The Twilight Zone: OTC Regulatory Regimes and Market Quality

Christian Leuz is the Sondheimer Professor of International Economics, Finance and Accounting at the University of Chicago.

In 2010, more than 8,000 domestic equity securities traded in the U.S. OTC market. Yet, research studying this market is limited. Stocks in this market tend to be small. The OTC market generally offers less investor protection than the traditional exchanges, and fraudulent and abusive practices in this market cause significant economic harm to investors. Thus, this market illustrates the trade-off that securities regulators face between their charter to ensure investor protection and their desire to create a viable market for small growth firms. This trade-off has come into focus with the passage of the JOBS Act in 2012, which intends to lower the regulatory burden on firms when they access public capital markets. One of its key provisions is to loosen the ownership limits for SEC registration, which will likely increase the number of unregistered securities in the OTC market. This change raises significant concerns with respect to investor protection. In light of these initiatives, it is important to understand the efficacy of existing regulatory regimes in the OTC market. In our paper, The Twilight Zone: OTC Regulatory Regimes and Market Quality, which was recently made publicly available on SSRN, my co-authors (Ulf Bruggemann, Aditya Kaul, and Ingrid Werner) and I analyze the association between these regulatory regimes and market quality.

There are three venues in the OTC market: the Bulletin Board, the Pink Sheets (now called the OTC Markets Group) and the Grey Market. Bulletin Board firms have been required to file with the SEC since the Eligibility Rule in 1999, but the Pink Sheets and the Grey Market do not require SEC registration. However, until the JOBS Act, any publicly traded firm with more than $10 million in assets and more than 500 record holders had to file with the SEC. Thus, firms trading in the Pink Sheets or the Grey Market may be SEC filers and hence provide regular disclosure. For SEC registrants, federal law preempts state regulation and hence sets the relevant rules. For non-registrants, state corporate law and state securities law provide the relevant rules for disclosure and registration. State corporate law, which depends on the state of incorporation, may stipulate that shareholders receive financial statements, or can obtain them on request. State securities laws (so called “blue sky” laws) require registration, which in most states amounts to a “merit review” of the issuer, assessing the quality of the issuer and whether the offer is fair to investors. State securities laws apply at the trade level, i.e., in every state where a firm sells securities to the public, as well as in the states of both buyer and seller in the secondary market. An important way in which firms can comply with state securities laws is to use the so-called “manual exemption.” In 42 states, issuers are exempt from registration if they are published in “a nationally recognized securities manual” such as Mergent’s (formerly Moody’s) Manuals, Standard & Poor’s Corporation Records, and others. These manuals perform a review and publish a brief business description, corporate history and financial statements. Finally, there are venue-based regimes. The OTC Markets Group, operating the Pink Sheets, has introduced several tiers and information labels differentiating firms for which current information, limited information or no information is available. It also has created a “Caveat Emptor” label to flag firms for which adequate current information is not available and there are public interest concerns.

Descriptive evidence characterizing the OTC market is important considering how little is known about this market. It is particularly relevant in light of recent changes in SEC registration requirements introduced by the JOBS Act. We show that the OTC market consists predominantly of micro-cap stocks that exhibit low liquidity, negative performance and high volatility. A significant number of firms in the OTC markets are “fallen angels,” i.e., stocks that have delisted from the traditional exchanges. We also show that few OTC firms eventually trade up to the traditional exchanges. At the same time, most OTC stocks survive and are quoted for long periods of time. Thus, the OTC market, although not a major breeding ground for young and eventually successful growth firms, is more than an interim home for firms that are on their way out of the public markets.

A key question is how regulatory regimes with different levels of transparency and investor protection affect investor demand and market quality. We study this question focusing on market liquidity and price efficiency. We show that market liquidity and price efficiency are lower in the OTC market than on the traditional exchanges and that both decline monotonically as the OTC market’s information environment deteriorates (i.e., moving from the Bulletin Board to the Pink Sheets to the Grey Market). We also document that OTC firms that file disclosures with the SEC or are published in Mergent’s or Standard & Poor’s securities manuals have higher market liquidity and more efficient prices. This evidence is consistent with the interpretation that investors recognize differences in the information regimes across OTC stocks and venues and trade accordingly.

Next, we analyze whether differences in states’ blue sky laws affect market liquidity and price efficiency. As state securities laws generally rely on merit reviews by state regulators, the mechanism by which they affect markets is less obvious than for federal securities laws, which are based on a disclosure doctrine. Firms’ registration filings with state regulators are generally not easily accessible and hence the information contained in them is unlikely to directly contribute to market liquidity or price efficiency. However, merit reviews by state securities regulators could contribute indirectly by screening out firms for which concerns about investor protection are more severe. Consistent with this notion, we find that market liquidity and price efficiency are higher for firms located in states with tougher merit review regimes. The effects are also stronger in states that do not offer a manual exemption and hence do not allow manual publication to substitute for state registration and merit review.

We address the effectiveness of venue-based regulation by analyzing differences in market liquidity and price efficiency associated with newly introduced Pink Sheets tiers and information labels. We find that market liquidity and price efficiency increase monotonically from the lowest to the highest Pink Sheets tier. The Caveat Emptor label is strongly associated with low liquidity and low price efficiency. We also show that these stocks exhibit much higher crash risk, consistent with the investor protection concerns for stocks in this category. The Pink Sheets information labels largely subsume the information in SEC filing and manuals. Moreover, judging from the associated levels of market liquidity and price efficiency, SEC filing, manual publication, and a “Current Information” label by the Pink Sheets appear to be relatively close substitutes to investors. Finally, recent Pink Sheets initiatives to improve information availability are associated with increases in market liquidity and price efficiency in this market relative to the Bulletin Board.

In sum, although the OTC market is often viewed as dark and unregulated, there are alternative federal-, state-, and venue-specific regulatory regimes, which are reflected in market quality. We provide robust evidence of associations between stricter regulatory regimes at the federal, state and venue level and better market quality, suggesting that investors recognize the regulatory differences when trading in the OTC markets.

The full paper is available for download here.

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