The term microcap security is not defined in the federal securities laws. Microcap securities include penny stocks 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, in the National Quotation Bureau’s Pink Sheets, or on the Nasdaq Small Cap Market. 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 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) 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. 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, NASDR, NYSE, NASAA, and Securities Industry Association. 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. 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. The reports with recommendations that were acted on focused on penny stock fraud; unscrupulous brokers (brokers who have committed a significant breach of sales practice rules or have a history of repeated sales practice violations); and NASD’s toll-free telephone hotline. 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 microcap stocks. In addition, NASD is developing an automated risk-based approach to examination scheduling to identify broker-dealers and branch offices for examination. 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. 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, and has added a requirement for periodic examination of data by data quality professionals. 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. The first report addressed the sales practice oversight of nine large broker-dealers (the large firm project report). The second report followed up on the first and focused on firms with problem brokers (the sales practice sweep 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. 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 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.