withdraw their applications. Withdrawal of an application is often a mutually agreed-upon resolution when an applicant is unacceptable. While some of the 57 broker-dealers that withdrew may have applied in an earlier year, the statistics have remained fairly consistent with a withdrawal rate of 25 to 35% of all broker-dealer applications filed.


Colorado records indicate that about 341 of the 68,644 sales representative licensing applications received by the Securities Division over the last two fiscal years (FYs 95-96 and 96-97) were withdrawn by the applicant or firm following an inquiry into reported disciplinary issues. The Division estimates that about 75% of those withdrawn applications were filed by individuals and firms involved in the "micro-cap" market.

Since Colorado enhanced its securities registration disclosure requirements and added escrow requirements for "blank check" offerings in 1990, the state has fought an ongoing battle with penny stock and "blank check" promoters. The offering documents describe what purport to be a real business, but in reality these entities are nothing more than empty shells designed to provide a vehicle to the public markets which is easily manipulated.

In summary, much of the regulatory effort exerted in Colorado against old and new penny stock operators, now dubbed "micro-cap" operators, is very difficult to quantify. However, the practical result has been that the combined efforts of federal, state and self-regulatory organizations has led to a very real reduction in the fraudulent activities that gave Colorado such a bad reputation in the 1970s and 1980s.


The Florida Division of Securities has been successful in curtailing the amount of micro-cap fraud in the state by implementing effective registration and examination programs. The Division routinely denies individuals with significant disciplinary histories, whether they are in this segment of the market or associated with New York Stock Exchange members. The information needed to deny or revoke these licenses is obtained during the course of examinations conducted on firms and individuals operating in, to, or from the State of Florida. The examination program, implemented by the Division's Regulatory Support Section, maintains a close working relationship with the registration staff in facilitating the active review of pending registrations of both individuals and firms in the state. The Division resolves concerns relating to customer complaints and registration and sales practices prior to rendering a decision on an application.

The Division also maintains close liaison with other states and with the NASDR, and the SEC regional and national offices. This exchange of "intelligence" on the movement of individuals from one firm to another and the exchange of examination documents is essential to the successful implementation of the program.

The Thomas James Associates, Inc. ("Thomas James") case exemplifies Florida's examination program. Thomas James had two branch offices in Florida on which the Division of Securities performed on-site examinations. The examinations uncovered many firm-wide unsavory practices that culminated in the Division taking action. In April, 1990, the State of Florida Department of Banking and Finance, the parent state office of the Florida Division of Securities, instituted an administrative complaint against Thomas James Associates, Inc. and 31 of the firm's registered representatives, including its principals, control persons and treasurer, which sought to revoke the firm's license and suspend many of its agents. Among other things, the complaint alleged market manipulation; non-disclosure of material facts; unregistered agent activity; lax supervision; and not executing customer requests to sell securities.

The filing of the complaint led Thomas James to enter into a consent order with the Department of Banking and Finance. As a result of the order, the firm was forced to withdraw its broker-dealer license from Florida and agree not to reapply for registration prior to June, 1994. Various sanctions were levied against the firm's agents as well, including, most prominently, barring James' President/control person and Treasurer from registering until June, 1994 and barring the Florida branch officer managers from registering in the state for several years. Their re-licensing is predicated upon entering into a conditional registration agreement which mandates that they do not act as supervisory personnel and, in fact, receive special supervision themselves.


Rather than allowing questionable brokers to register and then wait until constituents are harmed, in 1997, South Carolina recently implemented a proactive, two-step plan to prevent broker-dealer agents with significant disciplinary problems from registering in the state.

In the first phase, all applicants for registration are screened for disciplinary occurrences via the Central Registration Depository ("CRD") database. Those applicants with three or more disciplinary occurrences are automatically sent a letter asking for a signed, sworn and notarized explanation of these incidents, as well as verification that they have no clients in South Carolina. Approximately 40% of the applicants withdraw their applications upon receipt of this letter. This "step" serves two purposes. It affords fairness and due process to the applicants, who are provided ample opportunity to tell "their side of the story," while providing an efficient screening mechanism for regulators.

The second phase is to verify that the withdrawn or denied applicants are not transacting securities business with South Carolinians. The Securities Division contacts the broker-dealers' clearing firms for account activity reports and then ascertains whether or not unregistered agents effected any transactions in the state. If the withdrawn agents engaged in such transactions, the Securities Division may send a cease and desist letter to the agent and his or her firm, or revoke the entire firm's registration and levy a fine of up to $5,000 per occurrence.

South Carolina also protects investors by using other states' revocations as grounds for revoking a broker-dealer's registration in South Carolina. For example, on January 21, 1998, South Carolina revoked the registration of Meyers, Pollock, Robbins on the basis of both Massachusetts' and Indiana's revocations.


The Pennsylvania Securities Commission ("PSC") prepared a report on the corporate finance authority exercisable at the state level. The report analyzed the 112 filings with the PSC in Fiscal Year 1996.9 The report is representative of the type of front-end protection afforded by those states exercising substantive review. The offerings are frequently given a rigorous vetting by state examiners due to apparent conflicts of interest and potential abuses.

Examples of state substantive review include escrows of cheap stock held by company insiders, limitations on options and warrants granted, and ceilings placed on the offering expenses.

Meeting these state regulatory requirements defeats the primary mechanisms of unfair and inequitable offerings and helps to keep these IPOs from being sold to the investing public. Of the sixteen IPOs identified in the December 12, 1997 Business Week article, "The Mob on Wall Street," only eight were filed with the PSC. Of those eight, six were withdrawn as a result of PSC comments.

Recent changes in federal law have created an incentive for issuers to avoid initial registration in certain states, only to sell into those states in the secondary market shortly after trading commences in the IPO shares.


Almost one-third of the offered shares (32%) were offered at a price below $5 and another 33% offered between $5.00 and $5.99.

Forty-four percent of the offerings included an accountant's "going concern" letter in which the auditor's letter expressed concerns about the issuer's ability to continue as a "going concern."

Over 75% of the offerings had losses for the most recent fiscal year.

In over 40% of the offerings, the company's promoters, officers and directors paid $.01 or less per share for their stock.

Over 45% of all underwritten offerings subject to state review were underwritten by firms with three or more incidents recorded on the CRD within the past six years.

Five firms acting as such underwriters in PSC filings were cited in the December 12, 1996 Business Week article, "The Mob on Wall Street."

SUMMARY OF PSC DATA Total offerings filed 112 Offerings held for issuer response or withdrawn 75 OFFERINGS REGISTERED 37

As you can see, by placing substantive review criteria and resources up-front, the PSC was able to focus on the offerings with structural flaws or those potentially designed to enrich a few insiders at the expense of individual investors.



In 1995, with the organizational support of NASAA, Alabama undertook the lead role in a multi-state investigation of the broker-dealer firm Stratton Oakmont, Inc. ("Stratton") which had its headquarters in New York State. Investigators and examiners from Alabama, Kansas, Pennsylvania, Illinois, Colorado, New Mexico, Arizona, Mississippi and Georgia, with assistance from other states, joined together in this massive investigation of the acts, practices and transactions of Stratton and its agents. This thorough investigation consumed nearly two years, and half-a-million dollars in time and expenses to complete. As a result of this investigation, over 20 states brought actions against the firm.

The multi-state Stratton investigation presented a case study in the operations of a micro-cap fraud. Analysis of the web of financial dealings detailed how Stratton manipulated the offering to shift control of the IPO shares into the hands of a few insiders. In addition, the careers of the brokers, traders and principals were tracked to detail how the same individuals moved from one micro-cap firm to another over a period of at least twelve years.10


Hanover Sterling & Co. is another example of the states initiating actions against a firm which eventually found its NASD membership cancelled.

Beginning in October, 1993, Idaho was the first to take action against Hanover Sterling & Co., for selling into the state with unregistered agents. In June, 1994, Kansas denied Hanover Sterling & Co.'s registration. The following year, 1995, both Kansas and West Virginia brought actions against the firm for unregistered activities in their respective states. Later that year, Hanover Sterling & Co.'s broker-dealer registration was revoked or cancelled by Massachusetts, Illinois, California, Texas, and Oklahoma. Eventually, 29 states terminated the firm.

While states cannot put firms out of business nationally, they can doggedly pursue these firms until the NASD and the SEC act at the national level.


As noted earlier, state regulators have seen significant numbers of investor complaints regarding micro-cap firms and brokers. The majority of these micro-cap firms are introducing brokers and use the services of "big name" Wall Street firms to process their trades and provide their customers with account statements, confirmations and other documentation.

The number of these clearing firms is less than 800 while the number of introducing brokers is well over 5,000. Therefore, by accessing information on targeted micro-cap firms from the clearing firms, state investigations can move more rapidly and efficiently.

Given these numbers and the unique nature of the clearing business, clearing firms are in possession of information that can greatly aid the state discovery and investigations of micro-cap firms. The clearing firm as an access point is a tremendously efficient tool for the states, one that will be used increasingly in the future.

Below are just some of the abuses that clearing firm reports can assist in detecting:

Sell orders in unregistered securities;


Patterns of unauthorized trades;

Excessive commissions; and

Detection of manipulative trading practices.

In mid-January of this year examiners from the states of Utah and Missouri visited the offices of two major clearing firms in New York City. At first, the states encountered resistance to their requests, for production of customer complaints. Production was achieved only after regulatory demand letters were issued. Utah and Missouri are currently studying the results of these clearing firm examinations; however, the examinations have already confirmed that clearing firm records provide a wealth of useful information concerning the operations of introducing micro-cap brokers. Because dozens of the micro-cap firms may clear through a single clearing firm, it can result in "one-stop shopping" for regulators.


MICHIGAN - By early 1997 Michigan's enforcement staff, which audits and investigates brokerage firms, sales agents and investment advisers, had reached an all-time low of three investigators and one supervisor. Recent hires have doubled that number. Michigan has increased the number of inspections and revised audit procedures to include review of products being sold or promoted via the Internet.

The Securities and Land Development Bureau is participating in a task force (Senior Exploitation Quick Response Team) comprised of government agencies and industry representatives to address the problem of financial exploitation of senior citizens. Task force members act as contacts for their agency when a complaint comes in. The idea is to cut through the normal bureaucracy and give special expedited treatment to complaints concerning seniors, who are especially vulnerable.

The increased staff is already producing results. In January 1998, Michigan issued three orders to show cause, which involve allegations of the sale of unregistered and nonexempt securities (almost $3 million in one case).

OHIO - Micro-cap and penny stock dealers proliferated in Ohio in the late 1980s and early 1990s. In 1993, the Dayton Daily News estimated that approximately 60,000 Ohioans had lost more than $100 million in penny stock investments between 1989 and 1993. Beginning in 1991, the Ohio Division of Securities devoted a majority of its resources to a two-pronged effort to eradicate low-priced stock fraud in the state.

In the spring of 1991, the Division commenced legislative efforts to strengthen the dealer licensing requirements and anti-fraud standards of the Ohio Securities Act. A similar measure was re-introduced in the Ohio General Assembly in 1993 without opposition. The Bill became law on October 11, 1994. The law tightened dealer licensing requirements and added specific anti-fraud and disclosure requirements for penny stocks.

A vigorous enforcement program was commenced in Ohio with the revocation of the licenses of AEI Group, Inc., Liberty First Securities and First Ohio Equities. The Division's highest-profile enforcement action began in October, 1992 with the execution of a search warrant at the home office of Dublin Securities, Inc., the state's largest penny stock micro-cap dealer. The search warrant uncovered evidence that led a state grand jury to return a 1,023 felony count criminal indictment against two entities and five individuals. The three defendants who chose to stand trial were convicted of a total of 152 felony counts in December, 1995.

The Ohio Division of Securities pursued both legislative initiatives and enforcement actions to fight the problem of micro-cap fraud. The drastic reduction in number of complaints received by the Division gives an indication that the Division's efforts have been successful.

OHIO INVESTOR COMPLAINTS YEAR # OF COMPLAINTS 1992 542 1993 1385 1994 494 1995 258 1996 241 1997 223

ILLINOIS - In February, 1997, the Illinois Director of Securities proposed to the Secretary of State that the Securities Department reorganize to more appropriately meet the challenges of technology, globalization and the National Securities Markets Improvement Act of 1996. The primary objective was to reallocate existing Department resources and recognize the functional interrelationships in the Department, cross-train employees for multiple tasks and begin to shift away from office-based registration activities and move toward field-based activities such as compliance inspections, audits and investigations. The highlights of the reorganization plan include:

A new "Audit & Compliance" Division responsible for conducting and coordinating all field examination programs for Illinois registrants. The Audit Section will conduct all for-cause audits, while a new Compliance Inspection Section will coordinate all Department personnel involved in compliance examinations. The Department intends to increase the number of compliance examinations completed each year to 1,000 or more (at least six times the current level).

The Registration Division was divided and renamed "Registration & Licensing." A Small Business Information Center will be highlighted to provide assistance to legitimate small businesses.

Streamlined Department management from 14 to 6 positions.

Established a dedicated Investor Education position within the Director's office.


In addition to the individual states, the NASAA organization has focused on the issue of micro-cap fraud and has served as a coordinator and clearinghouse for many of these efforts.


The NASAA Enforcement Section has 36 members serving on five committees that cover the major enforcement areas. They are Enforcement Databases; Enforcement Policy and Zones; Enforcement Training Programs; International; and Internet.

ENFORCEMENT DATABASE COMMITTEE - Educates NASAA members on the use and benefits of the Securities Investigations Database ("SID"). Monitors and evaluates SID system performance and recommends changes, additions and upgrades to the system operator. SID currently offers two main features a securities investigation database and specific newsgroups to facilitate communication between securities enforcement personnel.

ENFORCEMENT POLICY AND ZONES COMMITTEE - Acts as a forum to develop enforcement policy and to coordinate investigations by state securities regulators by identifying trends and priorities, developing investigative approaches and enforcement remedies and collecting and maintaining information concerning enforcement cases and resources. This committee encourages and develops regional cooperation among state, provincial and federal regulators by organizing zone meetings within the regions and by acting as a conduit for communications on enforcement matters.

INTERNATIONAL COMMITTEE - Coordinates the exchange of information with international securities regulators regarding regulation of broker-dealers, enforcement and licensing guidelines.

INTERNET COMMITTEE - Coordinates the work on the development of a timely, efficient, and cost-effective means of policing the Internet for state securities law violations by issuers, broker-dealers, investment advisers and their agents or representatives and to develop a means to record and report such violations to members and investors.


The NASAA Broker-Dealer Section has 20 members serving on four committees that cover the areas of broker-dealer regulation. They are Broker-Dealer Operations, Broker-Dealer Sales Practices, Continuing Education and Forms Revision and Central Registration Depository.

BROKER-DEALER OPERATIONS COMMITTEE - Develops and helps implement state policies regarding broker-dealer operations, such as developing a model definition of "branch office" and updating the broker-dealer examination module as needed. This committee is also responsible for studying the use of affidavits to uncover pre-licensed sales activities by both broker-dealers and agents and, if appropriate, draft a policy statement on this issue. The Broker-Dealer Sales Practices Committee also assists in the planning and conducting of NASAA's Broker-Dealer Training Seminar. Finally, this committee will study the feasibility of member jurisdictions issuing a multi-state license where the applicant has a clean disciplinary record.

BROKER-DEALER SALES PRACTICES - Broker-dealer sales practices are often at the heart of abuses in the micro-cap area. This long-standing committee is charged with reviewing, analyzing and proposing NASAA policies associated with marketplace developments for the delivery of broker-dealer services. Potential areas of policy development include access payments, revenue sharing, commission sharing and referral fee arrangements, soft dollar compensation and utilization and standardization of performance data reporting. This committee is also responsible for developing programs for improving the effectiveness of state broker-dealer sales practice regulation generally.

CONTINUING EDUCATION - The joint efforts of NASAA and the SROs have made the continuing education program for registered representatives a marked success. NASAA is firmly committed to this cooperative undertaking. This committee makes recommendations to the membership and the Industry/Regulatory Council regarding any changes to the Continuing Education Program ("the Program") as developed, and provides representative "subject matter experts" to develop and refine Program questions. This committee also coordinates with the SEC and SROs in developing examination procedures, modules and training.


Starting in the 1980s, NASAA has invested a considerable amount of time and resources on training programs and conferences devoted to enforcement, litigation and examination issues. These programs have resulted in the development and publication of a NASAA broker-dealer examiners manual and an enforcement training manual utilized by all the state agencies. These sessions and materials are made available to administrators, examiners, attorneys, investigators and other state personnel at no cost to state governments.

The Winter Enforcement Conference is an annual event sponsored by NASAA and attended by securities regulators of the States, Canadian Provinces and Territories, members of academia, and federal government officials. This meeting provides a venue for regulators to formulate, recommend and implement enforcement policy.

Since 1985, NASAA has sponsored a three-track broker-dealer training program designed for broker-dealer examiners. Track I is for new examiners and contains a basic overview of the examination process, including books and records, the federal 1933 and 1934 Acts, and examination procedures. Tracks II and III are for more experienced staff and cover such topics as: update on NASD and SEC structure; Internet sites; newsletters; enforcement roundtable; soft dollar payment abuses; and Plain-English prospectuses.

The Attorney/Investigator Training Session is designed for attorneys and investigators involved primarily in enforcement of the securities laws. The agenda includes special sessions for new personnel to introduce them to basic concepts and methods in securities law enforcement. Part of the training involves separating the group into working sessions to solve hypothetical enforcement problems drawn from actual cases.

The Investment Adviser Workshop is an interactive session designed specifically for examiners. Faculty focus short presentations on issues such as custody, discretion, marketing, compensation, disclosure and practice management critical to examiners during an inspection of an investment adviser. Presentations are followed by a "breakout" into small groups led by an experienced examiner to review the books and records of a fictitious (but typical) state-registered investment adviser. Other sessions allow the small groups to conduct "mock" audits of another (more problematic) fictitious adviser.

Litigation Training draws panelists from a broad cross-section of the securities regulatory community and addresses numerous current topics relating to securities enforcement litigation. The goal of this seminar is to assist enforcement personnel in the development of effective securities litigation skills, including criminal prosecution.


NASAA regularly issues "Investor Alerts" that identify common types of schemes, scams and frauds about which investors and entrepreneurs need to know. Many of the alerts can be found on the NASAA website at under the Investor Education link. NASAA distributes brochures on these same subjects at town hall meetings and other investor education forums throughout the nation. NASAA and the Council for Better Business Bureaus have recently re-published a book based largely on these Investor Alerts entitled How to Be an Informed Investor.


State regulators rely heavily on broker-dealer and agent information contained in the Central Registration Depository (CRD), jointly owned by the states and the NASD. This database was set up in 1981 primarily as a registration tool. It contains administrative information about broker-dealers and their agents as well as customer complaints, arbitrations and other disciplinary information. State regulators have been working closely with the NASD for the past seven years on a comprehensive redesign of the CRD that will allow it to be data fields to be "searchable" by regulators. This capability will allow states to flag problem brokers and firms for further investigation, license review or revocation. The modernized CRD, when it comes on line, will be a significant step forward for state regulators in their battle against micro-cap fraud.


REGULATORY MICRO-CAP WORKING GROUP - NASAA is a member of the Regulatory Micro-cap Working Group designed to better coordinate enforcement efforts and facilitate exchange of information among the SEC, NASDR and the NYSE. Discussions will focus on preventive measures to address the micro-cap fraud problem. Several meetings are planned for the coming months.

ONGOING STATE SWEEPS - Plans for the current year include continued coordinated examinations of targeted micro-cap firms. It is anticipated that a second sweep, similar to the successful effort of 1997, will be undertaken during the first quarter of 1998.

COORDINATED REGULATORY TRAINING - The AMEX, CBOE, NASAA, NASDR, NYSE and the SEC are jointly sponsoring a training conference for securities examiners focused on the detection and examination of micro-cap fraud. The training will be developed and targeted for securities examiners with two to five years of experience. We believe it is essential to ensure that examiners are well-trained and knowledgeable with respect to current examination techniques and strategies most effective in detecting micro-cap fraud. This program complements the annual NASAA Broker-Dealer Training held in June.


As a result of the widespread and increasing number of complaints about fraudulent practices in the micro-cap area of the brokerage industry, The New York Attorney General's Office has dramatically increased the number of investigations and enforcement actions over the past two years and has submitted legislative recommendations to assist the office in combating securities fraud. Chief among the legislative recommendations of the New York Attorney General's Report (Tab 5) is the statutory authority for routine examinations and inspections of broker-dealer firms and their branch offices. Highlights of the other recommendations include administrative cease & desist authority, reciprocal subpoena authority, and enhanced licensing authority over securities professionals.


The problems in the micro-cap market are serious and growing. They should not be minimized because they are limited to a relatively small sector of the marketplace. The fraud and abuse in this market can cause catastrophic losses to individual investors and, if this problem is not vigorously addressed, it could erode the confidence in the overall securities marketplace. Unchecked, micro-cap fraud will harm not only investors but legitimate entrepreneurs who rely on equity capital to establish and grow their businesses.

State regulators play a vital role - a role that complements that of the SEC and the self-regulatory organizations - in policing our securities markets. The states are committed to working together with regulators and industry to curb the abuses in the micro-cap area. It will take coordinated action. As this letter makes clear, we have made progress, yet much more remains to be done. In order to reinforce the projects and initiatives we've already taken, NASAA recommends the following:

State and Federal enforcement actions filed against micro-cap firms should include actions against individual brokers and where appropriate the principals of the firm. This would make it more difficult for these individuals to stay in the securities business or to transfer to other firms. Sanctions must be commensurate with the harm caused. Mandatory fines without regulatory sanctions such as suspensions and revocations can be factored into the cost of operating a fraudulent investment scheme. In addition, criminal sanctions should be applied where the law allows (i.e., Texas - 1997: 116 convictions from indictments involving 69 transactions, and 1996: 60 convictions from indictments involving 102 transactions). SEC/NASDR recognition of state enforcement actions under Section 3(a)(30) of the '34 Act, which establishes "statutory disqualifications" that the SEC and SROs may consider with respect to revoking, suspending or denying registration to broker-dealers and their agents. The section does not specifically reference state securities actions as a statutory disqualification. Currently, the SEC and the NASDR bring their own complaints concurrently or subsequent to state actions, which can create duplication of efforts and unnecessarily drain the finite pool of enforcement resources (see Borg Testimony Tab 4, pages 12-13). Much more needs to be done on the investor education front. The disclosure-based system of regulation relies on the fact that if investors are well informed, they will make sound investment decisions. All investor education programs should include information on how to protect against fraud. Thank you for the opportunity to address the important issues raised in your letter. Please do not hesitate to contact Neal E. Sullivan, NASAA Executive Director, if you need additional information, or if we may assist your study in any way.


Denise Voigt Crawford

NASAA President

Last changed: March 17, 2000