Examples of Red Flags for Brokers filing a 15c2-11 and/or making a market in a stock -
The Following represents some red flags that the Broker Dealer and FINRA examiners might look for when reviewing a company for filing a 15c2-11 and/or making a market in a stock of a company. If your company has any such “Red Flags”, they should be addressed
If the broker-dealer discovers at any stage of the review process any red flags in the issuer information (whether the issuer is a reporting company or non-reporting company), it cannot publish a quote unless and until those red flags are reasonably addressed. Material inconsistencies in the paragraph (a) [reproposed paragraph (c)] information, or material inconsistencies between that information and the paragraph (b) [reproposed paragraph (d) information, are red flags. We have set our below examples of red flags that have been noticed in microcap fraud cases or in Rule 15c2-11 submissions made to the NASD. These examples, however, are not comprehensive, as red flags depend on the facts and circumstances of each case.
We are providing examples of red flags that require additional scrutiny by the broker-dealer to comply with Rule 15c2-11. These examples, however, are not exhaustive. Conversely, the presence of these or other red flags is not necessarily an indication of microcap fraud or even inaccurate issuer information. The red flag simply means that the broker-dealer should question whether the issuer information is accurate, and in certain cases, from a reliable source. The more red flags that are present, the more a broker-dealer should scrutinize the issuer information.
1. Commission Trading Suspensions. As indicated above, Commission trading suspension orders generally raise significant red flags as to whether the Rule 15c2-11 information is accurate and whether its source is reliable. Broker-dealers publishing quotes once a trading suspension terminates must satisfy the Rule’s requirements, which may include seeking verification from the issuer or soliciting the view of an independent professional.
2. Foreign Trading Suspensions. A trading suspension by a foreign regulator may indicate that the issuer information is unreliable or inaccurate. However, a trading suspension in a foreign market may be imposed simply because the issuer failed to meet exchange listing standards. If the broker-dealer learns of a foreign trading suspension, it should attempt to determine the basis for the suspension order and assess whether the issuer information is still accurate and whether its source is still reliable.
3. Concentration of ownership of the majority of outstanding, freely tradeable stock. Concentration of ownership of freely tradeable securities is a prominent feature of microcap fraud cases. When one person or group controls the flow of freely tradeable securities, this person or persons can have a much greater ability to manipulate the stock’s price than when the securities are widely held. In a “pump and dump” scheme, retail interest is stimulated, and the price of the securities is manipulated upward, at the behest or under the control of the manipulators who control much of the stock. Often, other broker-dealers that are not intentionallyh participating in improper activities publish quotations in response to escalating demand for the security resulting from increasing retail sales. The promoters of these companies, company insiders, and unscrupuous brokers make substantial profits when they sell their shares at inflated prices. When the scheme is over, the security’s price plummets, and innocent investors who paid a premium price are left holding worthless shares.
4. Large reverse stock splits. Microcap fraud schemes can involve the substantial concentration of the publicly traded float through a reverse stock split. The subsequent issuance of large amounts of stock to insiders increases their control over both the issuer and trading of the stock.
5. Companies in which assets are large and revenue is minimal without any explanation. A red flag exists when the issuer assigns a high value on its financial statements to certain assets that are often unrelated to the company’s business and were recently acquired in a non-cash transaction. In this situation, the company’s revenues often are minimal and there appears to be no valid explanation for such large assets and minimal revenues.
Also, a red flag is present when the financial statements of a development stage issuer list as the principal component of the issuer’s net worth an asset wholly unrelated to the issuer’s line of business. For example, from a review of Rule 15c2-11 submissions, art collections or other collectibles that are unrelated to the issuer’s business apparently have been overvalued on the financial statements of some issuers. While assets that are unrelated to the business of the issuer are not always an indication of potential microcap fraud, some uncrupulous issuers have overvalued these types of assets in an effort to inflate their balance sheets.
6. Shell corporation’s acquisition of private company. A shell corporation is characterized by no business operations and little or no asssets. In a fraud scheme, a reporting company with a large number of shares controlled by one person or a small number of persons often merges with a non-reporting company having some business operations. The new public company is then used as the vehicle for “pumb and dump” and other fraudulent schemes. Broker-dealers placing quotes for these issuers’ securities should be mindful of the potential for abuse.
7. Offerings under Rule 504 of Regulation D where one or more of the following factors are present.
Little capital is raised in the Rule 504 offering and there appears to be no business purpose except to provide some shareholders with free-trading shares;
The Rule 504 offering is preceded by an unregistered offering to insiders or others for services rendered at prices well below the price in the subsequent offering;
Sales immediately following the Rule 504 offering are at substantially higher prices than those paid in the Rule 504 offering; or
A shell company and an operating company merge, which results in the operating entity becoming the surviving entity. The surviving entity goes “public” by issuing shares pursuant to Rule 504.
Rule 504 of Regulation D allows non-reporting companies to raise up to $1 million per year in “seed capital” without complying with Securities Act registration requirements. The freely tradable nature of securities issued in Rule 504 offerings has facilitated a number of fraudulent schemes through the OTC Bulletin Board Display Service (OTC Bulletin Board) or the Pink Sheets published by the National Quotation Bureau, Inc. (NQB). Broker-dealers should be alert to information in the Rule 15c2-11 materials where an active trading market is being promoted for securities issued solely in a Rule 504 transaction.
8. A registered or unregistered offering raises proceeds that are used to repay a bridge loan made or arranged by the underwriter where:
The bridge loan was made at a high interest rate for a short period;
The underwriter received securities at below-market rates prior to the offering; and
The issuer has no apparent business purpose for the bridge loan.
Broker-dealers have given small issuers bridge loans at a high interest rate for a short time period. In exchange for this bridge loan, the broker-dealer receives a significant number of shares of the issuer’s common stock at a price that is substantially below market rates. The broker-dealer then engages in a scheme to manipulate the stock’s price and ultimately benefits when it dumps the stock at an artificially high price.
9. Significant write-up of assets upon a company obtaining a patent or trademark for a product
The significant write-up of assets upon the issuer’s obtaining a patent or trademark for a product is a technique used by issuer’s engaged in microcap fraud to inflate their balance sheets.
10. Significant asset consists of OTC Bulletin Board or Pink Sheet companies. Some microcap fraud schemes involve issuers whose major assets are substantial amounts of shares in other OTC Bulletin Board or Pink Sheet companies.
11. Assets acquired for shares of stock when the stock has no market value. In microcap fraud cases, the issuer’s financial statements often indicate that the issuer acquired assets to which it assigned substantial value in exchange for its essetially worthless stock.
12. Significant write-up of assets in a business combination of entities under common control.
Those persons engaged in microcap fraud often use a business combination such as a merger as an opportunity to falsify financial statements. We have seen microcap fraud schemes in which unscrupulous issuers use purchase method accounting to write up the historical value of an asset to an artificially high value in situations when the entities involved in the business combination are under common control or otherwise have a high degree of common ownership. For example, Generally Accepted Accounting Principles (GAAP) requres that the acquisition of one entity by another entity be accounted for at historical cost in a manner similar to that in “pooling of interests” accounting when these entities are under common control.
13. Unusual auditing issues.
Auditors refuse to certify financial statements or they issue a qualified opinion; or
There has been a change of accountants.
Rule 15c2-11 does not contemplate that the broker-dealer scrutinize the issuer’s financial statements with the expertise of an accountant. The above red flags, however, do not require an expertise in accounting matters and have appeared in several microcap fraud schemes. In one case, the respondents stated in the Form 211 submissions to the NASD that they relied on audited financial statements. However, the auditors orally advised the associated persons of the broker-dealer before they submitted the Form 211 that the auditor’s opinion attached to the pro forma financial statement was qualifie because of the auditor’s inability to verity the issuer’s financial information.
An accountant’s resignation or dismissal is characteristic found in some microcap fraud cases. If a broker-dealer sees any of these red flags, it should confirm the auditor’s credentials with the appropiate state licensing autority, question the circumstances of the change in accountants, and carefully scrutinize the Rule’s required informaiton.
14. Extraordinary items in notes to the financial statements, e.g. unusual party transactions. Unusual related party transactions are sometimes found in microcap fraud schemes. For example, an issuer’s financial statememnts may show a related party transaction between two companies, which later merge and inflate the worth of their assets by using purchase method accounting.
15. Suspicious documents.
Inconsistant financial statements;
Altered financial statements; or
Altered certificates of incorporation
Altered or facially inconsistent issuer documents have been present in various microcap fraud schemes. For example, Polaris Mining Co was a shell corporation with no meaningful assets and no trading market for its stock. Douglass and Co., Inc., a broker-dealer, published quotations for Polaris in the Pink Sheets in violation of Rule 15c2-11 because the Polaris financial information upon which Douglass and Co., Inc. relied was deficient and contridictory on its face: two balance sheets for the same years contained blatant disparities. Both balance sheets valued certain mined but unprocessed ores at the estimated eventual selling price even though significant processing work remained to be done. One statement did not list property location. One statement had an item for capitalized expenses and the other statement for the same year did not. The former statement showed no retained earnings or accumulated deficit, suggesting that the figure for capitalized expenses was an arbitrary one designed to make assets and liabilities balance out.
In addition, issuer information that is altered on its face raises red flags that, at a minimum, require the broker-dealer to contact the issuer.
16. Broker-dealer received substantially similar offering documents from different issuers with the following characteristics:
The same attorney is involved;
The same officers and directors are listed; and/or
The same shareholders are listed
It is not uncommon for the same individuals to be involved in multiple microcap frauds. If a broker-dealer realizes after reviewing the information for several issuers that the same individuals are involved with these entities, the broker-dealer should make further inquiries to determine whether it has a reasonable basis to believe that the issuer information is accurate.
17. Extraordinary gains in year-to-year operations. In microcap fraud cases, the issuer may show extraordinary gains in its year-to-year operations. This may be accomplished through assigning an artificially high value to certain assets or through other manipulative devices that are red flags, such as the significant write-up of assets upon merger or acquisition.
18. Reporting company fails to file an annual report. The fact that a reporting company has not filed an annual report suggests that there is a potential problem with the company.
19. Disciplinary actions against an issuer’s officers, directors, general partners, promoters, or control persons.
The following types of disciplinary actions should trigger further investigation by a broker-dealer:
Indictment or conviction in a criminal proceeding;
Order permanently or temporarily enjoining, barring, suspending or otherwise limiting an officer, director, general partner, promoter, or control person’s involvement in any type of business, securities, commodities, or banking activities;
Adjudication by civil court of competent jurisdiction, the Commission, the Commodity Futures Trading Commission or a state securities regulator to have violated federal or state securities or commodities law; or
Order by a self-regulatory organization permanently or temporarily barring, suspending or otherwise limiting involvement in any type of business or securities activities.
Many microcap fraud cases involve recidivist securities law violators. If a broker-dealer has information or could reasonably discover information about the above types of violations, it should question whether it has a reasonable basis to believe that the issuer’s information is accurate and complete in these circumstances.
20. Significant events involving an issuer or its predecessor, or any of its majority owned subsidiaries.
The following types of significant events should prompt further investigation by a broker-dealer:
Change in control of the issuer;
Substantial increase in equity securities;
Merger, acquisition, or business combination;
Acquisition or disposition of significant assets;
Bankruptcy proceedings, or
Delisting from any securities or the Nasdaq Stock Market
While not necessarily problematic, these are material events involving the issuer. The change in control of the issuer, merger, acquisition or disposition of significant assets can provide unscrupulous issuers an opportunity to artificially overvalue the issuer’s assets to support an upward manipulation of the issuer’s worthless stock. An increase in the issuer’s equity securities provides the securities necessary for such manipulation. Bankruptcy proceedings or a delisting from an exchange or Nasdaq Stock Market may also indicate problems with an issuer that could lead the broker-dealer to conclude that it does not have a reasonable basis to believe that the issuer’s financial information is accurate.
21. Request to publish both bid and ask quotes on behalf of a customer for the same stock. The highly unusual request from a customer for the broker-dealer to publish both bid and ask quotes is a red flag “that calls for appropriate inquiry on [the broker-dealer’s] part.”
22. Issuer or promoter offers to pay a “due diligence” fee. If a market maker receives an offer from an issuer to pay a “due diligence” fee in connection with making a market in the issuer’s security, this is not solely a red flag. It is a violation of NASD Rule 2460 for the broker-dealer to accept this offer. If the broker-dealer receives any consideration in connection with publishing a quotation, the reproposed Rule requires the broker-dealer to disclose any such compensation, as well as any other significant relationship information between the issuer and the broker-dealer publishing the quotation or any of its associated persons. In Douglass and Co., Inc., a registered representative said he would try to get the broker-dealer to initiate a market in the stock of Polaris Mining Co., but that it would cost the issuer about $1,500 to cover “expenses.” The registered representative late agreed to accept Polaris stock (some of which he kept himself) instead of the $1,500.
23. Regulation S transactions 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. We recently adopted amendments to Regulation S that are designed to prevent the abuses that relate to offshore offerings of equity securities of domestic issuers. Prior to the recent amendments, Regulation S transactions involving large amounts of the securities of U.S. issuers were particularly vulnerable to fraud and manipulation. The perpetrators of the fraud sold the securities to U.S. investors after the 40-day holding period expired, and little information was available to investors about the issuers.
Under the amendments, equity securities of U.S. issuers that are sold offshore under Regulation S are 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 is lengthened from 40 days to one year. These amendments make Regulation S abuses less likely, but broker-dealers should be alert to any questionable activities once the one year period expires.
24. Form S-8 stock.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 form has been abused by unscrupulous issuers to register on Form S-8 securities nominally offered and sold to employees or more commonly, to so-called consultants and advisors. These persons then resell the securities in the public markets, at the direction of the issuer or a promoter. In a typical pattern, an issuer registers on Form S-8 securities underlying options issued to so-called consultants where, by prearrangement, the issuer directs the consultants’ exercise of the options and resale of the underlying securities in the public market. The consultants then either remit to the issuer the proceeds from the sale of the underlying shares, or apply the proceeds to pay debts of the issuer that are not related to any services provided by the consultants. In some cases, these consultants perform little or no other service for the issuer. In other microcap frauds, the issuer uses Form S-8 to sell securities to “employees” who act as conduits by selling the securities to the public and remitting the proceeds (or their economic benefit) to the issuer. This public sale of securities by the issuer has not been registered, although the Securities Act requires registration. The failure to register this sale of securities deprives public investors of the protections afforded by the Securities Act.
To prevent these abuses, Form S-8 and related rules impose certainrestrictions on the use of the form for the sale of securities to certain consultants and advisors. We are also proposing additional amendments to Form S-8. Although these amendments should deter microcap abuses, broker-dealers nevertheless should be aware of the prior abuses of Form S-8 in microcap fraud cases.
25. “Hot industry” microcap stocks. Another characteristic of microcap fraud cases is that they often involve stocks that are in vogue. In the past, oil and gas ventures and mining operations, as well as stocks of issuers with purportedly innovative products, have been popular in frauds involving low-priced stocks.
26. Unusual activity in brokerage accounts of issuer affiliates, especially involving “related” shareholders. Many microcap frauds begin with the deposit and sale of large blocks of an obscure stock by a new and unfamiliar customer who often is affiliated with an issuer. At the same time, the broker-dealer is encouraged to make a market in the stock by the issuer.
27. Companies that frequently change names. Frequent name changes are another characteristic that has been seen in microcap fraud cases. For example, Twenty First Century Health (TFCH) was originally a company called Big Valley Energy, Inc. Big Valley then changed its name to Biotronic Energy Engineering, Inc., then to the Sonoron Group, then to Zorro International, Inc. then to Health & Wealth, Inc., and finally became TFCH in 1995. At the promoter’s request, TFCH issued false audited financial statements that recorded material, nonexistent assets.
28. Companies that frequently change their line of business. Besides companies that frequently change their names, we also see companies that frequently change their line of business in microcap fraud cases. For example, New Allied Development started out as a uranium mining company that was a dormant public shell with no assets. New Allied then acquired the rights to medical products in exchange for its overvalued stock. Next, New Allied became a vehicle to enter the gaming business purportedly to build a casino.