Monday, September 12, 2016

SEC seeks comment on DTC’s plan to impose global locks and deposit chills

By John Filar Atwood

The SEC is requesting public feedback on the amended version of Depository Trust Co.’s (DTC) proposal to alter the way in which it imposes restrictions on deposits of securities (deposit chills) and on book-entry services for securities (global locks). According to DTC, the changes are needed because wrongdoers have found ways to circumvent the prior system for implementing those restrictions.

Deposit chills and global locks. Previously, upon detecting suspiciously large deposits of a thinly-traded eligible security, DTC imposed a deposit chill as a measure to maintain the status quo. DTC required the issuer to confirm by legal opinion of independent counsel that the eligible security fulfilled the requirements for eligibility. The deposit chill was maintained, sometimes for years, until the issuer provided a satisfactory legal opinion.

DTC imposed a global lock on an eligible security when a governmental or regulatory authority brought an action alleging violations of Securities Act Section 5 with respect to the security. A global lock could be released when the enforcement action was withdrawn, dismissed on the merits with prejudice, or otherwise resolved in favor of the defendants. DTC noted that many enforcement actions are only resolved after several years and often without any definitive determination of wrongdoing.

Avoiding the restrictions. With respect to deposit chills, DTC believed that wrongdoers were taking into account DTC’s restriction process and avoiding it by shortening the timeframe in which they complete their scheme, dumping their shares into the market, and moving on to another issue. Similarly, global locks were proving ineffective because they dealt with enforcement actions alleging securities law violations that occurred in the past, and so could not affect the violative behavior. According to DTC, by the time of an enforcement action, the wrongdoers had long since transferred the subject securities. In addition, although a global lock barred book-entry settlements within DTC, it did not affect trading, which occurred outside of DTC.

DTC determined that its procedures for imposing deposit chills and global locks are more appropriately directed to current trading halts or suspensions imposed by the SEC, FINRA, or a court of competent jurisdiction. This would allow the restrictions to target more effectively suspected securities fraud that is ongoing at the time the restriction is imposed.

Rule change. In its release, the SEC explained that DTC’s proposal would add a new rule to DTC’s bylaws to establish the circumstances under which it would impose and release a deposit chill or a global lock. The rule also would set forth the fair procedures for notice and an opportunity for the issuer of the security to challenge the deposit chill or global lock.

If either FINRA or the SEC halts or suspends trading of an eligible security, DTC will impose a global lock. DTC also will impose a global lock if ordered to do so by a court of competent jurisdiction, or if it becomes aware of a need for immediate action to avert an imminent harm, injury, or other adverse consequence to DTC or its participants. According to DTC, the imposition of a global lock will prevent settlement of trades that continue despite the halt or suspension and prevent the liquidation of a halted or suspended position through DTC.

The proposed rule change also provides the conditions for releasing the restrictions. In the case of a global lock imposed when either FINRA or the SEC issues a trading halt or suspension, DTC will release the global lock when the halt or suspension of trading of the eligible security has been lifted. In the case of a restriction imposed by order from a court of competent jurisdiction, DTC will release the restriction when a court of competent jurisdiction orders DTC to release it. In other instances, DTC will release the restriction when it determines that the release would not pose a threat of imminent adverse consequences to DTC or its participants.

Initial comments. The proposal is an amended version of a proposal initially released in May on which the SEC received eight comment letters. Among other things, initial commenters suggested that allowing DTC to impose restrictions based upon the threat of “imminent harm” was too vague. DTC responded that it does not expect to use this authority very frequently, but that it is necessary to allow DTC the flexibility to protect itself from imminent harm that could arise from circumstances that would neither justify nor be impacted by a trading halt or suspension.

Commenters also said that restrictions imposed under the “imminent harm” standard should be automatically removed after a short period or should expire after 10 days. DTC responded that it would not be effective or practical for it to premise its proposed rule change on the assumption that the SEC or FINRA could take action quickly enough to protect DTC and its participants. DTC added that imminent harm to DTC or its participants could arise from circumstances that would not be addressed by a trading halt or suspension, such as the impending deposit of illegally distributed securities at DTC.