FINRA, Nasdaq, and NYSE published separate notices to alert their members about recent observations related to initial public offerings (IPOs) for certain small capitalization (small-cap) issuers listed on US stock exchanges and to remind members, including underwriters and other market participants, regarding associated regulatory obligations. These notices follow recent reports by several news outlets that listings of small-cap companies have been subject to enhanced scrutiny by Nasdaq over the last few months, as well as statements indicating that Nasdaq has halted IPOs of small Chinese companies. That said, Nasdaq has not announced any amendments to its listing rules.
In Regulatory Notice 22-25, FINRA lists eight elements that it observed as characteristic of pump-and- dump schemes:
- Small market capitalization and limited public float (an offering of less than $25 million, issuing less than 20 million shares)
- Foreign (especially Chinese) issuers, or issuers with operating subsidiaries or affiliates having primary operations in China
- A substantial number of shares allocated to Hong Kong or other foreign broker-dealers
- Concentrated allocations of IPO shares by underwriters to a small number of investors
- Trading by nominee brokerage accounts, predominantly held in the name of individual foreign nationals, but controlled by an undisclosed person or group in patterns of activity not consistent with the profile of the nominal account holders
- Omnibus accounts, opened for foreign financial institutions at US broker-dealers, that liquidate a large quantity of shares of small-cap issuers when the price spike is at its peak
- Significant price spikes on the opening trading day and the days immediately after, followed by price drops to levels at or below offering price, with both spikes and drops unrelated to news or other material events
- Allegations of social media scams whereby bad actors establish relationships with victims and subsequently recommend that the victims place limit orders in shares of new small-cap issuers
In light of the regulatory scrutiny in connection with IPOs, firms — both underwriters and broker-dealers that buy and sell in the secondary market — are encouraged by FINRA to assess and refine their compliance and risk management programs and supervisory systems, including policies and procedures, to address the evolving and heightened risk of fraud linked to small-cap IPOs. FINRA recognizes that these threats are evolving and suggests that firms evaluate how these schemes may affect their continued legal and regulatory obligations, including those related to: underwriter due diligence, Regulation M and offering fraud provisions, the Bank Secrecy Act, know-your-customer/identification of red flags, and the SEC Identity Theft Red Flags Rule (Regulation S-ID). FINRA also reminds firms of their continuing obligation to report potential fraud to FINRA, the SEC, the FBI, and local state securities regulators.
In Equity Regulatory Alert No. 2022-9, Nasdaq focuses on the underwriters’ role in the IPO process and manipulative trading concerns. It echoes FINRA’s sentiments regarding the significance of the role of the underwriter in monitoring for fraud and confirming investors are provided with accurate disclosures. In addition, Nasdaq highlights its reliance on underwriters to effectively introduce companies into the market through the selection of the selling syndicate and by ensuring that shares are placed in a manner that promotes liquid trading and the importance of due diligence reviews. Nasdaq also provides underwriters a non-exhaustive list of questions to consider when evaluating whether to price an IPO.
Lastly, in Regulatory Memorandum NYSE RM-22-18, the NYSE complements Reg Notice 22-25 and Alert No. 2022-9 by addressing its pre-IPO listing considerations and post-IPO review of trading activity. The memorandum includes a list of factors that NYSE Regulation considers, among others, in determining whether a company is suited for listing. Notably, as part of its review, NYSE compares offerings to prior IPOs that experienced unusual price movements and monitors member compliance with listing standards.
The warning from these three SROs should not come as a surprise. FINRA has raised similar concerns in its 2021 and 2022 Reports on FINRA’s Examination and Risk Monitoring Program. Likewise, Nasdaq and NYSE have expressed their continued commitment to investigating and enforcing applicable rules and federal securities laws, including those intended to address and prevent manipulation and misconduct. In fact, Nasdaq disclosed that it currently has open investigations related to activity discussed in its alert. For this reason, firms, including underwriters, broker-dealers, and other market participants, should employ the guidance provided by FINRA, Nasdaq, and NYSE as tools in evaluating whether its current practices, and policies and procedures, achieve compliance with regulatory obligations or require modification.
Peter W. LaVignePartner
Lauren A. SchwartzAssociate