Testimony of Barry R. Goldsmith
Executive Vice President, Enforcement
Hearings on Micro-Cap Stock Fraud
New York State Attorney General
August 12, 1997
I am pleased to be able to participate in these important public hearings on micro-cap stock fraud. As head of NASD Regulation’s Enforcement Department, my staff and I have had numerous opportunities to work with Andrew Kandel and the fine staff of the New York Attorney General’s Bureau of Investor Protection & Securities. Both of our respective organizations share the belief that America’s securities markets are essential to the capital formation process and economic well being of our nation, and increasingly the world. These are national treasures and, as such, it is our job to work together with others to protect investors and the markets from fraud and abuse of any kind.
I readily acknowledge that there are some dishonest individuals and firms in the business today. However, let me also say that the overwhelming majority of individuals in the securities industry today are honest, ethical professionals who treat seriously their obligation to comply with the law and put the individual investor’s interest first. The problem firms represent a tiny portion of the more than 5,500 securities firms in this country and are for the most part firms that concentrate their sales efforts in the securities of thinly capitalized, micro-cap companies. While these smaller companies may provide significant growth potential for investors, they are also susceptible to misrepresentation, manipulation, false price predictions, and phony guarantees against loss.
We, as securities regulators, must adopt a "zero-tolerance" approach to fraud. We must continue to look at ways of improving our enforcement and surveillance, as well as the rules we adopt to protect investors. We must also look at new ways of "investor outreach," so that the individual investor is armed with the information he or she needs to resist the scamsters and make responsible investment decisions. I will speak about these matters today.
The NASD – Who We Are and What We Do
Let me outline the NASD’s role in regulating our securities markets, including the over-the-counter market. Established under authority granted by the 1938 Maloney Act Amendments to the Securities Exchange Act of 1934, the NASD is the largest self-regulatory organization for the securities industry in the world. Every broker dealer in the U.S. that conducts a securities business with the public is required by law to be a member of the NASD. The NASD’s membership comprises more than 5,500 securities firms that operate in excess of 62,000 branch offices and employ more than half a million registered securities professionals.
The NASD is the parent company of NASD Regulation, Inc., and The Nasdaq Stock Market, Inc. These wholly owned subsidiaries operate under delegated authority from the parent, which retains overall responsibility for ensuring that the organization’s statutory and self-regulatory functions and obligations are fulfilled. NASD Regulation is responsible for the registration, education, testing, and examination of member firms and their employees. In addition, we oversee and regulate our members’ market- making activities and trading practices in the over-the-counter market and in the trading of securities that are not listed on Nasdaq or on any exchange. Although activities involving these securities may be reflected in different quotation media, the NASD is ultimately responsible for regulating the trading activity of its members whether it occurs in The Nasdaq Stock Market, the over-the-counter market, or any other area over which the NASD has jurisdiction.
The Nasdaq Stock Market, Inc., develops, operates, and regulates a variety of marketplace systems and services. The Nasdaq Stock Market is the largest electronic, screen-based stock market in the world, capable of handling trading volume in excess of one billion shares a day. Today, more than one-half of all equity shares traded in the United States each day are traded on Nasdaq. Companies trading either on Nasdaq’s SmallCap Market or the Nasdaq National Market -- the respective tiers of The Nasdaq Stock Market -- are required to make extensive financial disclosure and meet well-established listing standards. As I will discuss, these standards are being strengthened, particularly in the Nasdaq SmallCap market.
The Over-the-Counter Market
While not part of the Nasdaq market, the NASD has regulatory responsibilities for what is known as the OTC or over-the-counter market.
The over-the-counter market is a vast amalgam of publicly traded companies that list neither on Nasdaq nor on any exchange. Contrary to a popular misconception, often perpetuated by unscrupulous operators, the over-the-counter market is not Nasdaq. The two are separate and distinct. It is in the thinly traded, micro-cap securities that characterize the over-the-counter-market where we are seeing ever-increasing growth in stock fraud.
Fueling this fact is a significant number of OTC companies that report absolutely no information to the SEC, making their financial situation a virtual "tabula rasa" or blank slate to investors. While some companies make financial information available, what reaches investors is not required to be subject to any auditing standards. In other words, you have to take the company’s (or your broker’s) word for it; you have little more. There is no minimum price that an OTC company must maintain in order to trade. Stocks in the OTC market can and do trade for mere pennies, and indeed the OTC is where you find the so-called "penny" stocks.
A part of the over-the-counter market is what is known as The OTC Bulletin Board. While it is a system operated by Nasdaq, the Bulletin Board is markedly different and separate and distinct from The Nasdaq Stock Market. It is an electronic quotation service for subscribing members. While the system displays real-time quotes, last sale prices, and volume information in domestic securities, there is no formal legal relationship between the OTC issuers whose shares are quoted there and Nasdaq. There are no periodic reporting requirements for continued inclusion in the service; only limited phone, contact, and address information is available in the OTC Bulletin Board company listings. This system provides a centralized and automated alternative to the Pink Sheets, which historically have been published on paper once each day, but which are now available electronically via market data vendors.
The perception of the public, frequently fostered by scam artists, is that trading on the OTC Bulletin Board is akin to trading in a highly regulated market such as Nasdaq. They will often refer to an OTC stock as listing on "Nasdaq’s OTC Bulletin Board" or on "the Nasdaq OTC," or some deliberately confusing variation that improperly links the two. Even the sophisticated financial press mistakenly confuses the two markets.
Let me be blunt, there are significant problems in the over-the-counter market and a strong regulatory response is needed. As I discuss later in my testimony, we have made this area a prime focus of our regulatory program. But we need to expand our efforts even further. The NASD is actively studying this market, particularly the OTC Bulletin Board, to determine what rule changes and enforcement initiatives are needed to address the new problems we see. Investors need to have access to more accurate and current information about the companies whose shares trade there. Too often the only information investors have is the misinformation and hype posted on a stock promoter’s Web page or the pie-in-the-sky promises made by a brash cold-calling broker.
We must take a hard look at whether there should be higher threshold standards for including a stock in the Bulletin Board. We will look closely at whether a company that is unwilling to even provide full and timely disclosure of information to the public or to regulators should be given quotation visibility on this electronic medium.
We must also strengthen the tools we have to keep the shares of bogus companies from being traded in the over-the-counter market in the first place. This can be accomplished by toughening and clarifying the rules we have to prevent broker-dealers from initiating or continuing to quote an OTC security. In addition, we need to explore rule changes that would place new requirements on brokers to confirm with their customers, based on objective criteria, that purchases of these types of securities are suitable investments. In addition, we are looking at ways that brokers can be required to disclose to their customers specific information about these types of investments.
Finally, we must be more proactive in educating investors on the specific and unique characteristics of the OTC equities markets. The NASD has already begun a program to educate investors about the specific characteristics of the OTC Bulletin Board, the Pink Sheets, and other quotation media. The program will emphasize the distinct differences between those markets and The Nasdaq Stock Market. In addition, the program will describe to investors the risks associated with the OTC equities marketplace, including that certain issuers in this marketplace are not subject to listing or maintenance standards.
NASD Regulation's Enforcement Record
As these hearings demonstrate, we as regulators must redouble our efforts in the micro-cap area. NASD Regulation has already begun those efforts. In 1996, we significantly increased the number of staff dedicated to regulation and enforcement by adding more than 150 new positions. By the year 2000, NASD Regulation plans to spend more than $100 million to enhance its systems for market surveillance and increase examination, surveillance, enforcement, and internal audit staff. We are already beginning to see the fruits of our investment. In 1996, disciplinary actions brought by the NASD reached 1,200, an increase of 12 percent over the prior year. Disciplinary fines collected increased by almost two-thirds and the number of firms expelled from the NASD increased by approximately 20 percent. Just under 400 individuals were barred from the industry, with 200 more serving suspensions. I would like to mention a few of the many significant cases we have brought in recent years.
Stratton Oakmont — In December of last year, NASD Regulation expelled Stratton Oakmont from the securities industry. Following our own disciplinary proceeding and prior actions by the SEC and at least 19 different states, including New Jersey, Illinois, Indiana, Pennsylvania, Delaware, and Maryland, NASD Regulation expelled the firm and barred its president and its head trader from the securities industry. This case imposed restitution and fines in excess of $1 million. Another complaint was filed last year against Stratton Oakmont and others alleging that the firm made approximately $28 million in illegal profits during the first day of aftermarket trading of five small stock offerings. Other enforcement actions against those directly responsible for the firm’s actions are contemplated.
Hibbard Brown — Innocent investors are too often the victims of exploitation through the use of aggressive sales tactics. This happened with a shell company called Site-Based Media. Working with the New Jersey Bureau of Securities, the NASD reviewed over 6,000 trades and uncovered fraudulent tactics by the firm of Hibbard Brown that generated $8.7 million in illicit profits in just eight days.
Hibbard and its sole owner Richard Brown were subsequently expelled by the NASD and ordered to pay $8.7 million back to retail customers. Additionally, the firm’s head trader and Brown were barred and fined. We continue to prosecute former Hibbard employees for their conduct with the firm. The investigation brought to light hundreds of examples of improper sales tactics, ranging from guarantees against loss, to unauthorized trading, to high pressure, intimidating, fully scripted sales pitches. Indeed, sales reps at Hibbard, in addition to being required to read from scripts, were encouraged to call customers continually, even if the customer refused to do business. To date, 13 branch office managers and registered representatives have been barred for their abusive sales practice activities.
A.R. Baron — Another New York firm that has been prominently featured in these hearings is A.R. Baron & Co., Inc. In May, the Manhattan District Attorney announced the indictment of the firm and the arrest of 13 individuals for cheating thousands of investors out of more than $75 million. The individuals and the firm, which is now defunct, were charged with participating in a pattern of criminal activity. Included in that pattern were lying to investors to induce them to buy certain low-priced securities; manipulating the markets in certain micro-cap stocks to benefit themselves and their favored customers; making unauthorized trades in the millions of dollars; refusing to honor its customers’ directives to sell securities in their accounts; outright thefts from investors; and forging documents to prevent detection of their crimes. Four NASD Regulation examiners from our Chicago office worked closely with the Manhattan D.A. throughout this important investigation.
NASD Regulation has brought its own cases against A.R. Baron, its principals and reps. In one of those actions, the firm paid more than $1.5 million in restitution to customers and fines for charging fraudulently excessive markups in more than 200 separate transactions. Other cases against Baron’s brokers are still pending.
Test Cheaters — Finally, every investor has the right to expect that his or her broker is honest and understands the securities markets and its regulations. This is the cornerstone of investor protection. To fulfill this responsibility, NASD Regulation last month announced that it had barred, censured, and fined 20 more registered representatives suspected of paying an impostor to take a qualification exam on their behalf. More than $1.8 million in fines and forfeited commissions were assessed against these brokers, all but one of whom reside in New York. This brings to 41 the number of suspected "test cheaters" we have thrown out of the industry. NASD Regulation has also worked closely with the Manhattan District Attorney’s office in the indictments of 52 impostors and others implicated in this matter.
New Nasd Rules to Combat Fraud in the Micro-Cap Market
NASD Regulation combats fraud in the micro-cap market not only with enforcement actions directed at specific firms and registered reps, but through aggressive new rules as well. These rules apply to all of our members and all of their associated persons. They cover a wide range of investor protection areas including cold calling, taping requirements, trading, and sales. I would like to discuss several of them.
Clearing Firms — A focus of these hearings has been the responsibility of clearing firms. We are working hand in hand with both the SEC and the New York Stock Exchange to explore imposing, through across-the-board rulemaking, new reporting responsibilities on firms that act as clearing brokers for other firms. These proposals would require clearing firms to provide information that will allow self-regulators to better monitor the activities of the firms on whose behalf they clear trades -- so called "introducing firms." Under proposals that we are considering, clearing firms will be required to report to the NASD or other Designated Examining Authority certain written complaints that they receive concerning activities of the introducing firm, and forward all complaints received to the introducing firm. The clearing firm will also be required to make available to its introducing firms reports and analyses of the introducing firm’s own activities.
Telemarketing — We have seen too many instances where investors become the unwitting victims of "cold calls" and high pressure sales tactics. These tactics are used by certain brokers to convince an investor to purchase stock over the telephone from a broker they do not know and, in all likelihood, would never want to know. NASD Regulation has responded to abuses of this type by adopting "telemarketing rules." In 1995, we adopted a "cold call" rule that requires NASD member firms to keep "do not call" lists of persons who do not wish to receive telephone solicitations from the securities firm or its brokers. More recently we have strengthened the regulation of this area by prohibiting firms and their brokers from telephoning an individual’s residence to sell securities during certain times, unless they have the prior consent of the person. In addition, in making these calls, member firms and brokers must immediately give their names, the name of their firms, their telephone number or address, and state that the purpose of the call is to sell securities or related products.
Taping Rule — When we succeed in putting a recidivist firm out of business, our job is not over. Sometimes the principals in those firms turn around and form new firms under a different name, other times the brokers go in clusters to existing broker-dealers. When a large number of these brokers become employed at another broker-dealer, this raises the risk that their new firm will have significant sales staff who may not have yet forgotten their old bad habits. To attack this problem, the NASD Board last week approved a rule that would require brokerage firms to tape all customer sales calls if a certain percentage of the firm’s brokers worked for firms that have been expelled for telemarketing fraud or sales practice abuse.
Electronic Media and the Internet — The use of electronic media -- including the Internet and e-mail -- to disseminate securities related information has grown enormously. This is an area of concern to NASDR. This year we will implement an automated system that will greatly increase the range, speed, and early warning capabilities of our Internet surveillance. In addition to enhancing our technology, we have filed proposed rule changes with the SEC that require member firms to establish written procedures for the review of electronic correspondence.
NASDAQ Listing Requirements — Pending with the SEC is a proposal to increase the listing standards for Nasdaq listed companies. This proposal will raise the financial standards significantly, and also extend corporate governance standards to all Nasdaq listed companies. These listing standards, which do not apply to companies whose shares trade on the OTC Bulletin Board or the Pink Sheets, will continue to improve the quality of smaller issuers on The Nasdaq Stock Market.
Earlier this year, The Nasdaq Stock Market created and staffed its new Listing Investigations Department – a group of accountants, investigators and lawyers who will proactively investigate and review the financial reports, business plans and other filings from Nasdaq listed companies to identify potential listing problems and market abuses.
As you can see, investor protection initiatives through new rule proposals have been one of our highest priorities. We have coupled these efforts with an enhanced investor education and outreach program through our Office of Individual Investor Services. This Office was launched by the NASD in August of 1996 and given a mandate to help focus the attention of the organization and industry on the individual investor. NASD Regulation believes that one of the most effective ways to protect individual investors is to provide them with information they need to make educated and sound investment decisions. Through this Office, the individual investor has a strong advocate within our organization.
The foundation of this program is the NASD Regulation Web site (www.nasdr.com). This site provides investors a basic primer on how the regulatory process works, how investors can avoid problems before they occur, and steps they can take should they run into difficulty. The site contains an overview of NASD Regulation’s activities, information on investing wisely, timely messages on current regulatory developments, and descriptions of the arbitration and mediation process. It also allows investors the on-line ability to request disciplinary histories of brokers, file complaints, and comment on proposed rules.
Noting the importance of this information to investors, we have recently expanded the information available to investors about the disciplinary history of a member firm or an associated person. Earlier this year, new rules went into effect by which we will publicize disciplinary complaints at the time they are filed and non-final "trial level" decisions in cases involving designated investor protection rules and statutory provisions.
Our Web site is complemented by the NASD’s Individual Investor Services site (investor.nasd.com), which offers training on investment basics, guidance on working with a broker, market research, and a calendar of investor events. In addition, the NASD publishes an investor newsletter, makes presentations, and provides information at investor forums. And, continuing to focus our efforts on the use of electronic media, NASDR initiated an Internet Education program. The key element of this program is a brochure distributed free to investors through the NASD and its member firms either on-line or by mail. This brochure provides guidelines for using securities information on the Internet safely.
In closing, I wish to emphasize that the NASD is absolutely committed to providing a fair, well-regulated environment for the trading of all securities, even the most thinly-traded stocks. We must do this while at the same time providing legitimate small, entrepreneurial companies access to capital. Significant enhancements to investor protection have been made in the micro-cap market; however, as these hearings and our own experience demonstrate, we must all do much more. And more will be forthcoming from the NASD. Thank you.