On November 8, 2011, the SEC approved requests by the Nasdaq Stock Market, New York Stock Exchange and NYSE Amex to adopt additional initial listing requirements that would make it harder for companies that go public through a reverse merger or similar transaction (“Reverse Merger companies”) to become exchange listed, or to “uplist.” Specifically, the new requirements would prohibit a Reverse Merger company from listing its shares on all three major U.S. stock exchanges until:
- The company (i) has completed a one-year pre-listing “seasoning period” by trading in the U.S. over-the-counter market or on another regulated U.S. or foreign exchange following the reverse merger and (ii) has timely filed all required reports with the SEC (essentially requiring at least one full fiscal year of the Reverse Merger company’s periodic reports, including a Form 10-K with audited historical financial statements), and
- The company has maintained the requisite minimum share price ($4 in the case of Nasdaq and the New York Stock Exchange and $3 for NYSE Amex) in the over-thecounter market for a sustained period, and also for at least 30 of the 60 trading days immediately prior to submitting its listing application and the exchange’s decision to approve the application for listing (to counter any temporary effect of artificial stock manipulation or a company’s reverse stock split).
The new listing requirements would not apply to a Reverse Merger company’s listing application if (i) the listing is in connection with a firm commitment underwritten public offering providing gross proceeds to the company of at least $40 million or (ii) the reverse merger occurred five or more years before applying to list so that at least four annual reports on Form 10-K with audited historical financial information have been filed by the company with the SEC following the one-year trading period.
Background to the Rule Changes
According to the SEC’s release (No. 34-65708), the exchanges requested these additional listing requirements because:
- “[t]here have been widespread allegations of fraudulent behavior by Reverse Merger companies, leading to concerns that their financial statements cannot be relied upon;”
- “it appeared that promoters and others intended to manipulate prices of Reverse Merger companies’ securities higher to help meet Nasdaq’s initial listing bid price requirement;” and
- “companies have gifted stock to artificially satisfy Nasdaq’s public holder listing requirement.”
Prior to the SEC’s approval of the exchanges’ rule changes (which approval is required by the Securities Exchange Act of 1934, as amended), the SEC published the proposed rule changes in May 2011, and again in July 2011 with minor revisions, for public comment.
The comments generally fell into three groups:
- Virtually all of the suggestions of recent wrongdoing involve Chinese companies that completed reverse mergers, but that a number of other Chinese companies that completed full traditional IPOs face the very same allegations, so that focusing on the manner in which these companies go public is not necessarily indicative of abuse.
- Because the IPO markets have been so difficult for smaller capitalization issuers during the past four years, the proposals for enhanced listing standards will discourage these companies from pursuing reverse mergers, the only other practical way for them to obtain the benefits of public listed stock to expand their businesses.
- Nasdaq and the other exchanges already have extensive screening processes in which regulatory histories, review of financial arrangements and background checks are used to identify potential corporate frauds and there are no empirical data that support the notion that Reverse Merger companies bear additional scrutiny (and alternatively, Nasdaq could require a special independent forensic audit prior to listing if added diligence would be appropriate in certain instances).
SEC Approval of the Rule Changes
In deciding to support the exchanges’ rule changes, the SEC found that the underlying reasons for the changes were consistent with the overall mission of the exchanges — to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and to protect investors and the public interest. The SEC supported the exchanges’ right to “provide listed status only to those that are bona fide companies with sufficient public float, investor base, and trading interest likely to generate depth and liquidity sufficient to promote fair and orderly markets.”
More specifically, the SEC indicated that the one-year seasoning requirement for Reverse Merger companies before listing on a national securities exchange is reasonably designed to address concerns that the potential for accounting fraud and other regulatory issues is more pronounced for Reverse Merger companies, and that the additional initial listing requirements will assure that a Reverse Merger company has produced and filed with the SEC at least one full year of audited financial statements following the Reverse Merger transaction, which will improve the reliability of those reported results. The SEC also indicated that being quoted for at least one year in the over-the-counter market could make it more likely that analysts have followed the company to provide an additional check on the validity of the company’s financial and operating information.
The SEC did not find persuasive the argument made by some commentators that the proposals would inhibit capital formation by small companies, noting that the new rule “merely requires those entities to wait until their first annual audited financial statements are produced.”
As to the requirement for a Reverse Merger company to maintain the specified minimum share price for a sustained period, the SEC again explained that the new rules are reasonably designed to address concerns that the potential for manipulation of the stock to meet the minimum price requirements is more pronounced for Reverse Merger companies. The SEC also supported the exchanges in determining the “sustained” period of time for evaluating the minimum price requirement based on the trading volume, frequency of trading and trend of the company’s stock price.
Finally, the SEC found that the rule exclusions for a $40 million firm commitment underwritten public offering at or about the time of listing or the filing of at least four annual reports with the SEC “reasonably accommodate[s] issuers that may present a lower risk of fraud or other illegal activity.” In determining the level of such a public offering, the SEC noted that only with a “sizeable” underwritten public offering does an issuer undergo the due diligence and vetting required to warrant the same treatment as issuers that were not formed through a reverse merger.
Implications of the Rule Changes
Over the last several years, Nasdaq and the other exchanges had already informally adopted the new "seasoning period" and minimum share price trading requirements. Nasdaq routinely required Reverse Merger companies to file with the SEC at least one Form 10-K with audited financial statements covering periods subsequent to the reverse merger and would typically discount any stock price where only a small percentage of the company's shares were freely tradable. Of all the new rules, perhaps the $40 million firm commitment underwritten public offering requirement has created the most concern in the reverse merger community, especially smaller investment banking firms that have assisted companies with re-IPOs after their reverse mergers. Some of the most promising growth companies have attracted underwriters to conduct public offerings, often in the range of $20 million to $30 million. It is uncertain whether these transactions can now be accomplished in the over-thecounter market or whether typical offering sizes can be increased to meet the new listing requirements. The new rules also have the potential of tainting even traditional IPOs by smaller companies that raise less than $40 million in gross proceeds.
Because Reverse Merger companies will be deprived of the liquidity, transparency and perception of quality accorded exchange listed companies (in part due to stock exchange policies requiring independent board members, board committees and other corporate governance safeguards not required in the over-the-counter market), the owners of privately-held companies may be more reluctant to engage in a Reverse Merger. For the same reasons, new investors (investing either concurrently with or following the Reverse Merger in a PIPE transaction) will be harder to attract, thus making it more difficult to fund the growth of these companies. Similarly, the shares of Reverse Merger companies will be less useful as a currency to acquire other businesses and a lack of liquidity will make the stock less attractive to employees as a form of equity compensation. Regardless, the new listing requirements will have a substantial impact on these transactions and may discourage Reverse Merger activity, particularly during periods when the traditional IPO market window is closed.
The SEC's approval of the exchanges' additional listing requirements for Reverse Merger companies reflects a dichotomy within the SEC where the Division of Enforcement has actively sought out accounting fraud among smaller public companies since last summer while the Division of Corporation Finance has sought to address Congress' desire to encourage small business capital formation. In the meantime, Congress appears poised to pass the Small Business Capital Formation Act which is designed to make it easier for small businesses to obtain public capital by, among other things, increasing the threshold for offerings exempted from SEC registration under Regulation A from $5 million to $50 million. If this legislation is adopted by the Senate (having already overwhelmingly passed the House), reverse merger transactions may be further sidelined.