In the fall of 2008, amidst the U.S. government exerting significant effort to prevent an economic collapse, a barely noticed but highly significant change occurred in the world of listing standards. It took several years to come to the fore, but many Chinese companies, and investors in Chinese companies, have felt the effect of this change, whether they recognize it or not. In November 2008, the U.S. Securities and Exchange Commission (SEC) approved a NASDAQ rule proposal changing the way NASDAQ enforces its listing standard that requires companies to timely file periodic reports with the SEC and to timely provide all other material information to investors.
One might assume that a change in listing standards could only be in the direction of increasingly stringent standards, particularly given the fact that numerous banks and financial institutions were on the precipice of failure, many as a result of incorrect valuation and accounting assumptions as they related to real estate and accompanying derivatives products, a number of which were not well-disclosed. Well, not exactly. Since the rule change, late filers have been the recipients of longer grace periods from NASDAQ than the historical average — until Chinese companies became targets of short sellers.
The 2008 rule change was the culmination of a multi-year campaign by NASDAQ to convince the SEC that its enforcement mechanism was the more appropriate one as compared with the New York Stock Exchange's (NYSE) standard. In sum, prior to November 2008, the NASDAQ process relied upon independent Hearings Panels, consisting of non-NASDAQ employees authorized by the NASDAQ board to make a listing or delisting decision on the exchange's behalf, naming companies that were unable to remain timely in their periodic public filings. The NYSE followed a process where such matters largely were handled internally by NYSE Regulation employees, which tended to be more hands-on than the NASDAQ process. In the end, this enforcement process became a competitive issue between the exchanges, one which NASDAQ CEO Robert Greifeld recognized in a September 2006 speech: "We've been to the SEC and said either have the NYSE come to our standards or we'll have to roll ours to theirs, which many believe is the wrong thing because certainly the cornerstone of making investment in a public company is their financial reporting."1 For whatever reason, the SEC elected "the wrong thing", so two years later NASDAQ chose to move towards the NYSE process.
The problem with both processes is that, in the face of a filing delinquency, information required by SEC disclosure rules, i.e., periodic and current reports as well as the anti-fraud provisions of Rule 10b-5, remains withheld from investors resulting in both self-regulatory organization (SRO) processes being largely opaque to investors. The effect of this often enabled listed companies to maintain a listing while private adjudication processes with the exchanges ran their course, all the while leaving investors and prospective investors with insufficient information to make investment decisions. It is not clear how this is consistent with the principles of the Securities Exchange Act of 1934 (Exchange Act). Simply put, a regulatory process that exists to protect investors by requiring prompt disclosure of material information should not provide, or even imply, a safe harbor for doing the opposite. While there are many views on the use of extended trading halts by the SROs, there is a consensus that, if nothing else, they are effective catalysts in causing management teams to make public disclosure.
Impact on Chinese Companies
Fast forward to 2010: Self-disclosed short sellers, who can be characterized as somewhere between Internet bloggers and sophisticated independent research providers, began turning their attention from accounting irregularities relating to and/or accusations against largely small and mid-cap domestic issuers to Chinese companies listed in the United States within the past five or so years. The nature of the accusations, while still in the neighborhood of accounting shenanigans, was far more incisive and, in many cases, difficult for the management teams based in China to defend against.
The details of each case have been well-documented by the media, so this article will not repeat the details of each matter.2 Suffice it to say that claims by these short sellers led to a number of unfortunate situations for investors and, in others cases, some very public fights between the short sellers' allegations and the management teams' responses. Instead, our focus is on the responses by NASDAQ and the NYSE to these situations; why the nature of those responses deviates from the exchanges' usual playbooks; and how best for targeted issuers to cope with the SROs.
"Additional Information Requested"
On the heels of the research being disseminated, the market surveillance arms of NASDAQ and the NYSE began focusing on the trading of the target company, as both exchanges commonly do for any "irregular trading." This usually includes a referral to the exchange that, in turn, often contacts senior management of the subject issuer directly, seeking additional information about the underlying facts alleged in the research, as well as knowledge management may have about the trading in question.
All of this is common in the way NASDAQ and the NYSE monitor and enforce their listing standards. It is one reason executives and boards take great pride in becoming NASDAQ or NYSE listed. These are some of the best regulated exchanges on the planet, and the liquidity they provide reflects that - with one exception.
In 2011, an old regulatory tool was pulled out of the SROs' attic for Chinese companies with a bad case of the shorts: extended trading halts. An extended trading halt is the worst nightmare for both a management team and a long equity investor. Before discussing the practical impact of this practice, we briefly describe the history of trading halts.
Trading halts have long been a tool available to NASDAQ and the NYSE to pause trading pending anticipated material news entering the public domain. When trading halts do occur, trading stops completely, while the exchanges push a notification out to investors stating "Additional Information Requested." While confusion (for investors) and panic (for management) ensues, the situational drama is exacerbated by the exchanges, which do not provide any detail about what information has been requested or remains pending while trading is frozen and liquidity stops. Curiously, the exchanges, often considered the first line of regulatory defense for investors, prevent the very liquidity that they exist to perpetuate by means of extended trading halts. Yet, they do not disclose to investors, or require the company to disclose, what information has been requested from the company or why it has been requested. Then again, if an investor cannot obtain an execution on a trade while a trading halt is in place, what difference does it make? The answer, of course, is that it makes a huge difference.
Prior to 2004, NASDAQ and the NYSE occasionally utilized an extended trading halt — lasting an entire trading day or more — in situations where investors lacked or were being deprived of sufficient information to make an investment decision on a stock. Extended trading halts fell out of favor as a tool to be used by the exchanges in the middle part of the last decade, partly because there were no rules or guidance on when these halts should be implemented and how long they should last pending the outcome of formal delisting proceedings. It was entirely discretionary. The exchanges ultimately elected to use extended trading halts less and less in favor of acting as the liquidity provider that they are, regardless of how little information there is for investors to make an informed decision.
Scary as that may sound, such a policy can be viewed as consistent with the Exchange Act: increased pressure on the issuer to provide more timely and full accurate and complete disclosure for investors – so long as there is pressure to disclose. What happened in the late-2008 was the opposite. Absent a legitimate threat of an extended trading halt or delisting, issuers were not required by any regulator to make imminent disclosure. Investors were simply left to make the best investment decision they could no matter how little information was in the public domain.
Along came the short sellers in 2010 with an interest in taking a short position in Chinese companies listed on NASDAQ and the NYSE, and then publishing research with damaging public accusations about the accounting of these companies, and or the integrity of management. Rather than stick to the regulatory playbook that had evolved in its benevolence as the last decade came to a close, the extended trading halt was revived – absent any statement by regulators as to why.
The Swirling Winds of Change
NASDAQ and the NYSE both require listed companies to file periodic and current reports in a timely manner with the SEC.3 These rules have been in place for some time and mirror the disclosure requirement imposed by existing SEC regulations. As fundamental as such rules are to effective regulation of equity markets and their issuer participants, the manner by which NASDAQ and the NYSE enforced these rules varied significantly until November 2008. As referenced above, NASDAQ favored a more independent approach, forcing companies that were delinquent in filing SEC reports to enter into an independent hearings process that began a day or two after the report became late, with a hearing before an independent panel 30 to 45 days after the delinquency occurred. At that hearing, it was incumbent upon management to convince the Hearings Panel that the company had a definitive plan to cure the delinquency within a reasonable period of time, had acted appropriately to address the underlying facts and circumstances, and had the management credibility to give the hearing panel comfort that this plan would likely occur. If a company was successful on these three points, the Panel would often grant additional time to cure the delinquency. If not, the company's stock would be delisted.
The NYSE, by contrast, had, and continues to have, an administrative process that was led by NYSE Regulation employees. This process favored an in-house approach, whereby the adjudication process was much less formal, and consisted of telephone conversations between NYSE Regulation officials and company management in an effort to learn roughly the same types of details. The benefits of this process include more interaction between management and NYSE officials who have greater familiarity with a company and its history, periodic conversations between both sides on the progress being made by the company, and more predictability by management regarding where it stood vis-a-vis maintaining the listing.
As the differences in the two processes became a competitive point between the exchanges, particularly after the stock option backdating scandals of 2006 and 2007, and ensnared much larger listed companies than those that typically find themselves in the midst of these processes, the SEC pushed the exchanges to make their adjudication process more similar to one another. NASDAQ argued for some time that its process was superior, utilizing independent individuals to make delisting decisions on the exchange's behalf, lessening the effect of internal pressure to keep listings, especially important listings, and thereby enhancing revenues. The NYSE maintained that its process had worked effectively for a significant period of time and that there was no reason to change it.
Mr. Greifeld held firm in his contention that the independent process was the better one but, ultimately, reverted to the position that if the SEC was not going to force the NYSE to change its process, NASDAQ would redesign its process to be more akin to that of the NYSE, as NASDAQ no longer would tolerate the competitive disadvantage. Surprisingly, the SEC approved such a rule proposal in November 2008.
The significance of this resulted in less transparency around a process that had room for improvement in the area of transparency in the first place. Neither exchange publishes statistics on the percentage of companies that are successful in this process or the average length of an extension period prior to delisting.
Since the beginning of 2011, NASDAQ has ratcheted down the amount of leniency it once provided to companies embroiled in accounting and/or corporate governance scandals, which has included a resurgence of extended trading halts. These companies did not receive any additional grace period and, in several cases, were thrust directly into the hearings process, where they faced the possibility of immediate delisting. NASDAQ facilitated this by utilizing a seldom-used rule, Listing Rule 5101, that enables NASDAQ to "raise public interest concerns" against listed companies "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" as a basis for delisting. Recently, companies that have been on the receiving end of this rule application also have been subject to an extended trading halt. NASDAQ's explanation to the public upon implementation of such a trading halt has been "Additional information requested." Nothing more is disclosed by NASDAQ other than that the halt will remain in effect until the company "has fully satisfied NASDAQ's request for additional information."
A number of Chinese companies affected have been stuck in a trading halt for an extended period only to lose their listings before trading ever resumes. For example, last week, China Ritar Power Corporation apparently saw the trend. After its stock was halted on April 18, 2011, it entered NASDAQ's adjudication process. After disclosing that it had provided some information to NASDAQ on several occasions in May, though no detail on what information was provided, on June 23, 2011, it announced that it was voluntarily delisting from NASDAQ without any explanation as to why it was doing so. This resulted in trading resuming the following trading day, albeit with the price of the stock down significantly, with the Pink Sheets providing price discovery for investors.
A Rock and a Hard Place
The difficulty this raises for companies that are the targets of short sellers and their outside counsel is what to do if a company finds itself in this spot: Business seems to be cruising along just fine one day. Then a short seller publishes damaging research about the company, claiming essentially anything he or she wants — in some cases without substantiation. Almost immediately, the stock exchange calls, asking for an explanation regarding these assertions. If an explanation is not provided satisfactorily, the company could face stiff regulatory repercussions. Some allegations, of course, require significant investigation, preventing a swift response. For companies in these situations, which may include Chinese companies or others, we recommend the following:
– Act Deliberately and Swiftly: Internal and board investigations commonly depend on third-party verification of information. A successful investigation must be properly scoped and be systematic in execution. Adequate resources and quick access to information are vital. Having
experienced investigative teams which are able to act promptly, thoroughly and completely as well as to provide frequent updates to management and the board is critical to successfully addressing the crisis. With Chinese companies, there are legitimate cultural norms that will be tested in such a process. Executives and board members must accept that, in light of a U.S. listing venue, only a U.S.-style corporate investigation will satisfy U.S. exchanges and other regulators. Investigations that do not meet these rigors or that make compromises along the way pose significant risks that may undermine the entire process.
– Communicate: In this type of crisis, communication is critical and valuable. This includes communication between management and the board of directors, particularly the audit committee; communication with stock exchange officials and other governmental agencies; and communication with investors. It has been observed that several management teams that were targeted by short seller research quickly published a letter to stakeholders, and the public in general, challenging the allegations by the short sellers, in some cases on a blow-by-blow basis. While there are dangers associated with this type of aggressive response, we urge management teams to refrain from stretching the facts when making assertions that have not been confirmed or verified with appropriate support. It is equally important, though difficult, not to jump to the conclusion that the short seller is wrong and make a public statement to that effect. Changing stories can be more damaging to the credibility of management than the initial accusations.
– Be Transparent: The best way to avoid an extended trading halt or delisting situation is to explain to stock exchange officials how management and the board are addressing any allegations, submit names of outside professional advisors who are assisting and describe the timetable currently in place for completion. Although the time frame may later change, it is critical for exchange officials to recognize that the company is treating the allegation seriously and has engaged experienced and independent experts who are working diligently to assess the underlying facts and circumstances. SROs can accept bad facts; but they cannot accept evasiveness or deception.
Conclusion
It is human instinct to react when one is being attacked, typically with at least equal force to that of the attacker. Short sellers are not a meek group. However, when a company is under attack, senior management and the board of directors must rely upon experienced lawyers and investigators to avoid making a bad situation worse. The professionals should have the appropriate level of litigation, investigative, industry, geographical and regulatory expertise. A realistic understanding, rather than an emotional response by management and the board coupled with a dedication to full, fair and accurate disclosure can be an effective response to attacks by the shorts.
Jason S. Frankl and John J. Huber are senior managing directors in the Forensic and Litigation Consulting practice of FTI Consulting, Inc. and are both based in Washington, DC. Mr. Frankl leads FTI's Listing Advisory Services group, which consults with entities seeking to list on NASDAQ and/or the NYSE, and companies working to regain compliance with the quantitative, filing and corporate governance requirements of those exchanges. Mr. Frankl specializes in providing consulting services and expert witness testimony on issues involving compliance with the rules of NASDAQ, the NYSE and the SEC, with particular emphasis on corporate governance, corporate disclosure, securities compliance and securities trading. Mr. Huber provides consulting services and expert witness testimony in the areas of securities offerings, strategic transactions, corporate disclosure, restatements, internal control over financial reporting and corporate governance. He also provides assistance to companies facing FCPA violations and SEC enforcement actions, such as deferred prosecution agreements and monitorships.
Footnotes
1 The Boston Globe, September 13, 2006.
2 See, e.g. public disclosures involving China‐Biotics Inc., ShengdaTech, Inc., China Media Express Holdings, Inc. and China Integrated Energy, Inc.
3 See NASDAQ Listing Rule 5250 and Section 2 of NYSE Listing Company Manual.
The views expressed herein are those of the authors and do not necessarily represent the views of FTI Consulting, Inc. or its other professionals.
©FTI Consulting, Inc., 2011. All rights reserved.
