Nasdaq And The SEC: A Tough Predicament

Joseph Lucosky is the Managing Partner of Lucosky Brookman.

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The Securities and Exchange Commission (SEC) and the Nasdaq Stock Market LLC (Nasdaq) serve distinct yet interconnected roles in the United States securities industry, with the SEC serving as the industry’s primary regulatory body and Nasdaq functioning as one of the three leading securities exchanges.

Since the Nasdaq “pause” of September 2022, however, industry practitioners have experienced a complex predicament at the intersection of these two entities’ respective mandates relating to how and when investment bankers are permitted to confirm orders in a microcap IPO. This is creating a regulatory paradox, in turn causing much consternation and uncertainty among market participants who practice in this arena. This predicament has yet to be formally addressed by any regulator but appears to be part of the “new normal” for microcap IPOs, and there is a continuing need for clarity and a swift resolution.

An Impossible Predicament

The Securities Act of 1933 requires that a company’s registration statement be declared effective by the SEC prior to securities being sold to investors in an IPO. The SEC’s official policy is that it will withhold approval for making a company’s registration statement effective if it deems the company’s disclosure incomplete. In early 2023, the lack of approval by Nasdaq for the initial listing of securities appeared to, under certain circumstances, be another prerequisite to effectiveness. Thus, the SEC has withheld approval to declare a registration statement effective until such listing approval has been obtained from Nasdaq. The SEC appears to have backed off this policy beginning in the second quarter of 2023 and reverted to not requiring Nasdaq approval prior to declaring a registration statement effective.

However, what has resulted is that the SEC’s Division of Corporation Finance appears to now be allowing Nasdaq to compel investment bankers to confirm committed orders from investors in a microcap IPO (which are, effectively, purchases of securities) as a condition to Nasdaq approving the securities for initial listing. This has become a “chicken or the egg” dilemma because officially confirming orders prior to the effectiveness of the corresponding registration statement is clearly prohibited under SEC rules.

In essence, if Nasdaq requires confirmed orders before a registration statement is effective (which is prohibited) in order to obtain Nasdaq listing approval, then investment bankers are being caught up in a regulatory catch-22.

This predicament impacts the day-to-day operations of investment bankers and the companies they represent, creating a regulatory gridlock that places investment bankers in a difficult ethical position, as they are being asked to potentially violate long-standing SEC rules and industry practices to satisfy Nasdaq’s new listing approval procedures.

Indication Of Interest Versus Confirmed Orders

Under Section 5(a) of the U.S. Securities Act of 1933, investment bankers cannot sell, nor make contracts to sell, a security before the SEC has declared effective the related Securities Act registration statement. A corollary to this principle, as outlined in Securities Act Rule 134(d), stipulates that any communication soliciting an offer to buy or indications of interest must state that “no offer to buy” securities “can be accepted and no part of the purchase price can be received until the registration statement has become effective.”

Historically, investment bankers have navigated this restriction by obtaining indications of interest (IOIs) from investors prior to effectiveness. An IOI is conditional and not legally binding—it’s a way to show interest in purchasing a security that is being offered for sale pursuant to a registration statement that is still undergoing regulatory review (i.e., that the SEC has not yet declared effective). After the SEC has declared the registration statement effective, offers and sales may be made immediately.

Nasdaq’s requirement that investment bankers obtain confirmed orders from investors goes far beyond the limits of IOIs. Unlike IOIs, these commitments to buy are inherently binding, which are not allowed under SEC rules and would appear to violate Section 5(a) of the Securities Act. Such violations would create a larger problem for issuers as it may subject them to civil or criminal penalties and may result in investors having a one-year right to rescind the transaction, whereby the investors would get all their money returned on a strict liability basis.

This situation also raises questions about the role and responsibilities of Nasdaq as a listing authority. While Nasdaq has a legitimate interest in ensuring that the securities listed on its exchange are viable and have sufficient investor interest, requiring confirmed orders prior to the effectiveness of the applicable registration statement appears to overstep its mandate and encroach on the SEC’s regulatory territory.

Allocation Sheets And Nasdaq’s Requirements

Further complicating matters is Nasdaq’s implementation of the above policies by requiring investment bankers to provide allocation and order sheets to Nasdaq prior to the registration statement’s effectiveness.

These allocation sheets detail how shares will be distributed among investors in an IPO and need to be confirmed by Nasdaq prior to approval being granted for trading. Sending these allocation sheets sometimes results in an awkward, iterative back-and-forth between Nasdaq, the bankers and counsel. Anecdotally, Nasdaq has even gone so far as to warn investment bankers and issuers that trading will be halted if its final allocation sheets change materially from its pre-effectiveness submissions or, more recently, that future deals may be held up involving the same investment bank if their submitted allocations materially change post-effectiveness. This forces investment bankers to “get it right” by going beyond mere indications of interest and to actually confirm orders prior to effectiveness of a registration statement, which adds another layer of pressure on investment bankers and microcap companies seeking to complete a microcap IPO.

While it is understandable that Nasdaq wants to ensure the stability and integrity of its listings (as do most market participants, including myself), threatening to halt trading or penalize a bank on future deals based on routine (and sometimes necessary) changes in deal allocations seems excessive. This threat also interferes with the historical and normal capital-raising process in which flexibility to adjust to frequent and rapidly changing circumstances and market conditions is reasonably required.

We have presented this predicament to SEC examiners and have heard of many other market participants who have also asked for guidance. The common refrain has been along the lines of, “We understand the issue, but it’s not in our control,” which does not provide any practical solution or clarity. This lack of guidance from the SEC has not only exacerbated the confusion and uncertainty among market participants but has also undermined the SEC’s track record of consistency as the industry’s primary regulator of sales of securities.

Action Is Needed Now

Nasdaq’s new requirement puts investment bankers and issuers in a difficult position that appears to be inconsistent with decades of their professional norms—and potentially at odds with long-standing SEC rules.

The SEC, as the primary regulatory authority, needs to clarify its position and provide clear guidance to market participants. It cannot allow Nasdaq, the “tail,” to wag the (watch) “dog,” the SEC, and upend the 90-year prohibition on sales of securities prior to the effectiveness of the related registration statement and the SEC’s related longstanding rules and practice norms.

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