The Depository Trust and Clear Corporation (“DTCC”), through its subsidiaries, provides clearing,
settlement and information services for securities. DTCC’s subsidiary, the Depository Trust Company (“DTC”) was created to improve efficiencies and reduce risk in the clearance and settlement of securities transactions.
Not all securities are eligible to be settled through DTC and issuers must satisfy the criteria set by DTCC to be settled through DTC. All companies must satisfy these criteria in order to be DTC eligible, including Securities and Exchange Commission (“SEC”) reporting and non-reporting issuers who go public direct
Not only do issuers have to satisfy the criteria established by DTC to obtain initial DTC eligibility, but they must also satisfy the criteria to remain DTC eligible. If they fail to do so the issuer could find that its securities are subject to a DTC chill or global lock.
Complying with DTC’s criteria is often an unexpected legal and compliance cost for issuers, and a challenge for SEC attorneys not familiar with DTC’s procedures.
Often microcap issuers encounter problems with securities on deposit at DTC which results in DTC limiting or terminating its services with respect to the issuer’s securities. A “DTC chill” restricts DTC’s services, including limiting a DTC participant’s ability to make a deposit or withdrawal of a chilled security. A chill may be for a few days or an extended period of time depending upon the reasons for the chill and whether the issuer or transfer agent rectifies the cause of the chill. A “DTC freeze” is a termination of all of DTC’s services to an issuer. Like a chill, a freeze may last a few days or an extended period of time depending on the reason for the freeze. If the cause for the freeze cannot be corrected, then the security will be removed from DTC and transactions in the security subject to the freeze will no longer be eligible to be cleared at any registered clearing agency.
DTC places chills and freezes on securities for various reasons including legal, regulatory or operational problems with a security or trading or clearing transactions in the security. DTC chills and freezes occur when there is a suspicion or indication that the issuer or persons associated with the issuer have violated the securities laws. DTC may chill or freeze a security when it suspects that some or all of an issuer’s “free trading” securities were issued or transferred in violation of state or federal securities laws. For example, DTC Chills often follow reverse mergers involving public shell companies where there are large issuances of unregistered “free trading” securities being issued or exchanged. Additionally, DTC Chills often follow offerings made purportedly under Rule 504 of Regulation D which result in the issuance of “free trading” securities.
Often issuers lose DTC eligibility after notifying the Financial Industry Regulatory Authority (“FINRA”) of corporate actions such as name changes or stock splits which results in the issuer’s securities issuances and other activities being reviewed by DTC.
Factors that may cause an issuer’s securities to lose DTC eligibility include:
i. having multiple name changes and reverse splits;
ii. issuing improperly free trading shares which have not been registered with the SEC in reliance upon Rule 504, 144 or upon conversion of debt;
iii. engaging in a reverse merger with a company that has been involved in a state receivership or custodianship action or other action which resulted in a state court order to obtain control of a public shell company;
iv. engaging in a reverse merger with a public shell company which resulted in the issuance or transfer of unregistered free trading shares;
v. being involved in improper investor relations activities including spam campaigns, pump and dump schemes, or other fraudulent activities; and
iv. being subject to an SEC investigation or being associated with stock promoters, brokers, lawyers or accountants that have been subject to investigations by the SEC, FINRA or the Justice Department.
The solution to a DTC chill can vary depending upon the particular facts causing the chill. Often it is necessary to trace the issuance and tradability of all shares in the issuer’s public float and explain how the shares became free trading securities. In order to do this, it is critical that the issuer engage a competent securities attorney to review prior issuances and related legal opinions. While DTC chills can be devastating to a public company, often DTC’s services can be restored.