Depository Trust Company 101

The Depository Trust and Clear Corporation (DTCC), through its subsidiaries, provides clearing, settlement and information services for securities. DTCC operates through 10 subsidiaries – each of which serves a specific segment and risk profile within the securities industry. DTCC’s subsidiary, the Depository Trust Company (DTC) and its activities are regulated by the SEC, the Board of Governors of the Federal Reserve System, and the New York State Banking Department.

DTC serves as a custodian of the securities deposited by its participants and provides securities settlement services.  Not all securities are eligible to be settled through DTC and issuers must satisfy the criteria set by DTCC to be settled through DTC.  All companies must satisfy this criteria in order to be DTC eligible including SEC reporting and non-reporting issuers who go public direct and undertake direct public offerings and those who pursue reverse mergers with public shells.   Complying with this criteria is often an unexpected legal and compliance cost for many issuers who are unaware of DTC’s requirements.

How DTC Eligibility Affects Trading

After the purchase of a security occurs, the second portion of the trade transaction occurs. This portion is referred to as clearing. While brokers maintain individual books recording the entire amount of buy and sell orders transacted by their clients, the act of clearing these transactions is handled by DTC.  Clearing trades involves the matching of the buy and sell orders of a security. Once the transactions are executed details are sent to DTC and recorded and matched for accuracy. After all the trades are matched for buys and sells DTC notifies all member firms of their associated obligations, and arranges the transfer of appropriate funds and securities. Thus, individual brokers are not dealing with one another after every trade. Instead DTC serves as an intermediary that facilitates the transfer of stocks and cash. It is important to note that DTC guarantees delivery and if the buyer or seller of the security being cleared through DTC  does not deliver the purchase price or security sold,  DTC fulfills the obligations of the party that did not deliver.

The DTC clearing process takes typically three days to complete. When a security is not DTC eligible clearing occurs only upon physical delivery of the stock certificate representing the security from the seller to the buyer. Clearing with DTC eligibility through physical delivery could take weeks to complete. Without DTC eligibility it is impossible for an issuer to establish liquidity in its securities.

The Eligibility Process

Only participants can request that DTC make a security eligible. The issuer of the securities seeking eligibility must locate an underwriter or other financial institution that is a Participant and that is willing to sponsor the eligibility process. Participants can submit an eligibility request through the underwriting services of DTC either at the time a security is initially being offered and distributed to the marketplace or at a later time for already issued and outstanding securities.

A transfer/paying agent (the “Agent”) must be appointed with respect to the issuer or the security for which eligibility is being requested, prior to the security being made eligible for DTC services. The applicable Agent must have on file with DTC a completed DTC Operational Arrangements Agent Letter (“Agent Letter”) pursuant to which the Agent agrees to be bound by the terms and conditions of DTC’s Operational Arrangements. Please see the General Eligibility Requirements section for more information on Operational Arrangements which contains the form of the Agent Letter. The Operational Arrangements outline the Agent’s obligations to DTC to allow a security to become and remain eligible at DTC. The Agent may also be participating in DTC’s Fast Automated Securities Transfer (“FAST”) program.

In the case of an eligibility request for an older, already issued and outstanding security, the participant also must present a copy of the physical certificate representing the security and an Agent Attestation form. Further documents and data may be required as part of the eligibility review.

It is the responsibility of the participant requesting eligibility for the securities to establish that the securities satisfy the criteria set forth by DTC. Once DTC has reviewed the information submitted, it may request an opinion from the issuer’s securities attorney to substantiate the legal basis for eligibility. DTC requires any legal opinion to be provided by an experienced securities lawyer who is licensed to practice law in the relevant jurisdiction and is in good standing in any bar of which the practitioner has been admitted. Such counsel must be independent and not in-house counsel or an officer or director of the issuer. Additionally, DTC requires that the securities lawyer not have a beneficial ownership interest in the security for which the opinion is being provided. DTC reserves the right to approve the securities lawyer upon whose opinion DTC is being asked to rely.

Eligibility Requirements

DTC’s Operational Arrangements set forth the criteria for an issue to become and remain eligible at DTC. In addition to criteria specified in the Operational Arrangements, requirements include that the securities must be:

i. issued in a transaction registered with the U.S. Securities and Exchange Commission (“SEC”) pursuant to the Securities Act of 1933, as amended (the “Securities Act”); or

ii. issued in a transaction exempt from registration pursuant to a ’33 Act exemption, that at the time of the request for DTC eligibility no longer involves transfer or ownership restrictions; or

iii. eligible for resale pursuant to Rule 144A or Regulation S under the ’33 Act (and must otherwise meet DTC’s eligibility criteria).

General Document Requirements for Issuers

Whether at the point of initial offering or when the terms of an already eligible security are amended in a corporate action, underwriting may require the issuer to execute and deliver related documentation to DTC. The following is an overview of the most commonly requested documentation that may be required in order to receive DTC eligibility.

Letters of Representations and Riders Requirements for Book-entry-only Securities

Book-entry-only (“BEO”) securities are securities for which i) physical certificates are not available to investors and ii) DTC, through its nominee, Cede & Co., will hold the entire balance of the offering, either at DTC or through a FAST agent in DTC’s FAST program. Issuers of these securities must submit to DTC a Letter of Representations among the issuer, its Agent and DTC, to DTC prior to such issue being made eligible. An issuer may submit to DTC a Blanket Issuer Letter of Representations which is issuer specific and applicable to all DTC-eligible issuances of the same issuer or an Issuer Letter of Representations which is specific to an issuer.

Additional Requirements for Certain Securities

Additional riders to the LOR are required for eligibility of many securities. Some common examples where additional riders are required include Rule 144A and Regulation S securities, securities denominated or that have payments in non-U.S. currencies and securities of a U.K. issuer. All relevant CUSIP (or CINS) numbers must be listed on each applicable rider. The rider forms may be obtained from DTC’s website at the address listed in Annex A.

Legal Opinions

As described above, DTC evaluates issues for eligibility on a case-by-case basis and may require the participant seeking to make a security DTC-eligible to provide an opinion from the issuer’s securities lawyer regarding the security. Such opinions are typically requested to confirm either: (i) that the SEC registration requirements for that security have been met, or (ii) that the security was exempt from SEC registration by the Securities Act under an acceptable exemption and that the security is not subject to transfer restrictions and is freely transferable. Opinions from the issuer’s SEC attorney may also be requested in other circumstances, such as when an issuer changes its name or its form of organization in respect to a corporate action and in exchange offers.

Securities Not Registered Pursuant to the Securities Act

Opinions of counsel with respect to make unregistered securities eligible may be required in connection with the following transactions (among others):

i. securities (either newly issued, those in the secondary market or those issued in connection with corporate actions) which are issued pursuant to an acceptable exemption from SEC registration under the Securities Act; and

ii. the exchange of securities subject to transfer restrictions represented by certificates bearing a restrictive legend for certificates not subject to transfer restrictions with no restrictive legend (e.g., in reliance on the ’33 Act Rule 144(b)(1)).

Foreign Issuers

A foreign issuer may be required to make special representations or provide additional legal opinions to protect DTC and its participants from certain risks associated with the laws under which the issuer is organized and/or the laws governing the securities. A foreign legal opinion will refer to relevant laws of the foreign jurisdiction in which the issuer is organized.

Maturity Revisions of Eligible Securities

DTC cannot effect changes on its records with regard to the terms and conditions of an outstanding security without the lawful instruction and proper authorization from the issuer of the respective security. When the maturity of an issue is amended, the issuer must provide DTC with an indemnity letter which instructs DTC to make relevant changes to the terms and conditions of the affected security, at the time such changes are duly authorized.

Rule 144A and Regulation S Securities

To lift restrictions applicable to securities which DTC has initially accepted as eligible pursuant to Rule 144A and/or Regulation S on the grounds that the original restricted and/or distribution compliance period imposed under such exemptions has elapsed, the issuer of the securities must provide an instruction letter to DTC. The instruction letter confirms to DTC that the restricted period and/or distribution compliance period has elapsed and supports the exchange of the formerly restricted securities represented by a restricted CUSIP number for new unrestricted securities of the same issue represented by an unrestricted CUSIP number.

In order for an issuer’s securities to trade electronically, the issuer must also submit an application to DTC for its initial eligibility to trade. If eligibility is granted, DTC will agree to hold an inventory of free-trading street name shares on deposit. The shares that are free-trading and held by DTC become the “public float.” DTC is the only depository that provides an inventory for clearing and settlement of the securities of publicly traded companies in the United States.

DTC retains the right to deny any issuer the ability to use their depository for any reason at their discretion without notice or explanation to the issuer. For this reason, before an issuer applies for eligibility, it must provide information to DTC concerning the original issue date of its free trading shares, the holders and transferees as well as the specific consideration provided for any free trading shares.

Issues that will quicken the DTC process are:

i. being an SEC reporting issuer and not missing or being late with any reports;

ii. having very few name changes or reverse splits;

iii. not having people associated with the issuer including stock promoters, lawyers or accountants that have been under investigation by the SEC;

iv. not becoming public as the result of a reverse merger with a public shell company;

v. having no record of being involved in a spam campaign, pump and dump scheme, or other fraudulent activities that would raise Anti Money Laundering or Office of Foreign Assets Control issues; and

vi. having no record of unregistered securities sales especially by affiliates.