New Nasdaq Listing Requirements
By Louis Corrigan (RgeSeymour)
Nasdaq is now busy cleaning house. After a rather embarrassing year that proved it wasn't quite ready to be the "stock market for the next 100 years," Nasdaq has begun taking the necessary steps to bolster its reputation in the eyes of investors who found they had reason to question the market's integrity.
Changes implemented on January 20th promise to improve the handling of investors' orders, making the market more competitive and likely reducing prices that investors pay for stocks. The new system addresses concerns raised by the U.S. Justice Department's findings, made public last July, that 24 of Nasdaq's largest market makers had colluded to fix prices on Nasdaq listed stocks. That highly publicized case led to the creation of the National Association of Securities Dealers-Regulation (NASDR), an independent body that's now engaged in the self-regulating that the supposedly self-regulating NASD had failed to accomplish.
More changes are now on the way. On Tuesday January 28th, the National Association of Securities Dealers accepted a series of proposals made by the Nasdaq Stock Market to strengthen the listing requirements for stocks trading on Nasdaq's National Market or SmallCap Market. The new rules, which must still be approved by the Securities and Exchange Commission (SEC), will raise asset and minimum bid requirements for companies on both markets. They will also ensure that SmallCap companies adopt the same baseline corporate governance standards that apply to National Market firms.
Nasdaq estimates that 175 of the more than 4,147 companies on the National Market and 400 of the more than 1,409 SmallCap companies will be affected by the proposals. Some of these companies could eventually be knocked down to the SmallCap Market or the OTC Bulletin Board, if they fail to comply with the tougher requirements.
Listing standards for the National Market and SmallCap Market were last updated in 1989 and 1991, respectively. So it's certainly time for some modifications. The real impetus for the changes comes from the fact that more individual investors have turned to Nasdaq-listed companies looking for growth. They've sometimes found that the Nasdaq brand name doesn't necessarily mean quality.
That's hardly a surprise given Nasdaq's aggressive bid to build market share. As of December, the market now lists 6,384 companies, up from just 4,800 in 1992. Yet as a simple matter of good business, Nasdaq needs to ensure a modicum of legitimacy among its listed stocks or risk alienating investors. For a market that has too often worked alternately to appease dealers and its listed corporate customers, Nasdaq has finally woken up to the notion that a successful brand depends on the consumer -- that is, the retail investor.
Nasdaq's November 15th Bulletin put it this way. "Nasdaq recognizes that along with this growth and the changes in the market, there also is an obligation to maintain a commensurate level of quality and protection for investors. Nasdaq believes it is extremely important not only to ensure that all Nasdaq companies warrant listing by virtue of their compliance with the applicable qualification requirements, but also that the qualification requirements themselves are in fact appropriate and designed to foster the protection of investors."
Indeed, the ghost of COMPARATOR SYSTEMS (formerly NASDAQ SMALLCAP: IDID) rightfully haunts Nasdaq. The new rule changes represent the market's most concerted effort at an exorcism.
The California-based technology company claimed to have mastered the art of fingerprint identification, but Comparator had really just mastered the art of turning hype into blank checks for investors to sign. The company issued hundreds of millions of shares without ever producing meaningful revenues. The Comparator hit the fan last May when the stock briefly soared from pennies per share to $2 on record Nasdaq volume before then disintegrating in midair. This classic scam signalled speculative frenzy in the market even as it proved a debacle for Nasdaq, despite some quick action after-the-fact from market regulators and the SEC.
Rep. John Dingell, the ranking Democrat on the House Commerce Committee, later noted in a letter to the SEC, "The facts in this case raise serious questions about how Comparator was able to meet Nasdaq's listing requirements." The stock was finally delisted from the market in June after trading was halted. By then, individual investors had collectively lost millions.
Nasdaq's new listing standards aim to make such disasters less likely to happen. Though there are several alternative criteria for listing on the National Market, the proposed entry and maintenance standards will be raised, generally, above some minimum equirements. For example, the minimum level of net tangible assets (or total assets less total liabilities and goodwill) required for a company to qualify for listing will increase from $4 million to $6 million. Depending on whether or not a company has suffered recent losses, a firm can currently maintain that listing with as little as $1 million in net tangible assets. The new rules will require a company to maintain at least $4 million in net tangible assets.
Similarly, entry to the National Market would soon require a company to have at least 1.1 million shares in public hands versus the current 500,000 minimum. And those shares must have a value of at least $8 million rather than the current minimum $3 million. To maintain a listing, a company would need to have at least 750,000 shares, valued at $5 million or more, in the public float. The current rules require only that the public should hold at least 100,000 shares with a market value of $1 million.
The proposed changes would have even greater impact on the SmallCap Market. That market currently has no requirements for initial net tangible assets, net income, or market capitalization. The proposed changes would require $4 million in net tangible assets or $750,000 in net income in 2 of the last 3 years or a market capitalization of at least $50 million. These tougher criteria would supersede the current rules which allow a company to be listed as long as it has $4 million in total assets and $2 million in total equity. To maintain a listing, companies would need to have at least $2 million in net tangible assets or $500,000 in net income in 2 of the last 3 years, or a market cap of at least $35 million.
Similarly, entry to the SmallCap market would require a company to have at least 1 million shares in the public float valued at $5 million or more, a significant increase over the current 100,000 share and $1 million market cap minimum. The maintenance standards would also increase five-fold to a minimum public float of 500,000 shares valued at $1 million or more.
In addition to these stricter capitalization requirements, all Nasdaq companies would now need to meet the minimum $1 bid requirement. If a company's stock trades below $1 a share for 30 days, the company would have 90 days to get the stock above $1 or risk being delisted. Previously, SmallCap companies could skirt this issue if they had stock in the public float valued at $1 million or if they had capital and surplus equal to $2 million.
National Market companies trading below $1 per share could also satisfy the alternative standard of $3 million in the value of the public float and net tangible assets of $4 million. Nasdaq's new emphasis on the minimum bid requirement represents an admission that true penny stocks are readily subject to the kind of manipulation and volatility that can damage the public's confidence.
These requirements now approach those of the New York Stock Exchange (NYSE). To qualify for the NYSE, a company must have at least $2.5 million in earnings before taxes for the most recent year and at least $2 million in pre-tax earnings for the preceding two years. Alternately, a company could have $6.5 million in aggregate pre-tax earnings over the past 3 years with at least $4.5 in the preceding year, with the company showing pre-tax profits in all 3 years. A company must also have $40 million in net tangible assets. Market value requirements are indexed to the NYSE Composite Index; the current minimum is $40 million. The public must own at least 1.1 million shares of the common stock.
To maintain a listing on the NYSE, a company must, among other things, have at least 600,000 shares in the float, with a minimum market value of between $2.5 and $5 million, depending on market conditions. But the NYSE also adds an instructive qualifier. "The appropriateness of a continued listing of a security on the NYSE cannot be measured mathematically. The NYSE may at any time suspend or delist a security where continued dealings in the security are not considered advisable, even though a security meets or fails to meet any specified criteria." If this is paternalism, so be it.
Perhaps more important than Nasdaq's new quantitative requirements are the proposed improvements in corporate governance standards for SmallCap stocks. Essentially, these companies must catch up to the bare minimum governance strictures already accepted by National Market companies.
These include a minimum of two independent directors; an audit committee with a majority of outside directors; an annual shareholders meeting; and shareholder approval for various corporate actions such as the issuance of common stock equal to 20% of shares outstanding or a change of corporate control. Indeed, it's shocking that any market has listed public enterprises that lack such basic internal checks on management.
"It's about time," said Nell Minow about the new proposals. Minow is a principal at Lens Inc., an investment firm based in Washington, D.C. noted for its concern for corporate governance issues. She served on a recent commission on standards for corporate boards. In a phone interview, Minow said that independent directors are the key to holding management accountable to shareholders and that both a firm's audit and compensation committees should be composed solely of such outside directors. Minow also said a recent study showed that strong corporate governance can add 11% to a stock's value.
Nasdaq defines "independent director" as "a person other than an officer or employee of the company or its subsidiaries or any other individual having a relationship which, in the opinion of the board of directors, would interfere with the exercise of independent judgment." Such independent directors ensure that the board lives up to its fiduciary responsibilities to investors.
As a further check on management and the board, Nasdaq is also considering requiring auditors of Nasdaq-listed companies to subject themselves to peer review under a program established by the American Institute of Certified Public Accountants. Such a program would have made it difficult for Comparator to cook its books for years on end.
Nasdaq's new standards represent an important step in the right direction. But even if approved, they probably won't take effect for another six months to a year, according to Nasdaq spokesperson Reid Walker.
"First it went to the Nasdaq board. They passed it on to the NASD board who then approved it. Now it has been sent on to the SEC. And now it's on their timetable, which involves their review, their publishing it for comment in the Federal Register, and then if there are any changes that need to be made, coming back to us with recommendations and then an implementation time line
The SEC's public comment period lasts 21 days. The Commission then has at least 14 days to make a decision on the proposal. In turn, Nasdaq might need to respond to any proposed amendments before the SEC would ultimately sign off on the plan. Nasdaq would then need to communicate with the listed companies.
"There would be an educational period first of all just telling them about the new standards," Walker said. "Then there would be a grace period, which has not been determined at this point, for allowing them to meet those standards. Once that is passed, then action would be taken to either delist them or move them up or down on the market."
Walker said Nasdaq would probably publish the list of companies that risked being delisted under the new requirements so that investors would know well in advance of any potential Nasdaq action. He also said he doubted that any companies would be downgraded from the National Market all the way to the OTC Bulletin Board, though he agreed that such a move would create a possible liquidity crunch on any stock so affected.
Minimum bid and capitalization issues could be "a major issue for some companies," he said. "But we don't have stats at this point breaking down whether they're going to be affected more by the
governance standards or the listing standards."
A majority of companies that fall below the proposed minimum standards would likely be able to comply simply by bringing outside directors onto the board. Others threatened by the minimum bid
criterion could orchestrate a reverse stock split. Nasdaq frequently allows companies to comply with the bid requirement in this way.
K. David Kim, CFO for San Jose-based TELEVIDEO SYSTEMS INC. (NASDAQ: TELV)(N) (S) seemed unconcerned with the new proposal, despite that fact that TeleVideo shares have traded below $1 a share since last June. He said the company has a new strategy for 1997 that he thinks will send TeleVideo shares over $1 by the third quarter.
C. Kirk Bosche, CFO at the Houston-based mining and crude oil company GARNET RESOURCES (NASDAQ: GARN) (N) (S) said he had recently spoken with Nasdaq officials, who told him that companies would have six months to comply with the new proposals once they were approved by the SEC. Garnet shares have traded below $1 for most of the past year. He said that if a new oil discovery didn't boost the shares above that level, that the company would consider a reverse stock split. Bosche said he thought the new listing requirements were reasonable and would be good for Nasdaq.
Indeed, though the proposals have yet to endure a thorough public vetting, few have stepped up to criticize the changes. An article in the November 15th issue of The Financial Times suggested that
stiffer requirements may undermine Nasdaq's role as a source of capital for young entrepreneurial companies. Indeed, Europeans have recently tried to counter the competitive advantage Nasdaq provides American entrepreneurs, especially in high-tech businesses, by creating the Easdaq, or a European knock-off of Nasdaq, to help even out those differences.
The Times quoted David Golden, head of mergers and acquisitions at San Fancisco-based Hambrecht & Quist, a firm specializing in raising public capital for companies in the technology sector. "There's no doubt that the higher threshold will undermine the efforts of small companies to gain access to the capital markets," Golden said. "What has distinguished the US capital markets historically has been their ability to provide growth capital."
Both Golden and the Times worried that the OTC Bulletin Board simply could not provide the liquidity needed to fuel the capital requirements of young growth companies.
Neither Golden nor the head of Hambrecht & Quist's investment banking business could be reached for comment. But the worry seems overblown in an era when recent studies show venture capitalists have never before been so well financed. Hambrecht & Quist itself doesn't generally touch such small enterprises either. Besides, there ought to be some reasonable cut-off point for determining that a company is simply too small to merit access to public capital. Nasdaq's more stringent new listing requirements do seem to hit the mark.
A more fundamental concern is whether Nasdaq will adequately enforce whatever guidelines it establishes. For example, Foolish investors who have followed the saga of removable disk drive maker SYQUEST (NASDAQ: SYQT) (N) (S) say that Nasdaq is too willing to issue exemptions
to the current listing requirements. Last summer, SyQuest spent about two months out of compliance with the minimum net tangible asset rule.
"I think the specific rule is probably less important than the enforcement of the rule," commented Dale Velk, an investor active in the SyQuest folder for the last year. "Having reviewed a large number of 'violators' of the old rule it appears to me that the NASD was extremely lax and arbitrary in the enforcement of the net worth rule thereby greatly reducing the effectiveness of the standard."
Another problem is that Nasdaq's current contractual obligations to listed companies generally prevent it from informing investors when a company is out of compliance with minimum listing requirements. The market and its regulators could actually be sued by the listed firms for revealing that a company was out of compliance.
Yet, each year over 1,000 Nasdaq companies at some point violate the minimum listing standards. In many cases, the corporate secretary has simply failed to pass along earnings information to the market within the time period designated. In other cases, however, a company is in serious risk of being delisted, but neither Nasdaq nor the company has revealed this danger to the public. The new listing requirements do nothing to remedy this gap in public disclosure.
Nonetheless, the proposed changes show that Nasdaq is taking action to bolster the integrity of its markets in the aftermath of some embarrassing events. The proposed new minimum listing requirements represent an important step in establishing some basic guidelines for publicly traded companies. Investors interested in commenting on the proposals should watch the SEC's web site. The period for public comment should begin soon. |
