Less than two months after the PCAOB and the China Securities Regulatory Commission and Ministry of Finance signed a Statement of Protocol reaching a tentative deal to allow the PCAOB to fully inspect and investigate registered public accounting firms headquartered in mainland China and Hong Kong, Nasdaq effectively halted all small-cap IPOs with a China connection. This time, the issue is not audit-related.
During the week of September 19, one of our clients had a deal ready to be priced and begin trading on Nasdaq. We had thought we cleared all comments when a call came from our Nasdaq reviewer – all small-cap IPOs were being temporarily halted while the Exchange investigated recent volatility. The same day, an article came out on Bloomberg reporting on 2200% price swings (up and then steeply back down) on recent IPOs involving companies with ties to China – a repeat of similar volatility in the late ’80’s and early ’90’s despite three decades of market advances.
In the months that followed, the Exchange and market participants have taken baby steps towards reopening business. As part of the progress, the Exchange has asked detailed questions about investors, indications of interest, syndicate members, lock-up agreements, allocations and importantly, the location of all participants. Although the same level of information is being asked of all small-cap entities only a few deals, those without either operations or investors in China, have moved forward and completed their IPOs (or uplisting).
Early information requests include pre-pricing indications of interest and potential syndicate members. After a deal is priced, but before it starts trading, investment banks must provide a full list of syndicate firms being allocated shares during the IPO. But once the deal starts trading, Nasdaq also wants the list of investors that received shares directly from both lead underwriters and syndicate firms, although it will accept that information after the shares start trading. From my own experience, there is at least one Asia-based syndicate member that Nasdaq will flat out not allow to participate in deals.
On October 22, 2022, the Wall Street Journal published an article titled “Nasdaq Freezes Chinese Small-Cap IPOs After Price Spikes” reiterating what insiders already knew: “[T]he Nasdaq Stock Market has quietly halted listings of small-cap Chinese companies, holding up approval letters and demanding more information about related parties in deals, after a series of meteoric run-ups—and dramatic collapses—in IPOs this year.”
In addition to the extraordinary information requests, market participants are grappling with small but significant changes to the IPO closing process. Typically in an IPO process, the company files an 8-A to register with a national securities exchange such as Nasdaq, Nasdaq files its acceptance certification approving the company either the same or next day and the SEC declares the IPO registration statement effective thereafter (usually the next day). Effectiveness of the SEC registration statement is the last regulatory step, and the underwriters usually price the same day/night. Since an 8-A is not effective until both the Nasdaq certification and SEC registration effectiveness are complete, this sequence of event ensures that a company does not become subject to SEC filing requirements unless the IPO is closing.
There are many reasons for this sequence of events, including that neither the company nor the underwriter want the IPO registration statement to go effective unless and until, the company has been approved to trade on Nasdaq (or other national exchange). In recent weeks, the few deals that have been allowed to move forward, have been required to have the SEC declare their IPO registration statement effective, prior to Nasdaq certifying approval to trade on the exchange.
From a legal perspective, this means that the company has an effective registration statement and has become subject to SEC reporting requirements prior to being sure the exchange will certify them for trading. As a result, practitioners have added conforming language, including risk factors, to the IPO registration statement and updates to the underwriting agreement. From a practical standpoint, the requirements related to additional investor information (both before and after pricing) and the change in sequence of events, have added a complexity to securing the IPO funds and closing the deal.
Nasdaq hasn’t announced any official changes to its listing rules or policies, but both Nasdaq and the NYSE as well as FINRA issued regulatory notices on November 17, 2022, generally focused on underwriters. Neither the Nasdaq or NYSE release mentions China, but the focus has been clear to all practitioners during this difficult process and FINRA is much more direct. The NYSE has not had an official or even unofficial moratorium on listings, but clearly is aligned with its competitor and fellow regulator.
The Nasdaq release begins by noting the extreme price volatility in recent small-cap IPOs creating concern that the pattern “negatively impacts the ability of the securities markets to operate in a fair and orderly manner, to the detriment of investors.” Turning to the underwriter as gatekeeper, Nasdaq notes that it is their responsibility to “select the selling syndicate and ensure that the shares are placed in a way that is reasonably designed to allow liquid trading, consistent with Nasdaq’s listing requirements, and the successful introduction of the company to the marketplace.”
In addition to reminding underwriters of their due diligence obligations and that they are indeed under increased regulatory scrutiny, the Nasdaq release lists questions for underwriters to consider, including:
- Do the total offering amount and target price per share reflect market supply and demand? Is there more diligence the underwriter should conduct to ensure that the float proposed by the issuer is sufficient to ensure fair and orderly trading?
- Who are the selling shareholders and what is their relationship with the issuer or entities or individuals to whom shares are allocated?
- Are the terms and conditions of lock-up agreements reasonable? What additional diligence should be conducted to ensure that those lock-up agreements are not circumvented? Will the lockups contribute to an illiquid market in the company’s shares?
- Are shares allocated broadly, in a way that ensures liquidity is sufficient to encourage, rather than inhibit, price discovery? What more diligence can be conducted to ensure the entities and individuals to whom shares are allocated are not restricted from trading them, thereby potentially causing the price to artificially increase due to lack of supply?
- Will shares allocated outside the United States be immediately freely tradable or will they be subject to clearing or other logistical delays?
- Are the IPO’s terms and conditions fair and reasonable?
- Does the underwriter have any conflicts of interest with the IPO and, if so, have they been clearly disclosed?
- When releasing the security for trading in the IPO cross, is the underwriter confident that sufficient liquidity exists to ensure price stability?
- Once the IPO begins trading, is the underwriter fulfilling its obligation for price stabilization?
- What can the underwriter learn from prior IPOs that experienced unusual price movements? Is the underwriter making process improvements to mitigate the risk that an upcoming IPO will trade in a similar fashion?
The NYSE release is substantially similar though also noting that NYSE trades using an auction model with Designated Market Makers (DMM), which is different than the purely electronic Nasdaq trading model. The NYSE release also contains a list of questions but rather than directed at underwriters, its list is related to listing applications in general. In particular:
- whether the proposed size of the offering and disclosed price range are appropriate in light of the potential market for the offering and the issuer’s likely public market value;
- the nature and scale of the selling efforts being undertaken in connection with the IPO;
- the anticipated public demand for the offering and whether there are other recent comparable transactions;
- whether the underwriting group or syndicate includes foreign broker-dealers and the percentage of the offering that is anticipated to be placed outside the United States;
- whether the underwriter has experience successfully marketing an IPO of the proposed size and type in the United States;
- whether the issuer and any of the underwriters are under common ownership or otherwise affiliated with each other;
- whether there are any relationships between the issuer (and its affiliates) and investors receiving allocations in the offering;
- the percentage of the pre-IPO shares that will be subject to lock-up agreements and the terms of those agreements;
- whether the shares will be allocated broadly or whether there will be significant concentrations in the allocations of the offering;
- whether the underwriter has any conflicts of interest with respect to the IPO, and, if so, whether they have been clearly disclosed;
- whether the underwriter is confident that sufficient liquidity will exist to ensure price stability when the security is released for trading in the IPO cross;
- whether the underwriter is prepared to make appropriate efforts to fulfill its price stabilization obligations after the IPO has been priced;
- comparisons to prior IPOs that experienced unusual price movements; and
- whether the underwriter is taking appropriate efforts to mitigate the risks of unusual price movements in upcoming IPOs.
As an aside, related to the auction method, the DMM reports all bids and asks into the marketplace, quoting the National Best Bid and Offer (NBBO) a required minimum percentage of time, and sets the opening price of its assigned securities each day. The opening price may be different than the prior day’s closing price due to after-market trading or any other factor that affects supply and demand.
In other words, the DMM is an intermediary between the broker/dealer/market participants and the execution of trades themselves. It is thought that using a DMM will increase trading liquidity and volume, because the DMM is motivated to match buyers and sellers and fulfill trading requests by either using its own inventory of the security or finding broker-dealers with matching orders. A DMM may even solicit a broker-dealer to act as the counterparty to a requested trade.
NASDAQ does not have the auction or DMM model. Rather, NASDAQ relies on market makers. Market makers must quote both a firm bid price and firm ask price they are willing to honor. Each NASDAQ security has multiple market makers (generally at least 14) competing for trades and helping to ensure that the bid-ask spread is low and that supply and demand results in the best execution prices.
FINRA’s publication is in the form of an official Regulatory Notice to Members, titled “Heightened Threat of Fraud.” FINRA is more blunt, warning members of “pump-and-dump-like schemes” “most of which involve issuers with operations in other countries.” The release continues directly pointing at issuers with operations in China and foreign broker-dealers primarily based in Hong Kong. The foreign broker dealers usually request a significant allocation in a deal (up to 90%) which allocation is for a small group of investors.
FINRA believes the perpetrators are utilizing nominee accounts and social media scams. The FINRA release provides detailed red flags for U.S. firms to review indicating potential nominee accounts or other pump-and-dump related behavior. Underwriters are squarely in the bull’s-eye. The release reminds them that the due diligence defenses in Sections 11 and 12 of the Securities Act for the disclosures in registration statements are only as solid as the due diligence itself, including reactions to red flags or other indicia of fraud. Moreover, as these issues are emanating from foreign nationals, the release reminds member firms of their anti-money laundering (AML) obligations.
As an eternal optimist, I am hopeful that the IPO market will open back up, and that the bad actors will move on to their next scheme now that the easy money window is closed. However, as of today, the weekly Nasdaq IPO calendar remains empty, as it has each week for the last 2 months.
Laura Anthony, Esq.
Anthony L.G., PLLC
A Corporate Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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