Regulatory Enforcement in OTC Markets

By | February 10, 2021

Regulatory enforcement in over-the-counter (OTC) markets presents a unique challenge. Enforcement efforts by the Securities and Exchange Commission (SEC) among exchange-listed companies are facilitated by companies’ provision of audited financial statements and other extensive disclosures. Sophisticated investors and financial intermediaries, such as analysts and credit rating agencies, supplement the SEC’s monitoring efforts by reviewing corporate disclosures and questioning irregularities. In OTC markets, however, the information environment is significantly bleaker. Many OTC firms face few disclosure requirements and are rarely covered by the information intermediaries that help uncover reporting problems among exchange-listed firms. OTC firms also tend to be much smaller than their exchange-listed counterparts, making the cost-benefit tradeoff of investigating and prosecuting OTC firms suspected of fraud harder to justify. Yet the SEC frequently notes that it has a special obligation to protect less sophisticated retail investors — like those that dominate OTC markets — from securities fraud. In this post, we discuss the SEC’s approach to regulatory enforcement in OTC markets and highlight key findings from our recent working paper .

Overview of SEC Trading Suspensions

The SEC relies heavily on trading suspensions to help combat fraud in OTC markets. These trading suspensions are almost exclusively used to target OTC firms, and they represent by far the most common type of enforcement activity the SEC takes in OTC markets. Federal securities law allows the SEC to suspend trading in any stock for up to ten days if the SEC deems the suspension necessary to protect the public interest. However, anecdotal evidence suggests that many firms targeted by trading suspensions are never quoted by a broker on OTC markets again.

Historically, the SEC suspended trading in a stock either because the SEC became aware of suspicious disclosure or trading behavior, or — in the case of OTC firms that are also SEC registrants — because the firm was delinquent in filing SEC-required reports. However, in 2012, the SEC also began the preemptive suspension of trading in stocks of dormant shell companies under an initiative labeled “Operation Shell Expel.” The SEC has repeatedly claimed that this initiative was designed to prevent trading abuses by eliminating thinly traded stocks before fraudsters had the opportunity to manipulate them. Resource-constrained regulators likely view preemptive trading suspensions as an alternative for combatting fraud in OTC markets that is less costly than investigating and prosecuting realized fraud. Eliminating shell companies from the market may be beneficial because they represent the sort of illiquid securities that are particularly sensitive to stock price manipulation attempts.

But do trading suspensions actually reduce future fraud? Critics claim that Operation Shell Expel is ineffective because fraudsters in one expelled company simply move on to the hundreds or even thousands of dormant shell companies that remain unsuspended. Despite the SEC’s assertions, little evidence exists on the relation between SEC trading suspensions and the incidence of future fraud. Nor does evidence exist on how the SEC identifies shell companies to eliminate from OTC markets in the first place.

Evidence on the Determinants of SEC Trading Suspensions

To shed light both on how shell companies are identified for expulsion and on the efficacy of trading suspensions for preventing future fraud, our paper examines a comprehensive set of nearly 3,000 SEC trading suspensions from 2012 through 2019. Our results indicate that trading suspensions have catastrophic consequences for targeted stocks, as these stocks lose most of their equity value within 20 trading days after the SEC suspension, on average. Fewer than one percent of SEC-suspended stocks continue to be quoted by broker-dealers after the trading suspension.

We find that approximately half of all SEC trading suspensions during our sample period are due to firms’ delinquency in filing with the SEC. Relatively few (approximately 10 percent) of all SEC trading suspensions explicitly allege problematic disclosure or trading behavior as the reason for the suspension. The remaining 40% of all SEC trading suspensions are preemptive shell expulsions under Operation Shell Expel.

We find no stock trading patterns suggestive of stock manipulation attempts leading up to SEC trading suspensions due to filing delinquency. However, we find a distinctive pattern of higher returns and trading volume leading up to trading suspensions tied to allegedly problematic disclosure or trading behavior. Interestingly, we find that firms suspended ostensibly for “preventative” reasons under Operation Shell Expel exhibit stock return and trading volume patterns in the same direction (but of smaller magnitude) as firms targeted for suspension for explicitly problematic behavior. Our evidence is consistent with the notion that allegedly preventative suspensions are more likely to occur after stock manipulation has already occurred in the stock.

One possible explanation for why the SEC treats some shell company expulsions as preventative rather than reactive to fraud may be that prosecuting civil cases in court requires the SEC to meet a burden of proof that is not cost effective for relatively small OTC companies. Because many OTC firms targeted for fraud are shell companies, formally suspending the company due to its nonoperating status may be a way of eliminating the problematic firm without going through the costs of further investigation and prosecution.

Do SEC Trading Suspensions Prevent Future Fraud?

Ultimately, the benefits of these shell company expulsions hinge on their efficacy in deterring future fraud. We examine the relation between SEC trading suspensions and subsequent indicators of stock manipulation attempts among OTC firms in each U.S. state. On average, we find lower indicators of fraud among states with a higher rate of SEC trading suspensions in the preceding four quarters. However, this relation does not exist among suspensions representing shell company expulsions under Operation Shell Expel. Overall, our results are consistent with suspensions under Operational Shell Expel having little deterrence effect on future fraud.

Why would fraud deterrence be weaker for allegedly preventative suspensions than for other suspensions? One answer may be that suspensions under Operational Shell Expel are seldom accompanied by additional SEC investigations. Our data suggest that suspensions allegedly tied to problematic disclosure or trading behavior are accompanied by additional SEC investigations nearly 18% of the time. In contrast, we find evidence of only one out of approximately 1,000 preventative SEC suspensions under Operation Shell Expel being accompanied by a contemporaneous SEC investigation. Thus, shell expulsions may provide little deterrence effect for future fraud because they signal a weak regulatory response to market manipulation.

Informal Regulation Among OTC Markets

Despite the regulatory challenges to prosecuting and preventing fraud in OTC markets, we do find some reason for optimism. OTC Markets Group, the private operator of the electronic platform for most OTC trading in the U.S., independently monitors OTC stocks and identifies those suspected of manipulation attempts and other public interest concerns as “Caveat Emptor.” This designation, which results in a skull and crossbones icon next to the stock symbol on OTC Markets Group’s website, persists until the company has demonstrated there is no longer a public interest concern. We find that Caveat Emptor designations are issued in quick response to abnormal return spikes in OTC stocks. We also find investors respond to these designations over the next several trading days as subsequent returns become negative. Only about one-quarter of stocks targeted by a Caveat Emptor designation are still actively traded in OTC markets a year after the designation. Thus, formal regulatory efforts appear to be somewhat supplemented by informal regulation by a private intermediary.

Our research highlights the challenges associated with regulatory enforcement in OTC Markets. The combination of relatively unsophisticated investors and low disclosure requirements presents an optimal setting for securities fraud. Prior research cautions against imposing burdensome disclosure regulations on small OTC firms as a regulatory solution. Although SEC trading suspensions may be a good partial solution to regulatory enforcement in this market, so far it appears incomplete. Until the SEC can more thoroughly identify and eliminate all shell companies throughout the market, eliminating only some shell companies may leave others ripe for manipulation.

Dr. Richard Cazier is a Professor of financial accounting at the University of North Texas, Dr. Jianning Huang is an Assistant Professor at St. Frances Xavier University, and Fuzhao Zhou is a PhD Assistant Instructor at the University of Texas El Paso.

The post is adapted from their paper “Regulatory Enforcement in OTC Markets” available here.

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