Imagine the following conversation between a teen and his parents:
Teen: Good morning, Mom and Dad. I am headed to school. See you tonight after work!
Parents: Not so fast. Please go to your room.
Teen: My room? It's time to go to school.
Parents: We think you may have done something wrong. You will need to stay in your room for the next two weeks.
Teen: What did I do?
Parents: We can't discuss that right now. Now, go to your room.
Teen: Well, when can we talk about it? I want to know what you think I did.
Parents: If we need to talk to you, we will. In the meantime, we will tell everyone that the reason you aren't at school is that you may have done something wrong.
Teen: Seriously? Well, what happens after two weeks?
Parents: You can go to school, but we are taking away the keys to your car.
Teen: How will I get to work?
Parents: That's not our problem.
Teen: Well, what if I didn't do anything wrong. Will I get my keys to the car so that I can go to work? Will you tell the school that it was all a misunderstanding?
As crazy as this scenario sounds, it describes well the process between the SEC and companies the SEC suspends from trading. Since early March, there have been 10 suspensions by the SEC of companies in the cannabis sector. I do see clearly the need for government intervention to protect investors, but the current process is flawed, potentially resulting in a lack of due process for publicly-traded companies and their shareholders. In my view, this has created an overhang in the market, as investors endure "opening bell fear," waiting to see if there has been a suspension announced on the SEC website.
SEC and FINRA Take Action
For some background, FINRA, which is the self-regulatory organization charged with protecting investors and is formally known as Financial Industry Regulatory Authority, first warned about potential scams in the cannabis sector last August. When the stocks took off like rockets in January following Colorado's implementation of legal cannabis for adults, it warned again. Behind the scenes, it had been in dialogue with many companies beginning in November, and it passed information on to the SEC, which has enforcement power.
The SEC first suspended Aventura Equities (OTC:AVNE) on March 5th, citing "questions concerning the adequacy and accuracy of publicly available information about Aventura, including, among other things, its financial condition, the control of the company, its business operations, and trading in its securities."
The market didn't really react to the AVNE suspension, as it, like Petrotech Oil & Gas (OTC:PTOG), which was the next one, was both a non-SEC filer and not widely followed. The third suspension, Citadel EFT (OTC:CDFT), on March 21st, took place right after the Benzinga 420 Marijuana Index had peaked, up 535% YTD, but the market took little notice of this one too, though it was an SEC filer. The following week, the market was jolted by the suspension of Advanced Cannabis Solutions (OTCMKTS:OTCQB:CANN). Just as CANN reopened on 4/10, the SEC suspended one of the most popular stocks in terms of market cap, Seeking Alpha "followers" and other measures, GrowLife (OTCMKTS:OTCPK:PHOT). The press release, which specifically thanked FINRA for its assistance, stated that the suspension was due to "questions that have been raised about the accuracy and adequacy of information in the marketplace and potentially manipulative transactions in PHOT's common stock."
By the time the next suspension came of Cannabusiness Group (OTC:CBGI) on May 7th, the market had already declined by 55%. The next suspension was another popular stock, Fusion Pharm (OTCMKTS:OTC:FSPM), on May 16th, and the SEC published a press release at that time, shedding some light on the two-month old effort:
"Recent changes in state laws concerning medical and recreational marijuana have created new opportunities for penny stock fraud," said Elisha Frank, co-chair of the SEC Enforcement Division's Microcap Fraud Task Force. "Wherever we see incomplete or misleading disclosures, we act quickly to protect investors."
It has been 5 weeks since the last suspensions, which were the related SK3 Group (OTCMKTS:OTC:SKTO) and Alternative Energy (OTCMKTS:OTC:AEGY) on June 6th. These followed Fortitude Group (OTCMKTS:OTC:FRTD) on May 23rd (one that I thought seemed to be justified). The BZMJ index closed at 355 on July 11th, down 65% from the March peak, though it is still up 123% in 2014. One can't deny the correlation between the SEC suspensions and the hit to the market. The stocks that have been suspended have seen their share prices wither away, and other stocks have retreated in my view partially to reflect the risk of not only suspension but also of being banished to the Grey Market.
How the Process Works
The OTC Markets, where the vast majority of the stocks in the cannabis sector trades, offers three different "marketplaces", including OTCQX, OTCQB and Pink. Stocks that are suspended by the SEC automatically move to what is known as the Grey Market, which is quite unpleasant, as the stocks are no longer quoted:
Suspension is bad enough, but the real problem, in my view, is that the stock, when it resumes trading, is no longer quoted, meaning investors and traders can see only where the last trade was (no bid or offer). This is the case no matter what the cause for the suspension might be: All stocks suspended are automatically sent to the Grey Market. Not surprisingly, volume withers away (who likes to trade without bids and offers?) and the price tends to remain depressed. Apparently AEGY and SKTO think it is so bad that they plan to go to Canada.
FINRA holds the "get-out-of-jail" card. Rule 6432 governs the process for companies to begin trading with quotation by filing a Form 211 as per Rule 15c2-11 under the Securities Exchange Act of 1934 ("SEA"). I am glad to have learned that FINRA is looking at making some changes to the process (electronic submission, public access to the filings) that were announced just last week.
Companies must find a market maker to fill out the Form 211. The process is explained here:
Form 211 (SEC Rule 15c2-11)
- What is a Form 211?
Form 211 is the form which must be completed pursuant to FINRA Rule 6432 and submitted to the FINRA OTC Compliance Unit to initiate or resume quotations in the OTCBB, OTC Markets or any other quotation medium pursuant to SEC Rule 15c2-11. To view or print the Form 211, please visit our Forms Page. A 211 Addendum Form must be submitted in addition to the Form 211 for the OTCBB.
- After a Form 211 is filed, how long until the security can begin quotation on the OTCBB?
There is no standard time to process a 211 and clear the market maker to begin quoting a security on the OTCBB. The time it takes to review a 211 may vary significantly depending on many factors including whether or not FINRA has to request additional information from the market maker that submitted the form and upon how long it takes the market maker to respond to requests for additional information.
- How do I check the status of a Form 211 filing?
Contact the FINRA OTC Compliance Unit. Please note that the Form 211 review process is proprietary and, thus, FINRA will only discuss details of the filing or review directly with the firm that submitted the Form 211.
- Do financials submitted with the Form 211 have to be audited?
The periodic reporting requirements relied upon by FINRA Rule 6530 require annual audits of an issuer's financial statements for quoting on OTCBB. However, current FINRA rules do not require audited financial statements for quoting on other quotation mediums, but they should be prepared in accordance with GAAP or, for foreign issuers, in accordance with their home country's accounting standards.
- Do I have to file a Form 211 for a security delisted from an exchange?
An exchange delisted issuer that wishes to be quoted on the OTCBB should contact their market makers to request that they complete a Form 211 for review and processing.
Why the Current System is Unfair
Escaping the Grey Market is a very low-probability event from what I have learned. To be fair, it is very likely that most stocks that are suspended do indeed have serious issues that justify enforcement action. With that said, the current system has the potential to result in a company that is not guilty of anything still having its stock stuck in purgatory indefinitely. Some of the issues that stand out:
- The SEC doesn't have to ever share any information with the company it suspends. In fact, several companies have suggested that there was no contact by the SEC during the suspension (or in advance).
- Even if a company were to clear up any potential issues within the two-week suspension period, it would still get sent to the Grey Market.
- The SEC and FINRA don't update the market when the stock begins trading after two weeks. On the one hand, the public deserves to know if there are any real issues outstanding. If there is a problem, why does the stock begin trading again? On the other hand, if there isn't an outstanding problem, then it seems that the SEC and FINRA should update the public.
- The current process allows only one market maker to fill out the Form 211. This creates an undue burden as other market makers can benefit if the application is accepted without sharing the risk assumed by the market maker filling out the form.
- FINRA has no mandated time-line for accepting the Form 211.
The bottom line is that the current system results in the potential for a company (and its shareholders) to be punished by government action without the benefit of due process, which is guaranteed by the 5th Amendment and the 14th Amendment to the Constitution. This concept of "due process" is explained by Cornell Law School:
These words have as their central promise an assurance that all levels of American government must operate within the law ("legality") and provide fair procedures.
The current environment of close scrutiny of cannabis-related companies by FINRA and the SEC and heightened intervention via suspension is a real challenge to an industry that already faces limited access to capital. It is positive for the industry to weed out bad players, of which there remain many, but FINRA and the SEC can improve the process. I recently launched an online petition that respectfully requests FINRA to address the shortcomings of the current system. Without these changes, a dark cloud hangs over the sector.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.