Nasdaq Targets Emerging Market Companies with Proposed Listing Standards

If approved by the Securities and Exchange Commission (SEC), the Management Qualifications Proposal and the initial public offering (IPO) Proposal, as discussed below, are likely to affect only small issuers. However, in light of the recent focus by the SEC and Public Company Accounting Oversight Board (PCAOB) on the PCAOB’s inability to inspect the audit work and practices of auditors in certain countries, the Audit Qualification Proposal, as discussed below, may require, even for larger issuers, meaningful engagement with Nasdaq staff to address concerns about the quality of financial reporting and auditing, even if all enumerated criteria for initial or continued listing on the Nasdaq are satisfied.

Proposed Listing Standards

1. Management Qualifications Proposal

The Nasdaq believes that it is critically important, for the protection of investors and the public interest, for listed companies to have management or advisers familiar with regulatory and listing requirements, including internal control over financial reporting, disclosure controls and procedures, disclosure obligations and corporate governance requirements.

In the Nasdaq’s view, the risks arising from a lack of such familiarity are heightened when a company’s business is principally administered in a Restrictive Market. In determining whether a company’s business is principally administered in a Restrictive Market, Nasdaq may consider the geographic locations of the company’s (a) principal business segments, operations or assets; (b) board and shareholders’ meetings; (c) headquarters or principal executive offices; (d) senior management and employees and (e) books and records.¹

The proposed rule requires listing applicants from Restrictive Market countries to certify to the Nasdaq that they have, and will continue to have, a member of senior management or a director with relevant employment experience at a U.S.-listed public company or other experience, training or background that results in general familiarity with the regulatory and reporting requirements applicable to a U.S.-listed public company under Nasdaq rules and federal securities laws.²  Alternatively, the company may retain one or more advisers, acceptable to Nasdaq, that will provide such guidance. The proposed rule change would apply only to companies from Restrictive Market countries that apply to list on the Nasdaq after the date of effectiveness.

2. IPO/Business Combination/Direct Listing Proposal (the IPO Proposal)

The Nasdaq notes that the lack of transparency from certain emerging markets, particularly Restrictive Markets, raises concerns about the accuracy of disclosures, accountability and access to information. These problems may be exacerbated, and additional problems may arise, when the securities of a U.S.-listed foreign company are thinly traded, as may be the case if only a small offering is conducted or a small percentage of outstanding securities is listed in the United States. Securities with limited public float or liquidity may trade in a more volatile manner, and with a wider bid-ask spread, which may result in trading at a price that may not reflect their true market value. As a result, they may be more susceptible to price manipulation.

The proposed rules would require a minimum offering size or public float for Restrictive Market companies listing on the Nasdaq in connection with an IPO or a business combination and, in connection with a direct listing, would limit Restrictive Market companies to listing on the Nasdaq Global Select or Nasdaq Global Markets only.³

IPO: The company must sell a minimum amount of securities, in a firm commitment offering, in the United States to nonaffiliates, that will result in gross proceeds to the company of at least $25 million or will represent at least 25 percent of the company’s postoffering market value of listed securities, whichever is lower.⁴ The Nasdaq believes that a required minimum allocation to U.S. investors, along with the book-building process and due diligence associated with firm commitment offerings, will help generate an investor base and trading interest that promotes sufficient depth and liquidity to help support fair and orderly trading and will help ensure compliance with U.S. securities rules and regulations.

Business Combination: Similar to the IPO requirement described above, following the business combination, the company must have a minimum market value of unrestricted publicly held shares equal to the lesser of $25 million or 25 percent entity’s market value of listed securities.

For context, close to a quarter of the 59 Chinese IPOs on the Nasdaq since the end of 2016 raised less than $25 million. While these listings account for just 2 percent of the total funds raised by Chinese companies on the Nasdaq during this period, they have performed poorly, losing on average two-thirds of value from their IPO price.⁵ In 2020, to date, three of 10 Nasdaq IPOs by Chinese issuers have raised less than $25 million, and in 2019, 10 of 29 Nasdaq IPOs by Chinese issuers raised less than $25 million. Half of the Chinese issuers selling shares in Nasdaq IPOs in 2020 to date have floated less than 25 percent. As of May 20, 2020, Chinese companies have a combined current market value of approximately $380 billion on the Nasdaq and approximately $760 billion on New York Stock Exchange (NYSE).⁶

3. Auditor Qualifications Proposal

The Nasdaq believes that the PCAOB’s inability to inspect the audit work and practices of auditors in certain jurisdictions, such as China and Hong Kong, weakens the assurance that the auditor obtained sufficient appropriate audit evidence to express its opinion on a company’s financial statements and decreases confidence that the auditor complied with PCAOB and SEC rules and professional standards in connection with the auditor’s performance of audits.

The proposed rule seeks to codify the nature and scope of the PCAOB’s existing discretion to apply additional and more stringent listing criteria when an auditor of an applicant or a Nasdaq-listed company has not been or cannot be inspected by the PCAOB or where the auditor has insufficient resources, geographic reach or experience, or other deficiencies in its audit process or quality controls.⁷ The Nasdaq may consider certain factors when applying more stringent criteria to a company based on the qualifications of the company’s auditor, including these:

• whether the auditor has been subject to a PCAOB inspection, such as where the auditor is newly formed and has therefore not yet undergone 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
• whether the results of any PCAOB inspection indicate that the auditor has failed to respond to any PCAOB requests or that the inspection has uncovered significant deficiencies in the auditors’ conduct in other audits or in its system of quality controls
• whether the auditor can demonstrate that it has adequate personnel in the offices participating in the audit with expertise in applying U.S. generally accepted accounting principles, generally accepted auditing standards or International Financial Reporting Standards, 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-U.S. 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
• whether the auditor can demonstrate to the Nasdaq that it has sufficient resources, geographic reach or experience as it relates to the company’s audit

The Nasdaq has indicated that it will take a holistic approach when assessing an auditor’s qualification and work, even if there are concerns with respect to some of the factors outlined above. After considering these factors, if the Nasdaq determines that a company’s auditor does not satisfy the criteria, it may then impose higher listing standards to obtain comfort that the company meets financial listing requirements. The higher standards could include requiring:

• higher equity, assets, earnings or liquidity measures than otherwise required, such as a higher public float percentage, market value of unrestricted publicly held shares or average over-the-counter trading volume;
• any offering to be underwritten on a firm commitment basis, which helps ensure that third parties other than the auditors are conducting sufficient due diligence; or
• companies to impose lock-up restrictions on officers and directors to allow market mechanisms to determine the fair price for the company.

The Nasdaq may impose each of these standards separately or in combination, depending on the circumstances for each public company, or it may ultimately decide to delist or deny initial listing to a company. The Nasdaq may also impose additional criteria when the company’s business is principally administered in a Restrictive Market.

Broader Regulatory Context: Regulators and Legislators Eyeing Chinese Companies

The Nasdaq’s rule proposals are being issued during a period of widespread regulatory and legislative focus on Chinese companies, including the recent delisting notice the Nasdaq issued on May 15, 2020 to a Chinese foreign private issuer, as a result of “public interest concerns” in response to certain fabricated costs and expenses the company disclosed as well as the fabricated disclosures themselves.⁸

The SEC and PCAOB have recently emphasized the distinctive and sometimes greater risks associated with emerging market investments, including those arising from variability in the nature, quality and availability of financial information, including financial reporting and audit requirements; the PCAOB’s inability to inspect audit work papers in China; and legal and practical challenges U.S. regulators and investors face in bringing suits and enforcing judgments against emerging market companies.⁹ The SEC has announced a July 2020 roundtable on emerging market risks with a view to bringing greater attention to these risks.¹⁰

On May 20, 2020, the U.S. Senate passed S. 945, the Holding Foreign Companies Accountable Act, by unanimous consent (see Sidley’s Update on the Act here). This bill, if adopted, would prohibit certain companies from listing and trading their securities on any U.S. securities exchanges or through any other method regulated by the SEC if the PCAOB is prevented from reviewing the companies’ audits, as is the case for China-based auditors.

As emerging markets appear to be both a political and a regulatory priority, we expect to see further guidance and activity in this area in the coming months.

¹For example, if a company’s headquarters are located in the a non-Restrictive Market, but a majority of its senior management, employees, assets, operations and books and records are located in a Restrictive Market, the Nasdaq would consider the company’s business to be principally administered in a Restrictive Market.

²The proposed rule is available here.

³The proposed rule is available here.

⁴The rule proposal gives the following illustrative example: “Company X is applying to list on Nasdaq Global Market. Company X principally administers its business in a Restrictive Market and its post-offering Market Value of Listed Securities is expected to be $75,000,000. Since 25% of $75,000,000 is $18,750,000, which is lower than $25,000,000, it would be eligible to list under the proposed rule based on a Firm Commitment Offering in the U.S. to Public Holders of at least $18,750,000.”

⁵See Financial Times, “Nasdaq to tighten requirements for companies seeking to list,” available here.

⁶Nisha Gopalan, Bloomberg, “Nasdaq’s China Crackdown Looks Halfhearted” (May 20, 2020), available here. Note that Alibaba Group Holding Limited represents a majority of the total market capitalization of Chinese companies listed on the NYSE.

⁷The proposed rule is available here.

⁸Nasdaq publishes a list of noncompliant companies here.

⁹Jay Clayton, William D. Duhnke III, Sagar Teotia, William Hinman and Dalia Blass, “Emerging Market Investments Entail Significant Disclosure, Financial Reporting and Other Risks; Remedies are Limited” (Apr. 21, 2020), https://www.sec.gov/news/public-statement/emerging-market-investments-disclosure-reporting  (“April 2020 Guidance”); see also Sagar Teotia, “Statement in Connection with the 2019 AICPA Conference on Current SEC and PCAOB Developments” (Dec, 9, 2019), https://www.sec.gov/news/speech/teotia-speech-2019-aicpa-conference; Jay Clayton, Wes Bricker and William D. Duhnke III, “Statement on the Vital Role of Audit Quality and Regulatory Access to Audit and Other Information Internationally — Discussion of Current Information Access Challenges with Respect to U.S.-listed Companies with Significant Operations in China” (Dec. 7, 2018), https://www.sec.gov/news/public-statement/statement-vital-role-audit-quality-and-regulatory-access-audit-and-other.

¹⁰Jay Clayton, “Statement Announcing SEC Staff Roundtable on Emerging Markets” (May 4, 2020), https://www.sec.gov/news/public-statement/statement-clayton-roundtable-emerging-markets.