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March 1, 1998

Stock Fraud Crack-Up

By Cromwell Coulson

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  • Stock Fraud Crack-Up

The Securities and Exchange Commission has published for public comment proposed changes to 15c2-11, the rule that governs publication of quotes in securities that are not listed on Nasdaq or an exchange (see Release No. 34-39670).

The rule covers quotations in the pink sheets and on the OTC Bulletin Board as well as the over-the-counter markets in corporate bonds and foreign securities. While the SEC has good intentions, I think the rule would have unintended consequences highly detrimental to investors, issuers and the secondary markets.

The rule would require all market makers to:

* Obtain, review and verify the accuracy of information about an issuer when they initiate quotations in a non-Nasdaq OTC security.

* Obtain, review and verify the accuracy of that information annually if they publish priced quotations.

* Document their compliance and publish the collected information.

The proposed rule requires market makers to have a reasonable basis for trusting that issuer information is accurate and obtained from reliable sources. Market makers would have to ascertain if there are indications of potential or actual fraud or manipulation. The review process applies to both SEC-filing and non-filing issuers.

The proposed rule, however, is based on two flawed premises: that micro-cap fraud will cease if legitimate market makers discontinue publishing quotations in questionable securities, and that market makers should be responsible for issuer information.

It is wrong to give traders responsibility for the accuracy of information produced by third parties they do not control. The potential liability from an implied right of action by investors would drive legitimate firms from making markets, providing the remaining market makers an incentive to refrain from publishing prices.

In fact, it is much easier to manipulate trade reports when firm bids and offers are not transparent. This way, the crooks would have free reign as the honest players exit the business.

A competitive and transparent market should be available for all securities. Regulators should have the tools to punish entities that seeks to manipulate the markets or to defraud investors.

Fraud, of course, takes places across all markets. New York Stock Exchange-listed Centennial Technologies defrauded investors of more than $350 million. The corrupt New York-based penny-stock firm Stratton Oakmont was lead manager in twenty-seven Nasdaq stock offerings, according to Securities Data Publishing.

On Feb. 26, an officer of New York-based A.R. Baron & Co. was convicted of twenty-five charges, including enterprise corruption, scheming to defraud, falsifying business records, perjury and manipulating prices of eight Nasdaq-listed companies.

Alas, forcing issuers to provide financial disclosure does not prevent fraud. Other fraudulent outfits, Comparator Systems and Systems of Excellence, both Nasdaq companies, filed information with the SEC.

The issuers, promoters and retail brokerages that commit micro-cap fraud are violating and ignoring existing securities laws.

But placing higher regulatory and liability burdens on market makers that have no relationship with the issuers, promoters or retail brokers is not the answer to the problem. The market maker's role is to find a price point where supply equals demand. If there are falsehoods in the marketplace distorting the supply and demand, it is the entities that are lying that should be punished, not the honest participants.