The Good,
the Bad and
the Ugly
by William Cate
The
sixty-five year effort of the U.S. Securities and Exchange Commission (SEC)
hasn't reduced stock fraud. In 1932, over 98% of public (OC) companies failed.
In 1998, over 98% of the OTC companies will fail.SEC
enforcement doesn't benefit the small capital investor. The SEC's problem
is a mixture of Congressional ignorance, self-serving policies, legal reality,
emphasis on form over function and inappropriate goals. The result is a
brew of good, bad and terrible regulations and policies.Full
Disclosure is an excellent policy. Too often, it's lost in a morass of legal
boilerplate. Besides timely disclosure of negative corporate events, the
company should list these negative events in their annual Form 10K and Annual
Report to Shareholders.Due
Diligence is a reasonable policy. Filing a form doesn't mean that the responsible
party knows anything about the public company. The basis to Due Diligence
should be reliable third party information about the industry, the company
and the principals. The responsible party should collect this data. It shouldn't
be supplied by the public company.It's
a sound policy to use the Courts to discourage stock swindlers. Relying
upon criminal law hasn't worked. Criminal actions require a level of proof
"beyond a reasonable doubt." Most jurors can't balance their checkbook.
They don't understand the stock scam. They don't convict the culprits. Recognizing
the conviction problem, the SEC ignores 90% of the stock scams in the OTC
Market. The swindlers know the SEC policy and play the odds.The
SEC should follow the lead of the Federal Trade Commission. The SEC should
represent the public shareholders. Court actions should be Class Action
Civil Lawsuits against everyone who profited from the swindle. Civil lawsuits
are easier to win. The public shareholders profit. Consistent use of a civil
lawsuit policy would make stock scams unprofitable.Keeping
insider stock from the OTC Market is essential to protecting public shareholders.
It's easy to beat the time-hold restrictions on Reg S and Rule 144 shares.
Requiring insiders to keep their shares until the company becomes financially
viable would reduce the OTC failure rate. It would reduce the percentage
of stock swindles. If the swindlers can't sell their shares before the company
succeeds, they won't take phony companies public.Issuing
Treasury stock dilutes the value of shares in circulation. It doesn't matter
that the insider may hold the Treasury shares for one year. If acquired
assets don't offset the issued shares, the share price must eventually collapse.
A Reg S offering at a penny per share when the stock trades over $3.00/share
is a formula for disaster. The discount on Treasury stock should never exceed
the underwriters' discount on an IPO.A
Canadian Provincial Securities Law policy that the SEC should adopt involves
warrants. In the States, the usual exercise price of warrants is below the
share price. The warrant discount is based upon the date of issue of the
warrants. The SEC expects the mandatory one-year holding period to limit
abuse. In Canada, warrants must be sold at an exercise price above the share
price. The higher warrant exercise price is based upon the share price as
of the date of issue of the warrants. I believe the Canadians should widen
the warrant spread from C$0.05 to one dollar. However, the high warrant
price policy is an excellent idea.The
Canadian policy works to benefit existing public shareholders. The public
company must move up their share price to get the warrants exercised. Public
shareholders can sell into the upward move. If the spread were US1.00, public
shareholders would potentially benefit whenever the company attempted a
warrant financing.Regulators
usually develop an incestuous relationship with the industry they regulate.
The original mandate is to protect the public. Over time, the mandate becomes
protect the interest of the industry. The SEC applies more lenient policies
to major brokerage firms. It allows some brokerage firms to ignore the Law.
It defends the brokerage industry from outside and foreign incursions. These
policies aren't always in your best interest.Brokerage
firms make most of their money in two ways. They underwrite Initial Public
Offerings (IPOs). They sell stocks short. The short sellers are unregulated.
Unlimited short selling destroys public companies. The public loses because
the share price collapses and the company is delisted. The reason that short
selling is so profitable is that over 98% of OTC companies fail. If you
are certain of being right over 98% of the time, how can you lose money?You
can confirm the extent of the short selling problem by reviewing the audited
financial statements of brokerage firms. Every publicly traded brokerage
firm must file quarterly financial statements with the SEC.One
brokerage firm, often a defendant in short selling lawsuits, has a $30,000,000,000
declared short position. The question is what is their "undeclared"
(this won't appear on their financial statement) short position. It could
be zero. They could follow the Industry maxim and have 90% of their short
sales as "undeclared" short positions. The size of their short
position beyond $30 billion doesn't matter. Their assets are about $600
million. Their financial statements don't give a list of shorted stocks.
You can't be certain that they short U.S. OTC. Thus, the brokerage firm
could sell short stocks trading in Africa, South America, or Asia. However,
I'd bet they primarily sell short American stocks.The
public companies victimized by unregulated short selling have only one defense.
If they can get enough of their shareholders to request delivery of their
share certificates, the public company can force the short sellers to cover
(buy) shares to deliver to the shareholders requesting their stock certificates.
Breaking the short sellers stranglehold on the stock benefits the public
shareholders. It forces the short sellers to cover at progressively higher
share prices. The public has the opportunity to sell their stock at a profit.
The other side to this public profit is that the short selling brokerage
firms risk bankruptcy. Should enough public companies force the short sellers
to cover, the short selling brokerage firms must fail. Barings' Bank had
this problem in Japan. It went under. The SEC doesn't want to see major
brokerage firms follow in the Barings tradition.The
SEC wants to end the issuance of stock certificates. This is an ugly proposal.
The beneficiaries would be the short selling brokerage firms. The losers
would be the public. The SEC stock certificate policy is similar to New
York City's gun control policy. Every criminal has a weapon, often an assault
weapon. It's illegal for the public to own a gun. Until New York police
can regulate the criminals, honest citizens live dangerously in New York.In
the same way, until the SEC effectively regulates the short sellers, it's
unwise to disarm the public companies. The stock certificate defense is
like using BB guns against assault rifles. It may not be much protection,
but it's better than nothing.Power,
without reflection, equals terror. A terrorized goose doesn't lay golden
eggs. Since 1981, there's been a 70% decline in brokerage firms involved
with the OTC Market. The percentage of honest brokers hasn't changed. The
percentage of sound OTC companies hasn't changed. SEC regulation hasn't
created a better, safer or more honest marketplace. If the SEC doesn't reflect
on their policies and goals, they'll kill the OTC goose. As the SEC kills
the OTC goose, they may wipe out your bank account.