Responding to questions that have been raised about the disclosure in IPOs by companies principally administered in emerging markets, including China, and the inability of US regulators to inspect auditors of companies administered in China and Hong Kong, Nasdaq has filed three proposed rulemakings with the SEC that would make its listing requirements more restrictive for companies principally administered in China and other emerging markets. The principal changes, if adopted, would include the following:
- Discretionary authority to deny listing based on specified criteria related to the company’s auditor, including if the auditor cannot be inspected by the US PCAOB. Under Nasdaq Listing Rule 5101, Nasdaq currently has broad discretionary authority to refuse to delist, or to delist, a company’s securities if in Nasdaq’s view such listing is inadvisable or unwarranted. As proposed, Nasdaq would be specifically entitled to utilize this discretionary authority to deny initial or continued listing, or to apply additional and more stringent listing criteria, to an applicant or a Nasdaq-listed company based on proposed specified criteria related to the company’s auditor, including whether the auditor has been subject to a PCAOB inspection, or where the auditor, or an accounting firm engaged to assist with the audit, is located in a jurisdiction that limits the PCAOB’s ability to inspect the auditor (e.g., China).
- Discretionary authority to apply additional listing criteria to companies administered in a “Restrictive Market.” As proposed, Nasdaq would be entitled to utilize its discretionary authority to apply additional and more stringent criteria to an applicant or a Nasdaq-listed company when the company’s business is principally administered in a Restrictive Market (a jurisdiction with secrecy laws, blocking statutes, national security laws or other regulations restricting access to information by regulators of US-listed companies).
- Companies from Restrictive Markets must have one officer or director with relevant US public company experience. As proposed, companies applying to list on Nasdaq which are principally administered in a Restrictive Market would be required to have, and certify that they will continue to have, at least one member of senior management or a director who has relevant past employment experience at a US-listed public company or other experience, training or background which results in the individual’s general familiarity with the regulatory and reporting requirements applicable to a US-listed public company under Nasdaq rules and federal securities laws or, in the absence of such an individual, that it will retain on an ongoing basis an advisor or advisors, acceptable to Nasdaq, that will provide such guidance to the company.
- IPOs of companies from Restrictive Markets must have proceeds which exceed the lower of $25 million and 25% of the market value of the listed securities. As proposed, any company that is seeking to list on Nasdaq in connection with its IPO, and that principally administers its business in a Restrictive Market, would be required to – in addition to Nasdaq’s other listing criteria – offer a minimum amount of securities in a firm commitment underwritten offering in the United States to public holders (holders other than officers, directors and 10% holders) that (i) will result in gross proceeds to the company of at least $25 million or (ii) will represent at least 25% of the company’s post-offering market value of listed securities, whichever is lower.
Nasdaq’s proposals come in the wake of:
- Nasdaq’s proposed delisting in May 2020 of Luckin Coffee, a Chinese company which went public on Nasdaq in 2019, and which was subsequently found to have made significantly misleading disclosures;
- the US Senate’s unanimous approval of a bill to require companies to be delisted from US exchanges if their auditors could not be inspected by the US PCAOB (principally Chinese and Hong Kong based companies); and
- recent statements by senior officials from the SEC and the PCAOB about the risks to investors of investing in securities issued by companies from emerging markets, particularly China.
Nasdaq’s proposals have been submitted to the SEC, but as of today have not yet been published on the SEC’s website. Accordingly, the proposals are subject to amendment, and as of today we cannot predict when and whether any or all of these proposals will be adopted.
Nasdaq’s discretionary authority – specified criteria related to auditors
Nasdaq currently has broad discretionary authority regarding the initial and continued listing of securities, in addition to the specific enumerated criteria in its rules. Under Nasdaq Listing Rule 5101, Nasdaq “has broad discretionary authority over the initial and continued listing of securities in Nasdaq in order to maintain the quality of and public confidence in its market, to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and to protect investors and the public interest. Nasdaq may use such discretion to deny initial listing, apply additional or more stringent criteria for the initial or continued listing of particular securities, or suspend or delist particular securities based on any event, condition, or circumstance that exists or occurs that makes initial or continued listing of the securities on Nasdaq inadvisable or unwarranted in the opinion of Nasdaq, even though the securities meet all enumerated criteria for initial or continued listing on Nasdaq.”
According to Nasdaq’s proposing release, Nasdaq believes that it may currently rely on this broad authority and discretion to deny initial or continued listing, or to apply additional and more stringent criteria, when the auditor of an applicant or Nasdaq-listed company (i) has not been subject to a PCAOB inspection (either historically or because it is newly formed), (ii) is an auditor that the PCAOB cannot inspect, or (iii) otherwise does not demonstrate sufficient resources, geographic reach or experience (including where a PCAOB inspection has uncovered significant deficiencies in an auditor’s conduct or system of quality controls).
However, Nasdaq proposes to codify specific factors that it may consider with respect to a company’s auditor when determining whether to use its broad authority with respect to initial and continued listing. As proposed, these factors would include:
- whether the auditor has been subject to a PCAOB inspection, such as where the auditor is newly formed or where the auditor or an accounting firm engaged to assist with the audit is located in a jurisdiction that has limited the PCAOB’s ability to perform inspections (e.g., China);
- if a PCAOB inspection has occurred, whether the results indicate the auditor failed to respond to any requests by the PCAOB or uncovered significant deficiencies in the auditor’s conduct in other audits or its system of quality controls;
- whether the auditor can demonstrate it has adequate personnel in the participating offices with expertise in applying US GAAP, GAAS or IFRS, as applicable, in the company’s industry;
- whether the auditor’s training program for personnel participating in the company’s audit is adequate;
- for non-US auditors, whether the auditor is part of a global network or other affiliation of individual auditors where the auditors draw on globally common technologies, tools, methodologies, training and quality assurance monitoring; and
- whether the auditor can demonstrate to Nasdaq that it possesses sufficient resources and geographic reach or experience as it relates to the company’s audit.
Nasdaq’s proposal indicates that it will consider these factors as a whole and that Nasdaq may be satisfied with an auditor’s qualifications despite concerns being raised with respect to some of the factors above. The proposing release states, specifically, that “Nasdaq may be satisfied that an auditor that is not subject to PCAOB inspection has mitigated the risk that it may have significant undetected deficiencies in its system of quality controls by being a part of a global network where the auditors draw on globally common technologies, tools, methodologies, training and quality assurance monitoring.”
In addition, the proposal provides examples of more restrictive listing standards which Nasdaq may impose, including (i) higher equity, assets, earnings or liquidity measures than otherwise would be required, (ii) a requirement that any offering be underwritten on a firm commitment basis, which typically involves more due diligence by an underwriter than a best efforts offering, and/or (iii) a requirement to impose lock-up restrictions on officers and directors.
Nasdaq’s discretionary authority – companies principally administered in Restrictive Markets
Nasdaq’s proposed rulemaking would also clarify that Nasdaq may use its discretionary authority with respect to initial or continued listing to impose additional or more stringent criteria in circumstances where a company’s business is principally administered in a “Restrictive Market” (i.e., a jurisdiction that Nasdaq determines to have secrecy laws, blocking statutes, national security laws and/or other laws or regulations restricting access to information by regulators of US-listed companies in such jurisdiction).
In determining whether a company’s business is principally administered in a Restrictive Market, Nasdaq may consider the geographic locations of the company’s (i) principal business segments, operations or assets, (ii) board and shareholders’ meetings, (iii) headquarters or principal executive offices, (iv) senior management and employees, and (v) books and records.
Nasdaq states it will consider these factors holistically and is conscious of the fact that a company’s headquarters may not be the office from which principal business activities are conducted. For example, a company may be headquartered in Country A, which is not a Restrictive Market, but have the majority of its employees, operations, senior management, assets and books and records in Country B, which is a Restrictive Market. In such cases, Nasdaq would consider the company’s business to be principally administered in Country B. This is particularly relevant for US-listed companies whose principal business activities are in China – such companies are generally organized in offshore jurisdictions such as the Cayman Islands but the majority of the company’s actual operations in China. Under the Nasdaq proposal, such entities would be considered based in a Restrictive Market.
Additional management qualification for companies from Restrictive Markets
As proposed, companies principally administered in a Restrictive Market which are filing for their IPO on Nasdaq would need to have, and certify to Nasdaq that they will continue to have, a member of senior management or a director with relevant experience at a US-listed public company or other experience, training or background enabling a general familiarity with the regulatory and reporting requirements applicable to a US-listed public company under Nasdaq rules and federal securities laws. Alternatively, such companies could also retain an advisor on an ongoing basis, acceptable to Nasdaq, that will provide such guidance.
Nasdaq’s proposal release states that the individual or advisor meeting this requirement is meant to be a resource to the company with respect to corporate governance requirements, SEC reporting obligations (including financial reporting obligations), internal controls, related party transactions, insider trading restrictions, whistle-blower protections and investor communications. Nasdaq notes this requirement would be in line with other global market policies (e.g., the Toronto Stock Exchange and Hong Kong Stock Exchange). Once a company becomes subject to this requirement in its IPO, it would become a continued listing requirement afterward. As proposed, the requirement would not apply to existing Nasdaq-listed companies. Companies that are subject to but not in compliance with this requirement would be obligated to disclose this non-compliance in order to apprise investors.
Additional listing requirement for companies from Restrictive Markets – lesser of $25 million and 25% of the market value
Under the Nasdaq proposals, a company principally administered in a Restrictive Market that is listing its primary equity security on Nasdaq in connection with an IPO must offer a minimum amount of securities under a firm commitment underwriting in the US to Public Holders (all shareholders other than officers, directors and 10% holders) that will result in the lower of (i) $25 million in gross proceeds to the company or (ii) a public float representing at least 25% of the post-offering market value of listed securities.
Nasdaq believes that this proposed requirement will help ensure there is sufficient liquidity, US investor interest and distribution to support price discovery. The firm commitment requirement and related book building process is similarly meant to foster a more robust and diverse investor base, generate broader interest and promote the fair and orderly trading of listed securities. Nasdaq also notes that offerings made on a firm commitment basis are generally subject to a higher order of due diligence than best-efforts offerings.
Discussing the reasoning behind this proposal, Nasdaq’s proposing release states that, “[l]ess liquid securities may be more susceptible to price manipulation, as a relatively small amount of trading activity can have an inordinate effect on market prices. The risk of price manipulation due to insider trading is more acute when a company principally administers its business in a Restrictive Market (a “Restrictive Market Company”) because regulatory investigations into price manipulation, insider trading and compliance concerns may be impeded. In such cases, investor protections and remedies may be limited due to obstacles encountered by US authorities in bringing or enforcing actions against the companies and insiders.”
In addition, the Nasdaq proposal provides that in connection with certain business combinations in which one of the parties involved is principally administered in a Restrictive Market, the listed company must have a minimum market value of unrestricted publicly held shares following the combination equal to the lesser of (i) $25 million or (ii) 25% of the post-combination entity’s market value of listed securities. The market value of unrestricted publicly held shares excludes securities subject to resale restrictions as such shares are not freely transferable and do not contribute to a security’s liquidity upon listing. The business combinations to which this proposal applies are reverse mergers and acquisitions by specialty purpose acquisition companies (SPACs). Nasdaq’s proposing release states that the proposed requirement would help ensure there are sufficient freely transferable shares and there is investor interest to support fair and orderly trading of the security when the target company principally administers its business in a Restrictive Market.
Finally, the Nasdaq proposal clarifies that a company principally administered in a Restrictive Market which is pursuing a “Direct Listing” is permitted to list on the Nasdaq Global Select Market or Nasdaq Global Market, provided that the company meets all applicable listing requirements of the relevant market. Companies principally administered in a Restrictive Market would not be permitted to list on the Nasdaq Capital Market in connection with a Direct Listing, despite otherwise meeting the applicable listing requirements. Direct Listings on the Nasdaq Global and Global Select Markets are currently required to comply with enhanced listing standards. As a result, Nasdaq believes that since a Direct Listing on these market tiers subjects companies to heightened listing requirements, it is appropriate to permit Restrictive Market Companies to engage in Direct Listings on such markets. However, the additional requirements for Direct Listings on the Nasdaq Capital Market are insufficient in Nasdaq’s view to overcome the concerns regarding adequate liquidity and investor interest regarding companies from Restrictive Markets and therefore Direct Listing by such companies on this market tier are not permitted.
Conclusion
Potentially the most significant of all these proposals is Nasdaq’s emphasis on retaining specific authority to refuse to list, or to delist, companies whose auditors cannot be inspected by the PCAOB. The Chinese government’s refusal to allow auditor inspections by the PCAOB has been a longstanding issue in Chinese IPOs, generally appearing as a risk factor in the IPO prospectus. The US Senate has recently passed a bill which would call on the SEC to require delisting if a company’s auditor could not be inspected by the PCAOB for three years, and the US House of Representatives has also introduced a companion bill.
The proposal to require a member of management or a director to have some US public company experience is similar in concept to the SEC requirement that an audit committee have an audit committee financial expert or disclose why it does not. The proposal has been carefully crafted to only apply to newly listing companies, not to existing companies. And Nasdaq also would allow newly listing companies to satisfy this requirement by hiring an advisor, if there is no officer or director with the requisite experience.
The proposal to raise at least $25 million is most relevant only to small cap companies contemplating an IPO. Significantly, the proposal is not necessarily requiring IPO proceeds of at least $25 million – the alternative prong would permit a public float representing at least 25% of the post-offering market value of listed securities even if IPO proceeds are lower than $25 million.
If you would like to discuss this post, please feel free to reach out to any of the authors or other US securities partners and counsel.
New York
- Valerie Jacob – valerie.jacob@freshfields.com
- Michael Levitt – michael.levitt@freshfields.com
- Pamela Marcogliese – pamela.marcogliese@freshfields.com
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Frankfurt
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Hong Kong
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Singapore
- Arun Balasubramanian – arun.balasubramanian@freshfields.com
