NASDAQ Proposes Enhanced Requirements for Reverse Merger Companies
In the past two months, the securities of more than a dozen Chinese companies listed on US exchanges have been halted or delisted as a result of allegations of fraud, accounting irregularities or other regulatory concerns. Almost all of these companies became public companies in the US by completing a reverse merger, a transaction by which an existing public company (which often engages in little to no active business) acquires all of the equity of another company in return for a negotiated percentage of the public company’s stock. In so doing, the private company’s shareholders generally own a substantial majority of the public company post-merger. While reverse mergers are not inherently problematic and a number of reputable Chinese companies have used them to restructure in preparation for listing in the United States, they have been disproportionately used by fraudulent Chinese companies.
In a speech on March 5, 2011, Luis Aguilar, Commissioner of the Securities and Exchange Commission (SEC), criticized the use of reverse mergers of private companies into public trading shells as “a disturbing trend that seems to have challenging implications for capital formation and investor protection.” On April 18, 2011, The NASDAQ Stock Market LLC (NASDAQ) filed a proposed rule change with the SEC designed to impose additional listing requirements on companies that become public through reverse mergers. Proposed Rule 2011-056 (the “Reverse Merger Rule”) could complicate the listing process and significantly lengthen the time it takes to uplist to NASDAQ.
Mechanics of the Reverse Merger Rule
The Reverse Merger Rule would apply to NASDAQ listing applications for all companies that are “formed by a combination between a private operating company and a public shell company,” other than listing applications in connection with “a firm commitment, underwritten public offering.”
Where the Reverse Merger Rule applies, a company seeking to list on any NASDAQ exchange must meet the following requirements beyond those applicable to non-reverse merger companies:
- The company’s stock must trade for at least six months after the completion of the reverse merger and filing with the SEC of audited financial statements for the post-merger combined entity. During this six-month period, the stock must trade on “the over-the-counter market, another national securities exchange, or on a listed foreign market.” The “pink sheets” would not meet this requirement.
- The company’s stock must maintain a bid price of at least $4.00 per share on at least 30 of the 60 trading days immediately preceding the filing of the initial listing application.
- The company must “timely file” six months worth of financial statements following the reverse merger. For domestic issuers (the shell was a US entity or the company is a smaller reporting company that elects to file on domestic forms), this requirement means that the issuer has filed at least two periodic financial reports (Forms 10-Q and/or 10-K). These reports would be considered timely if they are filed within the time required, including any extensions. For foreign private issuers (the shell is not a US entity and the company has not voluntarily elected to file on domestic forms), this requirement would impose an obligation to file financial statements for a period of not less than six months. Foreign private issuers are required by the SEC to file an annual report six months after the end of the fiscal year but not quarterly reports; NASDAQ further requires, under Listing Rule 5250(c)(2) that a company file on Form 6-K an interim report including balance sheets and income statements for the first half of the fiscal year within six months after the end of the second quarter.
Implications of the Reverse Merger Rule
As mentioned above, the Reverse Merger Rule does not apply to all listing applications by reverse merger companies. By carving out firm commitment, underwritten offerings, NASDAQ has acknowledged that such offerings “are more similar to IPO’s, in that the SEC reviews the registration statement and the underwriters and other experts are strictly liable under the federal securities laws for any misstatements.” As currently written, the Reverse Merger Rule would not exempt best efforts offerings, Dutch auction offerings, resale offerings by existing shareholders (which sometimes follow a private round of financing) or any type of offering other than the traditional firm commitment offering. While a number of strong public companies have listed by methods other than firm commitment offerings (Google’s Dutch auction offering for example) and while underwriters and other experts have liability without regard to whether a public offering is structured as a firm commitment offering the market tends to see firm commitment offerings as involving significant due diligence.
Although the Reverse Merger Rule by its terms does not apply to firm commitment, underwritten offerings, companies would be wise not to read too much into that distinction. The Reverse Merger Rule simply creates an objective barrier to application for reverse merger companies that do not apply in connection with a firm commitment, underwritten offering. It does not, however, prohibit NASDAQ from considering the very same issues for other applicants under NASDAQ’s “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.” The discretionary authority, described in NASDAQ Listing Rule 5101, permits denial of initial applications even when the securities otherwise “meet all enumerated criteria for initial […] listing on NASDAQ.” We would expect, for example, that combining a small firm commitment, underwritten offering with a large resale offering by existing shareholders of a company would not shield the offering from NASDAQ’s analysis under the principles of the Reverse Merger Rule. Instead, NASDAQ’s denial simply might cite Listing Rule 5101, rather than the new sections, Listing Rules 5110(c) and 5210(i).
The most immediate effect of the Reverse Merger Rule is to require that a reverse merger company demonstrate that it is ready to operate as a public company before NASDAQ will accept its application. In the absence of the SEC scrutiny and underwriter due diligence present in underwritten public offerings, NASDAQ has proposed a rule that will require that the company operate and trade as a public company for a significant amount of time. Late filings of periodic reports will no longer merely affect public perception of management’s capabilities; they will delay a listing application. Although the current language of the Reverse Merger Rule is silent about whether a domestic issuer needs to timely file two consecutive periodic filings, the use of the phrase “a period of not less than six months” for foreign private issuers suggests that a similar six month period should apply to domestic issuers. We expect that this matter will be clarified in the final rule.
The six-month seasoning period and minimum stock bid price combine to reduce the likelihood that fraudulent companies list on NASDAQ. The extended $4.00 bid price is designed to prevent quick, manipulative trading schemes that briefly cause the stock price to exceed $4.00. Companies tend to have relatively thin trading shortly after completion of a reverse merger into a shell corporation. For this reason, the effort required to maintain a $4.00 bid price through manipulation would likely become apparent upon the Financial Industry Regulatory Authority’s (FINRA) review of trading patterns over this six-month seasoning period. While the minimum bid price requirement technically only applies to 30 of the 60 days immediately prior to the listing application, a sudden uptick in trading only in the window immediately before the listing application would make it even easier for FINRA to detect improper patterns.
In addition, for existing shareholders of the pre-merger shell, a $4.00 bid price might well be an attractive inducement to sell, so maintaining that bid price could prove to be expensive for would-be manipulators. Such a bona fide bid price differs dramatically from the nominal bid prices for many Chinese reverse merger companies prior to preparation for uplisting. In addition to protecting against manipulation, the six-month seasoning period gives the post-merger company time to operate under public scrutiny. The company will need to work with its auditor on an ongoing basis, which should give the auditor several chances to review financial statements. Internal controls put in place to help the formerly-private company meet its new obligations as a public company will have several months to take hold and improve the company’s reporting quality. In short, the Reverse Merger Rule seems designed to improve the quality (from a disclosure perspective) of companies it reviews for listing decisions.
As of the date of the proposed Reverse Merger Rule, only NASDAQ has proposed such requirements for reverse merger companies. The NYSE and NYSE Amex have not yet proposed similar rules. That being said, in light of the impact of the recent spate of fraud reports, we would be surprised if the other exchanges failed to act. While we understand that the Reverse Merger Rule will likely make it more difficult for some smaller Chinese companies to have their stock listed on NASDAQ, we view the Reverse Merger Rule as a long-term positive for Chinese companies looking to list their stock in the United States. The Reverse Merger Rule promises to give NASDAQ additional tools to improve the integrity of the Chinese companies on its market by reducing the likelihood that the most speculative ventures even apply, a tremendous benefit for investors and Chinese companies alike.
The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2022.