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Issuers and the DTCC – Choice Without a Choice

Updated: Mar 9, 2023

Companies who seek listing on an exchange and entering the publicly traded markets must clear certain bars first. The DTC is a subsidiary of the DTCC, a Self Regulatory Organization (SRO) which organizes the settlement of securities in the United States [1]. In order to trade on established exchanges, and be available through brokers to the investing public, an issuer will need to seek eligibility status through the DTCs guidelines.

Only DTC partners can lobby for individual securities to be made eligible, so issuers will first need to find broker partners to work with them and sponsor the process. The DTC is able to provide benefits starting from the underwriting process - using the centralized depository Cede and Co. to maintain custody of securities and transferring holdings using book entry accounts, the DTCC further claims their program “eliminates the risk of a missed election on a corporate action, or a missed dividend payment” [1].

The slang term "street name" refers to the beneficial owner of these securities owned by Cede and Co., (which is the nominee of the DTC). “DTC holds legal title to the securities and the ultimate investor is the beneficial owner.” [1].

If investors choose to move securities out of the vault at Cede and Co. and instead seek direct ownership, the Direct Registration System is used. Securities are still held in book entry, and rather than information and communication traveling through the DTC to the investor, the investor receives these communications directly from the company of which they are invested.


The centralization of the DTC did present improvement and less risk in settlement compared to operations before it’s founding in 1973, and helped pave the way for multiple improvements in the market, such as decreased settlement times in the following decades. However, with the introduction and adoption of book-entry (electronic) securities, it has become possible for the transfer agents to communicate with investors just as efficiently. Transfer agents track the ledger of the issuer directly, are the most primary source for the record keeping of the shareholder ledger for issuers. The DTC does provide less risk than independent settlement, but still introduces multiple middleman-like entities when compared to the value of direct participation on the ledger of the issuer.

In "What is DRS" some reasons were explored to explain why individual investors and issuers might prefer for shareholders to invest directly with the company, rather than involving additional complications and layers of ownership.

It is possible for certain market conditions, such as short selling, to create more shares of a security trading on the market than there are legitimately issued fungible shares of that security. The DTCC has recognized that if issuers attempted to withdraw all shares of stock in a scenario like this - it would not be possible for them to meet all of their obligations to the beneficial or "street name" owners of securities effected by these market conditions. In 2004, the DTCC successfully convinced the SEC to implement a rule which would disallow issuers from leaving the DTC to seek other settlement avenues [2] [3]. "The Commission also has approved the rule filings of self regulatory organizations that require their members to use the facilities of a securities depository for the book-entry settlement of all transactions in depository-eligible securities and that require securities to be made depository eligible if possible before they can be listed for trading." In their settling argument justifying the implementation of this ruling, the SEC has taken the stance that - not only is keeping as many shares as possible with a single securities depository beneficial for settlement and accuracy - but that “clearing and settling securities transactions outside of a depository causes greater risks and inefficiencies, including credit risk issues and risk of defaults, than clearing and settling securities transactions within a depository" [2]. While this can be true in some cases, there are still risks which exist when dealing with the central depository.


Here are some quotes from the discussion around this decision, but it’s well worth reading in full for those who are curious.

"A small but growing number of issuers whose securities are registered under Section 12 or are reporting under Section 15(d) of the Exchange Act 36 recently have restricted, or indicated their intention to restrict, ownership of their securities by prohibiting their transfer agents from acknowledging ownership of shares registered in the name of DTC or by prohibiting transfer of their securities to DTC or in some cases to any securities intermediary" [2].

"Issuers imposing these restrictions, sometimes referred to as ‘‘custody-only trading,’’ frequently state that they are imposing ownership or transfer restrictions on their securities to protect their shareholders and their share price from ‘‘naked’’ short selling. These issuers believe that requiring all securities to be in certificated form and precluding ownership by certain securities intermediaries forces broker dealers to deliver certificates on each transaction and eliminates the ability of naked short sellers to maintain a naked short sale position" [2].

The SEC operates under the goals and obligations listed in the Securities Act of 1934, which dictates that it must seek streamlined and consistent settlement for securities transactions. Although issuers were wary to the risks represented by short selling and by naked short selling to their businesses, they would no longer be allowed to remove their shares from the vault at Cede and Co. The DTCs argument was that “by purporting to exercise the rights of the shareholders, issuers are interfering with the legal and beneficial rights of DTC and its participants with respect to securities deposited at DTC and with DTC's obligations under Section 17A of the Act” [3].

"Furthermore, forced certification of securities is inconsistent with the industry’s goals of streamlining processing of securities transactions."

"While some issuers have claimed they have the right to control the disposition of securities trading in the public market and have directed that shares owned by and registered in the name of the DTC’s nominee be surrendered, the DTC contends that issuers do not have continuing ownership rights in securities they have sold into the marketplace and that attempts to exercise control is improper and may constitute conversion" [2].


Thankfully, the SEC had the foresight to realize that restricting issuers ability to make this decision could not come at the expense of the freedom of individual investors seeking self-custody of their shares. "The Commission is making clear that the rule applies only to restrictions or prohibitions imposed by issuers on transfers of their publicly traded securities to or from those securityholders that are securities intermediaries and are not the ultimate beneficial owners" [2].

"The use of the national system for clearance and settlement, and more specifically, the use of clearing agencies, does not hamper an investors’ ability to register securities in their own name or obtain certificates, provided that the issuer allows for certificated positions. Generally, an investor who wants an individually registered position in certificate form can instruct her broker dealer to register the securities in her name and issue a certificate" [2]. This is referring to the Direct Registration System, which is still in use today.

Individual investors maintain the protected right to seek self-custody of their securities. Concerns about short selling and naked short selling are unfortunately still an unsolved and understudied issue within the financial markets.

In 2003, one commenter on this ruling drew a strong image of concerns. "One only has to look at who sits on the Boards of Directors for the NASD and the DTC to quickly realize that the fox is guarding the henhouse. The SEC has received thousands of complaints about naked shorting and so far seems to have turned a blind eye to the issue. On behalf of the millions of hard working investors who have lost billions of dollars and are being raped daily by the system as it presently exists, I pray that you are inspired to promptly make changes which will help restore some integrity to the marketplace" [4].


Short selling and naked short selling continue today and are most vocally discussed around the GameStop and "meme stock" phenomenon starting in January 2021. Although issuers are not able to take the step out of the DTC which may be respite from this market risk, individual investors are able to take that step for a company they invest with in order to protect it.

Citations:

1. DTCC - FAQs: How Issuers Work With DTC

2. 2004 SEC Rule that issuers cannot encourage their investors to exit the DTC (for example, transfer to the Direct Registration System).

3. 2003 SEC release #34-47365: Self-Regulatory Organizations; The Depository Trust Company; Order Granting Approval of a Proposed Rule Change Concerning Requests for Withdrawal of Certificates by Issuers

4. 2003 SEC release #34-47365 comment:

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