Better Late Than Never: DTC to Propose Fair Procedures to Lift DTC Chills

If you're not a securities professional, chances are you've never heard of the DTC. While the three-letter acronym, DTC, can easily be mistaken for the kind of shorthand you may hear on the MTV reality show Jersey Shore, the DTC, which stands for the "Depository Trust Company", plays an important role in the US securities market. As the largest securities depository in the world, the DTC is responsible for the clearance and settlement of DTC eligible securities through its book-entry transfer services. In 2010, DTC processed 295 million book-entry transfers of securities worth $273.8 trillion.

For public companies in the US, being DTC eligible is an absolute must as it allows for the orderly trading in a company's securities without the need for the physical delivery of paper certificates. From time to time however, DTC suspends its book-entry transfer services for a particular stock forcing trades to be cleared through the actual physical delivery of a certificate - the impact of which is usually the "chilling" of trading in that stock. For under-capitalized companies, such a suspension or chill can literally mean the end as sophisticated investors balk at the prospect of investing in a company that is tainted with the stigma of a DTC chill.

Guided by the overarching goal of maintaining the integrity of the financial markets, DTC generally imposes chills when it suspects that unregistered shares for which there is no available securities exemption have been deposited into the pool of publicly tradable shares. Situations in which DTC suspicions are aroused range from the more obvious like when the SEC commences enforcement action against a company for the unlawful sale of unregistered securities to the more questionable when large deposits of shares are made with the DTC.

In many cases, there is little transparency into the often arbitrary decision to impose a chill. Until recently, it was common practice for the DTC to chill a company without providing basic due process rights such as notifying the company of the chill, explaining the reasons for the chill and describing what actions need to be taken in order to lift the chill. In fact, on the pretext that public companies are not members of DTC, DTC would in many cases refuse to even speak directly with company representatives instead insisting that any dialogue be conducted through a member broker. Denied the fundamental protection of due process, it's not surprising that many public companies suffered and continue to suffer the consequences of a DTC chill with little practical recourse.

Things however began to change with the landmark decision of International Power last year. International Power, a Pink Sheets waste-to-energy company, brought an action against the DTC before the Securities and Exchange Commission (which oversees the DTC) challenging a decision to chill its stock after the DTC refused to grant International Power its request to contest the chill before the DTC. In finding for International Power, the Securities and Exchange Commission harshly criticized DTC's lack of due process opining that

[i]f DTC believes that circumstances exist that justify imposing a suspension of services with respect to an issuer's securities in advance of being able to provide the issuer with notice and an opportunity to be heard on the suspension, it may do so. However, in such circumstances, these processes should balance the identifiable need for emergency action with the issuer's right to fair procedures under the Exchange Act. Under such procedures, DTC would be authorized to act to avert an imminent harm, but it could not maintain such a suspension indefinitely without providing expedited fair process to the affected issuer.

More importantly, the Securities and Exchange Commission opined that DTC should adopt fair procedures for imposing chills to be applied uniformly in future cases. It's against this backdrop that the DTC - approximately 18 months after the International Power decision - has just published a White Paper outlining its intention to propose rules formalizing the process for objecting to DTC chills. These proposed rules will include, among other things, procedures for notifying a company of the imposition of a chill, providing time frames to respond and establishing guidelines for the removal of chills.

Though too late for International Power that appears to have gone out of business, it's encouraging to see that the DTC is finally taking active steps towards the adoption of rules designed to provide due process for companies subject to DTC chills. Preserving the integrity of the financial markets also requires transparency, certainty and fairness in the way government-sanctioned bodies exercise the powers vested in them.