United States General Accounting Office

GAO Report to Congressional Committees

September 1998 SEC ENFORCEMENT

Responses to

GAO and SEC

Recommendations

Related to Microcap

Stock Fraud

GAO/GGD-98-204

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-279399 

September 30, 1998

The Honorable Susan M. Collins

Chairman

The Honorable John Glenn

Ranking Minority Member

Permanent Subcommittee on Investigations

Committee on Governmental Affairs

United States Senate

The Honorable John D. Dingell

Ranking Minority Member

Committee on Commerce

House of Representatives

In separate letters, dated December 12, 1997, and February 23, 1998,

respectively, you expressed concern over reported increases in fraud

involving microcap stock—the stock of companies with low-priced

securities and minimal capital. You also indicated interest in the actions

securities regulators have taken to combat such fraud. As an initial step,

you requested that we inform you of the actions taken in response to

recommendations in our and Securities and Exchange Commission (SEC)

reports that address issues related to microcap stock fraud. This report

summarizes the May 27, and 28, 1998, briefings we provided your

respective offices on the status of SEC and self-regulatory organization

(SRO)1

 actions on these report recommendations.

Results in Brief SEC and the SROs have taken, or reported taking, actions that respond to

many of the recommendations in our and SEC reports that address issues

related to microcap stock fraud. In responding to these recommendations,

actions have been taken to (1) expand the disclosure of and public access

to broker disciplinary information, (2) improve National Association of

Securities Dealers (NASD)2

 branch office examination selection, (3) provide

more focused sales practices examinations, (4) improve compliance with

industry reporting requirements, and (5) implement a continuing

professional education requirement for broker-dealers.3

 These actions

1

SROs are private membership organizations given authority and responsibility under federal law and

regulations to adopt and enforce rules of member conduct. Securities SROs include the stock

exchanges, National Association of Securities Dealers, and Municipal Securities Rulemaking Board.

2

NASD operates the Nasdaq Stock Market, Inc., and, through its independent subsidiary NASD

Regulation, Inc., establishes and enforces standards of industry conduct.

3

A broker-dealer is a registered firm that buys and sells securities for its customers and itself.

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should enhance regulatory oversight of microcap stock firms and help

provide investors with additional protections against abusive practices by

such firms.

Actions have not been completed that would respond to other

recommendations related to the (1) migration of unscrupulous brokers

from the securities industry to other financial services industries;

(2) modernization of the central registration database (CRD) to improve

oversight of problem brokers and public access to broker disciplinary

histories; (3) ability of SEC to identify, across firms, trends in violations

found during its broker-dealer examinations; and (4) provision of

information on the availability of broker disciplinary histories before

activity occurs in an account. Completing actions on these

recommendations would further enhance regulatory oversight and

investor protection.

Background The term microcap security is not defined in the federal securities laws.

Microcap securities include penny stocks4

 and generally describe the

low-priced securities of companies with market capitalizations of less than

$300 million. Prices of microcap securities may be quoted on the NASD

over-the-counter (OTC) Bulletin Board,5 in the National Quotation Bureau’s

Pink Sheets,6

 or on the Nasdaq Small Cap Market.7

Public information on microcap securities is limited; often a small number

of broker-dealers dominate trading, making the securities more

susceptible to fraud. Microcap fraud is typically associated with “pump

and dump” schemes involving high pressure sales tactics designed to

induce investors to purchase relatively worthless stocks in which the firm

or other insiders hold a large inventory. When successful, these high

pressure sales tactics result in an increase in the price of the targeted

stock (pump). Insiders then sell (dump) their shares, sometimes realizing

large profits at the expense of public investors. A variety of other

fraudulent practices are also used as part of these schemes, including “bait

4

Penny stocks are generally defined by SEC rules as stocks having an offer price of less than $5.

5

NASD’s OTC Bulletin Board is a quotation service that displays real-time quotes, last-sale prices, and

volume information on OTC securities. OTC securities are not listed or traded on a national securities

exchange.

6

The National Quotation Bureau’s Pink Sheets are daily printed listings containing quotations for

thousands of OTC stocks that are not listed on a major stock market.

7

The Nasdaq Small Cap Market includes the securities of more than 1,300 smaller, less-capitalized

companies that do not qualify for inclusion in the Nasdaq National Market.

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and switch” tactics, unauthorized trading, failure to execute sell orders,

and excessive markups or price increases. Firms investigated for microcap

fraud have typically been owned or controlled by individuals with ties to

other firms with a history of stock fraud.

The securities markets, of which microcap securities are a part, are

regulated by SEC, industry SROs, and state securities regulators. The SROs

monitor members, including individuals and firms, for compliance with

federal and SRO requirements. Among its responsibilities, SEC inspects SRO

compliance programs for adequacy and conducts examinations of

broker-dealers, including microcap firms. The states license firms and

individuals to operate in their jurisdictions. Many states also conduct

on-site examinations of broker-dealers.

To centralize broker licensing and registration, NASD and the North

American Securities Administrators Association (NASAA)8

 established CRD

in 1981. The database was designed to provide a more efficient licensing

and registration process by eliminating redundant state reporting

requirements. Operated by NASD Regulation Inc. (NASDR), CRD’s centralized

computer system has allowed individual brokers and firms to satisfy both

state and NASD reporting requirements. Over the years, however, CRD’s role

has expanded to serve several other regulatory functions, such as

gathering information for federal, state, and SRO enforcement and

examination purposes, including identifying problem brokers or firms. CRD

has also become the primary source of information for NASD’s public

disclosure program. Among other things, this program provides investors

with information on the professional background, business practices, and

conduct of NASD member firms and their brokers. The information is

available via NASDR’s toll-free telephone information service (hotline) or its

Internet web site.

Scope and

Methodology

To determine the status of SEC and SRO actions on recommendations in our

and SEC reports that address issues related to microcap stock fraud, we

reviewed SEC, NASD, and New York Stock Exchange (NYSE) documents that

report on their respective actions. We also interviewed officials of the SEC

Divisions of Enforcement and Market Regulation, SEC Office of

Compliance Inspections and Examinations, the Department of Justice,

8

NASAA is a voluntary association of state, provincial, and territorial securities administrators in the

United States, Canada, and Mexico that is devoted to investor protection and efficient capital

formation.

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NASDR, NYSE, NASAA, and Securities Industry Association.9 In addition, we

analyzed SEC and SRO data on examinations completed, customer

complaints, and disciplinary actions taken from 1992 through 1997.

We did our fieldwork between February and July 1998 in accordance with

generally accepted government auditing standards. We obtained written

comments on a draft of this report from SEC. These comments are

discussed at the end of this letter and are reprinted in appendix II.

The Actions Taken

Respond to Many of

Our

Recommendations

SEC and the SROs have taken actions that respond to many of the

recommendations in our reports that address issues related to microcap

stock fraud.10 The reports with recommendations that were acted on

focused on penny stock fraud;11 unscrupulous brokers (brokers who have

committed a significant breach of sales practice rules or have a history of

repeated sales practice violations); 12 and NASD’s toll-free telephone

hotline.13

Penny Stock Report Our 1993 report on penny stock fraud recommended that SEC require NASD

to (1) provide callers using its toll-free telephone hotline with information

on final arbitration awards and (2) identify and examine high-risk branch

offices of penny stock broker-dealers. NASD’s public disclosure program,

which includes its toll-free telephone hotline, now provides information

on, among other things, all consumer-initiated arbitrations that are

pending or have been settled (for $10,000 or more) and final arbitration

decisions that resulted in an award to the customer. NASD district offices

also target branch offices for review based on complaints of customers,

termination of registered representatives for cause, and transactions in

9

The Securities Industry Association is a trade group that represents broker-dealers.

10Some of the actions taken on our recommendations involved changes to industry rules. See appendix

I for a list of new, amended, and proposed SEC and SRO rules addressing our and SEC report

recommendations and/or microcap stock fraud.

11See Penny Stocks: Regulatory Actions to Reduce Potential for Fraud and Abuse (GGD-93-59, Feb. 3,

1993), which addresses NASD’s efforts to reduce fraud and abuse in the penny stock market.

12See Securities Markets: Actions Needed to Better Protect Investors Against Unscrupulous Brokers

(GGD-94-208, Sept. 14, 1994), which addresses the extent to which unscrupulous brokers were active

in the securities industry, regulatory and industry efforts to discipline unscrupulous brokers, and the

industry’s ability to identify unscrupulous brokers through CRD.

13See NASD Telephone Hotline: Enhancements Could Help Investors Be Better Informed About

Brokers’ Disciplinary Records (GGD-96-171, Aug. 19, 1996), which addresses the accessibility of the

NASD hotline to investors, including how investors were informed about the hotline; what perceptions

users had about the usefulness and appropriateness of the types of information provided by the

hotline; and whether the information provided by the hotline met NASD disclosure policies.

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microcap stocks. In addition, NASD is developing an automated risk-based

approach to examination scheduling to identify broker-dealers and branch

offices for examination.

Unscrupulous Broker

Report

Our 1994 report on unscrupulous brokers recommended that SEC impose a

permanent industry bar, with no opportunity for reentry, on certain

problem brokers and ensure that CRD includes SRO formal disciplinary

actions as well as information on customer complaints and their

dispositions. SEC clarified in September 1994 that, absent extraordinary

circumstances, persons subject to bars with no provision for readmission

to the securities industry would be unable to establish that the public

interest was served by allowing their reentry. Also, SEC officials said that

they have begun an inspection of NASDR that will review actions taken on

reentry applications. In addition, the NASD public disclosure program now

discloses SRO formal regulatory actions as well as customer complaints

and their disposition.

NASD Hotline Report Our 1996 report on the NASD hotline recommended that SEC encourage

NASDR to (1) publicize its hotline number to more investors, such as by

including the number on account-opening documents; (2) provide hotline

callers with all relevant CRD disciplinary-related information or, at a

minimum, inform them that the information is available from most state

regulators; (3) make disciplinary-related information directly available to

investors through the Internet; and (4) ensure that the CRD information

provided to callers is disclosable and complete.

Addressing these recommendations, SEC approved an NASD rule on

September 10, 1997, that requires members to provide customers, at least

annually, with written information on the NASDR hotline telephone number,

its Internet address, and the availability of a brochure describing NASD’s

public disclosure program. In addition to informing investors of the

availability of information from state regulators, as of March 16, 1998, NASD

reports information related to pending and final disciplinary actions, civil

judgments, arbitration decisions, pending customer complaints, criminal

convictions, settlements of $10,000 or more, and bankruptcies. On the

same date, CRD information also became available to the public over the

Internet, with disciplinary information available via electronic mail

(discussed below). To better ensure the quality of the CRD data disclosed,

NASD now requires an additional review prior to data input, has instituted a

statistical quality-control process to measure the accuracy of disclosures,

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and has added a requirement for periodic examination of data by data

quality professionals.

The Actions Reported

Respond to Many SEC

Recommendations

SEC and the SROs have reported taking actions that respond to many

recommendations in two SEC reports that address issues related to

microcap stock fraud.14 The first report addressed the sales practice

oversight of nine large broker-dealers (the large firm project report).15 The

second report followed up on the first and focused on firms with problem

brokers (the sales practice sweep report).16

Large Firm Project Report The 1994 large firm project recommended that SEC and the SROs devote

additional resources to sales practice examinations and to identifying and

prosecuting problem brokers. The large firm report also recommended

that (1) the SROs disclose all pending disciplinary actions, (2) NASD require

its members to report customer complaints quarterly, (3) SROs enhance

their tracking of regulatory filings related to disciplinary actions and

terminations and sanction firms for failing to promptly and accurately file

required forms, (4) SEC take action to implement uniform policies

governing liability for information provided in regulatory filings, and

(5) the securities industry adopt a mandatory continuing education

requirement.

In response to the large firm report recommendations, federal, state, and

self regulators undertook the sales practice sweep.17 As part of the sweep,

101 small- to medium-size broker-dealers were examined, focusing on the

sales practices of selected problem brokers and the hiring and supervisory

14Some of the actions taken on SEC recommendations involved changes to industry rules. See

appendix I for a list of new, amended, and proposed SEC and SRO rules addressing our and SEC

report recommendations and/or microcap stock fraud.

15See The Large Firm Project: A Review of Hiring, Retention and Supervision Practices (May 1994),

which responded to concerns about the increased frequency and severity of sales practice abuses.

SEC, NYSE, and NASD staff conducted 170 examinations of 9 firms and their 161 branch offices in 32

states in completing the project.

16See 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), in which examiners interviewed 230 problem brokers during 179

branch examinations at 101 small-to-medium size firms.

17The sweep was conducted by SEC, NASD, NYSE, and the following state securities regulators:

Alaska, Arizona, California, Colorado, Connecticut, District of Columbia, Florida, Idaho, Illinois, Iowa,

Kansas, Maine, Maryland, Michigan, Montana, New Jersey, New Mexico, Nevada, North Carolina,

North Dakota, Oklahoma, Oregon, Pennsylvania, Puerto Rico, Texas, Utah, Virginia, Washington, and

Wisconsin.

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practices of the firms employing them (discussed further below). As a

result of the sweep, 28 firms and 23 brokers were referred for enforcement

action. In response to both the large firm project and sweep report

recommendations, SEC and the SROs reported increasing their examination

focus on sales practices and hiring and supervisory practices. In addition,

SEC drafted several new examination modules to further address microcap

and penny stock fraud, sales practices, and hiring and supervising problem

brokers. SEC consolidated its SRO inspection and broker-dealer

examination programs and created a separate office of broker-dealer

examination oversight to expand and give greater focus to the

broker-dealer examination program. As discussed above, NASD is

developing an automated risk-based examination system. Furthermore,

NYSE added questions and procedures to its examinations and

implemented a surveillance system to track brokers with disciplinary

histories.

Also in response to the large firm report recommendations, SROs are now

required to report all formal investigations as well as pending and final

disciplinary actions to CRD for public disclosure. In addition, NASD

members are required to report certain customer complaints within 10

business days and summary data on written customer complaints each

quarter. In August 1994, SEC requested that the SROs closely monitor the

timeliness of required filings and increase sanctions when noncompliance

is discovered. In April 1998, NASD proposed a rule that would provide

members with qualified immunity for statements made in good faith in

filings related to disciplinary actions and terminations. In 1995, SEC

approved a uniform industry continuing education program that requires

periodic training in regulatory matters and ongoing programs by firms to

keep brokers up to date. A permanent continuing education council was

created to recommend the specific content of the curriculum and to

monitor the program.

Sales Practice Sweep

Report

The 1996 SEC sales practice sweep report recommended various voluntary

best practices for hiring and supervising problem brokers and follow-up

examinations for problem firms. As previously discussed, SEC and the SROs

have reported increasing their examination focus on firms with problem

brokers, improving the selection of firms for examination, and drafting

new examination modules. The new modules should provide SEC a means

of gauging adherence to the best practices. Also, in April 1997, NASD and

NYSE issued a joint notice to members that encouraged the adoption of the

best practices. Although adoption of these practices was voluntary, the

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notice provided guidance on heightened hiring and supervisory

procedures for brokers with prior disciplinary histories, customer

complaints, or arbitrations and detailed overall member supervisory

responsibility under existing rules. The Securities Industry Association

adopted a similar set of best practices.

Actions Have Not

Been Completed on

Some

Recommendations

Although the actions taken have responded to many of our and SEC report

recommendations, for some other recommendations, actions have not

been completed. Actions have not been completed on our

recommendations related to the migration of unscrupulous brokers from

the securities industry; modernization of CRD to allow regulators to more

easily monitor brokers with disciplinary histories; and ability of SEC to

identify, across firms, trends in violations found during its broker-dealer

examinations.18 Also, SEC’s recommendation that would require

disclosures to customers on the availability of broker disciplinary

information prior to account activity has not been implemented.

Action on the Migration of

Unscrupulous Brokers Is

Not Complete

Our report on unscrupulous brokers discussed the potential for brokers

barred from the securities industry to migrate to other financial services

industries, such as banking and insurance. As a result, we recommended

that the Secretary of the Treasury work with SEC and other financial

regulators to (1) increase disclosure of CRD information so that regulators

can consider a broker’s disciplinary history in allocating examination

resources and employers can use the information in making hiring

decisions and (2) determine whether legislation or additional reciprocal

agreements between SEC and other financial regulators are necessary to

prevent the migration of unscrupulous brokers to other financial services

industries.

In 1996, the Office of the Comptroller of the Currency, Board of Governors

of the Federal Reserve System, and Federal Deposit Insurance

Corporation proposed a rule that would have required banks to report the

hiring of brokers to CRD and for brokers hired by banks to take NASD

qualification examinations.19 Among other things, the filings required by

the proposed rule would have allowed bank regulators to consider a

broker’s disciplinary history in allocating examination resources, thereby,

18See Securities Industry: Strengthening Sales Practice Oversight (GGD-91-52, Apr. 25, 1991), which

addresses SEC oversight of SRO monitoring and enforcement of sales practice compliance among

broker-dealers.

1961 Fed. Reg. 68,824 (1996).

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helping address the migration of unscrupulous brokers to the banking

industry.20 To date, the proposed rule has not been finalized. In June 1998,

NASD expressed concern to the banking regulators over bank employees

taking the NASD examination. NASD communicated that the use of its

examinations would not test for knowledge of bank rules and regulations.

NASD recommended that new bank-specific examinations be developed

and offered to assist in developing them. No further agreements on this

point have been reached.

In the absence of a rule change, no reporting has occurred and thus no

record exists of the movement of unscrupulous securities brokers to

banks or unregistered affiliates of banks. Completion of CRD’s

modernization (discussed further below) will not ensure effective

surveillance of the migration of these brokers to banks because banks are

not required to report to CRD.

The CRD Modernization

Nears Completion

Recommendations in our unscrupulous broker and hotline reports

addressed the need to modernize CRD to allow regulators to more easily

monitor brokers with disciplinary histories and to improve public access

to broker disciplinary information, including Internet access. Although

many actions have been taken on these recommendations, including

limited Internet access, the CRD modernization is not yet complete.

As previously discussed, CRD’s original role as the securities industry’s

centralized licensing and registration system has expanded and now

includes numerous other regulatory and disclosure functions. CRD’s

original technology, however, was not able to accommodate this

expansion. As a result, NASD began a redesign of CRD in 1992. This redesign

has taken longer than expected, partly because of a switch in 1997 to

technology that would allow Internet access. When completed, regulatory

components of the new system will provide (1) automatic reports to

regulators when certain predefined events occur, such as multiple

customer complaints against a broker; (2) greater detection of late,

deficient, or missed report filings; and (3) customized analytical

capabilities to help regulators identify industry compliance trends,

including those associated with specific problem brokers and firms. Also

when completed, investors will be able to view broker and firm

disciplinary information while on line. Currently, this information can be

requested on line, but the response is provided via electronic mail. Full

20The agreement did not address the migration of unscrupulous brokers to the insurance industry.

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implementation of all system improvements, including enhanced

regulatory functions and full Internet access, is scheduled for late 1999.

SEC Plans a New

Examination Tracking

System

Our 1991 report on SEC oversight of industry sales practices recommended

that the agency explore ways to record and maintain information on the

number of each type of violation found during on-site examinations of

broker-dealers and, as one option, include this information in its

examination tracking system, called the Examination Activity Tracking

System (EATS). The intent of our recommendation was to address SEC’s

inability to identify, across firms, trends in violations found during

examinations that could warrant greater regulatory attention. Having such

a capability would enhance the agency’s ability to more efficiently and

effectively target its resources. According to SEC, its planned replacement

of EATS with the Super Tracking and Reporting System (STARS) will allow

headquarters and regional office staff to identify and analyze trends in

violations. For example, SEC staff said they will be able to query the system

to determine the number of firms within a state or across the United States

that have been cited for specific violations, such as those related to books

and records violations or specific types of fraudulent conduct. Also,

according to SEC, in order to gather more information about the

significance and extent of violations found in examinations, the full text of

all reports will be stored on a computerized system, called Zyindex, that

will enable staff to search all reports using key words and to compile an

analysis of the information. SEC staff told us that implementation of STARS

and Zyindex is scheduled to begin in the fall of 1998. If implemented as

described, taken together, these enhanced capabilities would be

consistent with our recommendation that SEC be able to analyze, across

firms, trends in violations found during its examinations of broker-dealers.

Disclosures Are Not

Required Before Activity

Occurs in an Account

SEC’s 1994 large firm report recommended that information on the

availability of a broker’s disciplinary history via NASD’s toll-free hotline be

disclosed to investors before any activity occurs in their accounts. Our

hotline report suggested this information could be included on

account-opening documents or account statements. Investors could use

such information to protect themselves against unscrupulous brokers.

In 1992, SEC’s penny stock rules had been amended to require that

information on the availability of a broker’s disciplinary history via NASD’s

toll-free hotline be provided to a customer before effecting any penny

stock transaction with the customer. However, this rule did not cover

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nonpenny stock transactions (i.e., securities priced at $5 or more). On

September 10, 1997, SEC approved NASD Rule 2280, which required NASD

members to provide information on the availability of broker disciplinary

information to customers in writing at least annually, along with the

Internet web site address of the NASD public disclosure program and a

statement regarding the availability of an investor brochure describing the

program. However, the NASD rule does not require that the information be

provided before activity occurs in an account or at account opening.

Since the issuance of the SEC report, numerous additional efforts have

been made to educate the public on the availability of information on a

broker’s disciplinary history through NASD’s toll-free hotline and web site

as well as through other information on how to invest safely. These efforts

have included information made available through federal, state, and SRO

Internet web sites, free publications on investing, and SEC town meetings

for investors. NASD also stated that it includes the toll-free hotline number

and web-site address on every disciplinary action press release and has

publicized them in a multilingual radio and television public service

announcement campaign, in investor fairs and seminars, and in

conjunction with investor and other associations. As a result, access to

this information is now more readily available and widely disseminated.

Nonetheless, we believe SEC’s initial rationale for recommending that

information on a broker’s disciplinary history be available to investors

before any activity occurs in their accounts remains valid.

Conclusions SEC and the SROs have taken actions that respond to many of our and SEC

report recommendations. These actions have improved the availability of

registration and disciplinary information on brokers and firms, branch

office audit selection, and availability and analysis of customer

complaints, which should enhance regulatory oversight and investor

protection. We continue to support the need to implement prior

recommendations related to the migration of unscrupulous brokers,

completion of CRD modernization, ability of SEC to identify trends in

violations across firms, and disclosure of the availability of broker

disciplinary information before account activity. Full implementation of

these recommendations should further enhance regulatory oversight and

investor protection.

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Agency Comments

and Our Evaluation

Written comments from SEC on a draft of this report are contained in

appendix II. SEC and NASD also provided technical comments on the draft

report, which were incorporated as appropriate.

SEC said that most of SEC and our recommendations have been

implemented and focused its comments on the four recommendations

where actions have not been completed. SEC commented that it expects to

continue working with NASD to complete the CRD upgrade. It also

commented that planned enhancements to its examination tracking

capabilities will enable it to identify trends in violations. If implemented as

described, these enhanced capabilities would be consistent with the intent

of our recommendation that SEC be able to analyze, across firms, trends in

violations found during its broker-dealer examinations that could warrant

greater regulatory attention. In addition, SEC explained NASD’s concerns

about the banking regulators’ proposed rule on the migration of

unscrupulous brokers.

Finally, regarding SEC’s recommendation to disclose the availability of

broker disciplinary information prior to any account activity, the agency

commented that the availability of this information is now widely

publicized to investors for their use before opening an account and

committing to buy or sell securities. Although we agree that this publicity

is valuable, we also believe that SEC’s original recommendation to require

the disclosure of the availability of this information directly to individual

investors when they are about to open an account would provide the

information to the investor when it is of immediate use.

As agreed with your offices, unless you publicly announce its contents

earlier, we plan no further distribution of this report until 5 days after the

date of issuance. At that time, we will send copies of this report to the

Chairman, SEC and other interested parties. We will also make copies

available to others upon request. Please contact me at (202) 512-8678 or

Cecile O. Trop, Assistant Director, at (312) 220-7600 if you or your staff

have any questions. Major contributors to this report are listed in

appendix III.

Richard J. Hillman

Associate Director, Financial Institutions

 and Markets Issues

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Page 13 GAO/GGD-98-204 Microcap Stock Fraud
Contents

Letter 1

Appendix I 

New, Amended, and

Proposed SEC, NASD,

and NYSE Rules

Related to Microcap

Fraud

16

SEC Amended Rule 16

SEC Proposed Rules 16

Amendments or Plans Being Considered by SEC 17

NASD New and Amended Rules 18

NASD Proposed Rules 19

NYSE Proposed Rule 20

Appendix II 

Comments From SEC

21

Appendix III 

Major Contributors to

This Report

25

Abbreviations

CRD central registration database

EATS Examination Activity Tracking System

IB introducing broker

NASAA North American Securities Administrators Association

NASD National Association of Securities Dealers

NASDR NASD Regulation

NSCC National Securities Clearing Corporation

NYSE New York Stock Exchange

OTC over the counter

SEC Securities and Exchange Commission

SRO self-regulatory organization

STARS Super Tracking and Reporting System

Page 14 GAO/GGD-98-204 Microcap Stock Fraud
Page 15 GAO/GGD-98-204 Microcap Stock Fraud
Appendix I 

New, Amended, and Proposed SEC, NASD,

and NYSE Rules Related to Microcap Fraud

SEC Amended Rule

Amendments To

Regulation S

On February 17, 1998, the Securities and Exchange Commission (SEC)

adopted amendments to Regulation S that are designed to prevent abuses

related to offshore offerings of equity securities of domestic issuers.

Regulation S provides a safe harbor from the registration requirements of

the Securities Act of 1933 for offers and sales of securities by both foreign

and domestic issuers that are made outside the United States. In abusing

this safe harbor, issuers have illegally distributed securities in the United

States and, in doing so, have denied investors the protections provided by

registration under the Securities Act. Under the amendments, equity

securities of U.S. issuers that are sold offshore under Regulation S would

be classified as “restricted securities” within the meaning of Rule 144

under the Securities Act, and the period during which these securities

cannot be distributed in the United States would be lengthened from 40

days to 1 year. SEC also adopted amendments that would affect applicable

reporting requirements along with other amendments intended to prevent

further abuses of Regulation S.

SEC Proposed Rules

Amendments to Rule 504

of Regulation D

On May 21, 1998, SEC proposed amendments to Rule 504 of Regulation D

that would require all securities issued under the rule to be “restricted

securities” and would allow their resale only after certain criteria were

met. Rule 504 allows companies to raise up to $1 million per year in “seed

capital” without complying with Securities Act registration requirements.

SEC is concerned that the freely tradable nature of securities issued in Rule

504 offerings may have facilitated a number of fraudulent market

manipulations through the over-the-counter (OTC) Bulletin Board and

National Quotation Bureau’s Pink Sheets. The comment period on these

amendments expired on July 27, 1998.

Amendments to Rule

15c2-11

On February 17, 1998, SEC proposed amendments to Rule 15c2-11 that

would require all broker-dealers to review issuer information before

publishing quotations on non-Nasdaq OTC securities and require

broker-dealers quoting a price to annually review updated issuer

information. Rule 15c2-11 currently operates so that just the first market

Page 16 GAO/GGD-98-204 Microcap Stock Fraud
Appendix I 

New, Amended, and Proposed SEC, NASD,

and NYSE Rules Related to Microcap Fraud

maker21 in these stocks is required to review basic issuer information

before publishing quotations for that issuer’s securities. Other market

makers may “piggyback” on the first market maker’s quotes and publish

quotes after 30 days without reviewing issuer information. Retail brokers

“hyping” a microcap security may refer to a market maker’s quotation

when marketing a security to a potential customer. SEC is concerned that

most market makers for unlisted securities publish quotations without

reviewing current financial and other information on the issuer. The

comment period for these amendments expired on April 27, 1998.

Amendments to Form S-8

and Related Rules

On February 17, 1998, SEC proposed amendments to Form S-8 and related

rules that would restrict the use of the form for the sale of securities to

consultants and advisors. Form S-8 is the short-form registration statement

for offers and sales of a company’s securities to its employees, including

consultants and advisors. The amendments are designed to deter misuse

of this form either by avoiding the Securities Act requirements that apply

to securities sales to nonemployees or by issuing securities as

compensation to stock promoters. Other proposed amendments would

permit Form S-8 to be used by employees’ family members for the exercise

of stock options that employees give as gifts to their families. The

comment period for these amendments expired on April 27, 1998.

Amendments or Plans

Being Considered by

SEC

Amendments to Penny

Stock Rules

Currently, the definition of “penny stock” excludes securities that, among

other things, are priced at $5 or more per share. However, SEC believes that

some broker-dealers have circumvented the rules by pricing securities

above the $5 threshold. The SEC Chairman has testified that SEC is

considering whether to recommend changing the penny stock rules to

raise the price threshold to cover the types of securities that might be

involved in microcap stock fraud.

21Market makers are dealers who, with respect to a security, hold themselves out as being willing to

buy and sell the security for their own accounts on a regular or continuous basis.

Page 17 GAO/GGD-98-204 Microcap Stock Fraud
Appendix I 

New, Amended, and Proposed SEC, NASD,

and NYSE Rules Related to Microcap Fraud

Plan for National

Securities Clearing

Corporation Reporting on

Suspicious Transactions by

Introducing Brokers

Under a plan being discussed by the securities industry and SEC, the

National Securities Clearing Corporation (NSCC)22 would consolidate a

variety of data received from clearing firms, SROs, and other sources. NSCC

would use these data to identify suspicious activity by broker-dealers

(introducing brokers (IB) and others), and this information would be made

available to regulators.

NASD New and

Amended Rules

New Rule 2280 On September 10, 1997, SEC approved NASD Rule 2280, effective January 1,

1998, which requires NASD members that carry customer accounts to

provide customers in writing, at least once each calendar year, the NASD

public disclosure program hotline number and web site address as well as

a statement regarding the availability of an investor brochure describing

the public disclosure program.

New Rule 2211 On December 2, 1996, SEC approved NASD Rule 2211, effective December 2,

1996, that imposes time restrictions and disclosure requirements on

telephone calls to customers by NASD members and their associated

persons.

New Rule 3070 On September 8, 1995, SEC approved NASD Rule 3070 for reporting customer

complaint information and other specified events to NASDR. The rule,

which became effective on October 15, 1995, requires that NASD members

report to NASDR if any of 10 specified events occur and that they provide

quarterly summary statistical information on written customer complaints.

New Rule 3110(g) On June 9, 1995, SEC approved NASD Rule 3110(g), or “cold calling” rule,

effective June 9, 1995, consistent with rules of the Federal Communication

Commission promulgated under the Telephone Consumer Protection Act,

which require telemarketers to establish and maintain a list of persons

who have requested that they not be contacted by the telemarketer

(do-not-call list).

22NSCC, owned jointly by the New York Stock Exchange (NYSE), the National Association of

Securities Dealers (NASD), and the American Stock Exchange, clears 98 percent of all stock and bond

transactions in the United States.

Page 18 GAO/GGD-98-204 Microcap Stock Fraud
Appendix I 

New, Amended, and Proposed SEC, NASD,

and NYSE Rules Related to Microcap Fraud

New Rule 1120 On February 8, 1995, SEC approved NASD’s membership and registration

Rule 1120 to implement the Securities Industry Continuing Education

Program, which became effective July 1, 1995. The rule required all

registered persons to take computer-based training within 120 days of

their second, fifth, and tenth registration anniversaries. Effective July 1,

1998, this training is required every 3 years.

Amendment to Rule 3010 On April 17, 1998, SEC approved an NASD amendment to Rule 3010 that

requires an NASD member firm to tape record conversations between

customers and registered representatives if it hired a significant

percentage of individuals (dependent on firm size) from disciplined firms.

Amendment to Rule 8310 On January 20, 1998, SEC approved an amendment to Interpretive Memo

8310-2 (Release of Disciplinary Information), which allowed for the

release of additional disciplinary information that is required to be

disclosed pursuant to amended forms U-4, U-5, and BD, including, but not

limited to (1) customer-initiated arbitrations that are pending or settled

(for $10,000 or more), (2) civil proceedings and written customer

complaints (within certain dollar limits), (3) current investigations

involving criminal or regulatory matters, and (4) bankruptcies less than 10

years old. The rule also was amended to allow NASDR to respond to

electronic requests for information. Amendments in 1993 allowed for the

release of pending formal SRO disciplinary actions, criminal indictments,

civil judgments, and final judgments in arbitration decisions.

NASD Proposed Rules

Rules 2315 and 2360 In July 1998, NASD filed proposed Rules 2315 and 2360, which would,

respectively, require NASD members to (1) review current issuer financial

statements prior to recommending a transaction to a customer in an

unlisted equity security and (2) provide a disclosure statement to a

customer on each customer’s confirmation following any trade of an

unlisted equity security. SEC has not yet published the proposals for public

comment.

Amendments to Rules 6530

and 6540

In July 1998, NASD filed an amendment to Rule 6530 to limit quotations on

the OTC Bulletin Board to the securities of issuers that are current in

Page 19 GAO/GGD-98-204 Microcap Stock Fraud
Appendix I 

New, Amended, and Proposed SEC, NASD,

and NYSE Rules Related to Microcap Fraud

reports to be filed with SEC or other regulatory authorities and a

companion Rule 6540 that would prohibit an NASD member from quoting a

security on the OTC Bulletin Board unless the issuer’s filings are current.

SEC has not yet published the proposals for public comment.

Interpretation of Rule 3010

and Amendment to Rule

1060

In July 1998, NASD filed a proposed interpretation to Rule 3010 and an

amendment to Rule 1060 that would limit the kinds of cold calls that may

be made by unregistered persons and impose obligations on member firms

to supervise these employees. However, in its description of the proposal,

NASD states that “the proposed rule change would permit members to use

third-party telemarketing firms” to make cold calls on behalf of the

member firm. SEC has not yet published the proposal for public comment.

Rule 1150 On April 21, 1998, NASD filed proposed Rule 1150 with SEC to provide NASD

members with qualified immunity in arbitration proceedings for

statements made in good faith in certain required disclosures filed with

NASD on forms U-4 and U-5, the uniform registration and termination

notices for registered persons, respectively. The comment period expired

on June 19, 1998.

Rule 3230 On November 21, 1997, SEC published for comment a proposed change to

NASD Rule 3230 that would require clearing firms to (1) forward customer

complaints about an IB to the IB and the IB’s designated examining

authority, (2) notify complaining customers that they have the right to

transfer their accounts to another broker-dealer, (3) provide IBs with a list

of exception reports to help them supervise their activities, and (4) assume

liability for any mistakes or fraud made by an IB that issues checks drawn

on the clearing firm’s account. The comment period expired on

December 22, 1997.

NYSE Proposed Rule

Amendment to Rule 382 NYSE proposed an amendment to Rule 382 on September 16, 1997, that is

similar to proposed NASD Rule 3230. The comment period has expired.

Page 20 GAO/GGD-98-204 Microcap Stock Fraud
Appendix II 

Comments From SEC

Note: GAO comment

supplementing those in

the report text appears at

the end of this appendix.

See comment.

Page 21 GAO/GGD-98-204 Microcap Stock Fraud
Appendix II 

Comments From SEC

See p. 8.

See p. 12.

See p. 9.

Page 22 GAO/GGD-98-204 Microcap Stock Fraud
Appendix II 

Comments From SEC

Page 23 GAO/GGD-98-204 Microcap Stock Fraud
Appendix II 

Comments From SEC

The following is GAO’s comment on the August 28, 1998, letter from the

Securities and Exchange Commission.

GAO Comment Based on discussions with SEC staff to further clarify the intent of our

recommendation and the capabilities of SEC’s planned system

enhancements, we revised the text of the report. The report now

recognizes that, if implemented as described, SEC’s planned enhancements

to its systems capabilities would be consistent with the intent of our

recommendation. The intent of our recommendation was that SEC be

capable of identifying, across firms, trends in violations found during its

broker-dealer examinations that could warrant greater regulatory

attention.

Page 24 GAO/GGD-98-204 Microcap Stock Fraud
Appendix III 

Major Contributors to This Report

Chicago Field Office Cecile O. Trop, Assistant Director

Roger E. Kolar, Evaluator-in-Charge

General Government

Division, Washington,

D.C.

James R. Black, Senior Evaluator

Office of General

Counsel, Washington,

D.C.

Rosemary Healy, Senior Attorney

(233555) Page 25 GAO/GGD-98-204 Microcap Stock Fraud
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