21 Jul What are DTC chills and locks, and how can they affect me?
by Janice Shell
On 18 July, 2013, DTC slapped a global lock on Biozoom, Inc (BIZM), though it didn't get round to informing the public by putting a notice on its website until after the close on the next day. Several brokerages did, however, hear about it, and conveyed the news to clients who called to ask why they were unable to trade the stock. Word must have spread beginning around 12:30 p.m. on the 19th; there were only a few trades in BIZM after that. Going forward, there will probably be none at all. Global locks are intended to shut down trading altogether.
As most penny traders know, Biozoom was pumped to an intraday high of $4.50 only a few days before the SEC suspended trading in it, citing “a lack of current and accurate information concerning the securities of Biozoom because of concern that that certain Biozoom affiliates and shareholders may have unjustifiably relied upon Rule 144 of the Securities Act of 1933 (“Securities Act”) and they, Biozoom, and others may be engaged in an unlawful distribution of securities through the OTCBB.” The company itself hadn't helped matters by stating in an 8-K memorializing a change of control that the company was no longer a shell as of late February, and so could do everything other stocks could do. That was untrue; Rule 144, which permits holders of restricted stock to free it up and sell it into the market, is not available to former shells for a year after they declare their change in status.
Moving with uncharacteristic speed, the SEC subsequently charged eight Argentine citizens with fraud involving the sale of unregistered securities, and obtained an order freezing their U.S. trading accounts. Despite the agency's enforcement action, BIZM traded a little better than most new Greys, briefly touching a high of $0.75 on 16 July. Some investors, believing the company's product would eventually be a big winner, hung on, hoping for better days. DTC put paid to their dreams.
The Depository Trust Company
The Depository Trust Company, known as “DTC” without a “the,” is a subsidiary of the Depository Trust & Clearing Corporation (“DTCC”). DTC was created in 1973 to “reduce costs and provide clearing and settlement efficiencies by immobilizing securities and making "book-entry" changes to ownership of the securities. DTC provides securities movements for NSCC's net settlements, and settlement for institutional trades (which typically involve money and securities transfers between custodian banks and broker/dealers), as well as money market instruments.” DTC provides clearing and custody services through its nominee Cede & Co.; it's Cede that holds the stock you own in street name.
For investors and traders, DTCC and DTC are mysterious entities, secretive and remote. They do not welcome inquires about anything at all from what they call “non-participants.” They see themselves as business-to-business companies, and provide very little useful information to the general public. Don't call: they don't want to hear from you.
DTC is not a believer in information-sharing. At the SEC's Roundtable on Microcap Securities in the fall of 2011, a DTC panelist said flatly that she didn't want to tell companies why they weren't DTC eligible, or had been chilled, because if they were able to fix it, they'd just find a new way to get around the rules. The SEC didn't fully agree with that policy, and eventually compelled them to create a way for issuers to appeal.
As a consequence of this reluctance to impart information, there's a good deal of confusion about what chills and global locks (or “freezes”) are, when they may be invoked, what they mean for a stock you may own, and when they may be lifted.
Chills and global locks
DTC chills and locks may be imposed for a variety of reasons. As noted above, often the public, and even the issuer itself, may be left in the dark about those reasons. But some broad categories may be suggested.
A chill is a restriction placed by DTC on one or more of its services. DTC will issue a notice on its website announcing the event, but will not explain further. It may limit a participant's ability to make a deposit or withdrawal of its stock at DTC. A chill can last only a few days, or for an extended period. Global locks are scarier: all DTC services will be suspended, except, in many cases, for custody.
If a company lacks a transfer agent, or if its transfer agent isn't complying with DTC requirements for transferring securities, the stock may be chilled. Often this problem can be fixed easily, and the chill removed fairly quickly. Another type of chill that isn't necessarily worrisome occurs in the case of a corporate reorganization; DTC will temporarily chill the security for book-entry activities. A freeze can be short term, but usually isn't. If the problem can't be fixed, the security will probably be removed from DTC, and transactions will no longer be eligible to be cleared at any registered clearing agency.
Other situations that may provoke a chill are more complicated and more serious. If DTC determines that there may be a legal, regulatory, or operational problem with the issuance of the security, or with clearing of transactions in the security, it may be chilled or frozen. As the SEC puts it:
DTC may chill or freeze a security when DTC becomes aware or is informed by the issuer, its transfer agent, federal or state regulators, or federal or state law enforcement officials that an issuance of some or all of the issuer’s securities or transfer in those securities is in violation of state or federal law. If DTC suspects that all or a portion of its holdings of a security may not be freely transferable as is required for DTC services, it may decide to chill one or more of its services or place a freeze on all services for the security.
Much of the time, the cause of concern is the sale of unregistered stock into the market. That was the case with BIZM.
When a chill or lock is imposed, DTC will not only issue a notice at its website, but will also inform participants. Those would include brokers, who are expected to restrict trading, or, in the case of a freeze, to block it altogether. Until around 2005 or 2006, brokerages, especially those that self-cleared, didn't always pay attention to DTC edicts quickly, but that has changed.
If a stock you own has been chilled, the chill may or may not make a significant difference to your ability to trade it, depending on what services have been restricted. A freeze is different.
Once brokerages have become aware of a global lock, the stock will stop trading entirely. Bancorp International (BCIT) was locked in August 2005, following a corporate hijacking. A few weeks later—there was no excuse for the delay—the SEC suspended. Between the announcement of the global lock and the suspension, BCIT continued to trade. Volume had declined a little, but was still significant. Obviously the brokerages had paid little attention to notice of the lock. Trading activity didn't stop until the day of the suspension. Over the next four years, very occasionally a trade or two would go through, but essentially the stock was shut down. In 2009, registration was revoked.
Longs and shorts alike are caught in limbo when DTC imposes a freeze.
For good reason, many traders don't want to buy stocks that are chilled. Their problem is finding out what's chilled and what's not. DTC does not offer a handy list. Your broker will or should know, however, so make a call. Insist on an answer, so you can make an informed decision about the stock you're interested in. The broker should also be able to tell you if the company has any history of DTC restrictions. Given DTC's policy in these matters, he may not be able to tell you the reasons for the restrictions, if there have been any. The SEC recommends that potential investors thoroughly research companies and their transfer agents before investing.
Anyone caught in Biozoom has little to look forward to. It was dumped to the Grey Market, where it was at least able to trade, as a result of the SEC suspension. That is over. Traders who didn't get out when they had the opportunity are unlikely to have another chance. BIZM is a fully-reporting company, but once its management has come to understand what a global lock means, it probably won't bother to keep up with its SEC filings. If that happens, somewhere down the road registration will be revoked.
It's best always to keep an eye out for DTC. Chills are problematic, and global locks are deadly.