Assuming that both questions result in “yes” answers, I believe the NASD implements a rebuttable presumption that a listing application (or a continued listing) from a company affiliated with such an individual will serve to facilitate further violative conduct to the public’s detriment. Increasingly the NASD’s approach has become more doctrinaire on the qualitative issues and has become tantamount to a zero-tolerance policy.  Among the reasons advanced for taking such a rigid posture is that a NASDAQ listing effectively constitutes an exemption from the Commission’s Penny Stock rules.[vi] Notably, that NASDAQ exemption relieves a broker-dealer from undertaking federally mandated risk disclosure to customers purchasing a Penny Stock.  Accordingly, such an exemption provides ample opportunity for mayhem. Nonetheless, the Commission cautioned the NASD against any unwarranted blanket policy and pointedly required that the SRO “form a reasonable belief as to whether certain persons connected with an issuer may be predisposed to engage in further violative conduct contrary to interests of the investing public.”[vii]  

Practitioners should focus on the following language in the Criteria Order: 

[T]he rule change will also provide important guidance to the NASD review process, and will alert issuers seeking inclusion in NASDAQ, as well as current NASDAQ issuers, that the NASD considers an issuer's connection to a person with a history of significant securities or commodities violations in determining whether to grant initial or continued inclusion of the security, and that the security may be subject to additional criteria as a condition for initial and continued inclusion in NASDAQ.  The rule change establishes the NASD's discretionary authority under Part II, Sections 1 and 2 of Schedule D to deny initial inclusion or [Ed. Footnote omitted] apply additional or more stringent criteria for the initial or continued inclusion of particular securities or suspend or terminate the inclusion of particular securities based on any event, condition, or circumstance which exists or occurs that makes initial or continued inclusion of the securities in NASDAQ inadvisable or unwarranted, even though the securities meet all enumerated criteria for initial or continued inclusion in NASDAQ. Nonetheless, the Commission expects that before the NASD exercises its discretionary authority under the new rule, it will consider as one of several factors the extent to which events or circumstances giving rise to the proposed action were previously disclosed.[viii]

NON-DISCLOSURE AND DUE DILIGENCE

As many a practitioner has unfortunately learned, clients often lie about regulatory violations or securities-related convictions. On the other hand, in some non-disclosure situations, the client is simply uninformed or misinformed as to the actual circumstances of his or her criminal/regulatory history.  Nonetheless, effective corporate counsel will usually suggest that a corporate client routinely verify the backgrounds of its control persons.  Initially, such verification may be nothing more complicated than paying a third-party to perform a computerized search of 1) federal, state, and local court criminal records, and 2) regulatory agencies’ records.  Any disclosures should generally be followed up by obtaining underlying documents, e.g., complaints, answers, decisions, etc. However, efforts to perform even cursory inquiries may pose some unusual problems.  

Practitioners involved in preparation of registration statements are usually familiar with the need to make disclosures concerning directors, executive officers, promoters and control persons under Regulations S-K and S-B, which under Items 401 state: 

Involvement in Certain Legal Proceedings. Describe any of the following events that occurred during the past five years and that are material to an evaluation of the ability or integrity of any director, person nominated to become a director or executive officer of the registrant:

(2) Such person was convicted in a criminal proceeding or is a named subject of a pending criminal proceeding (excluding traffic violations and other minor offenses.[ix]

In addition to criminal disclosures, Regulations S-K and S-B also require information concerning orders, judgment or decrees that enjoined, barred or suspended from involvement in any business, securities, or banking activities.  Further, in the checklist provided by NASDAQ to companies interested in listing, applicants are specifically urged to “determine whether any of the Company’s officers, directors, or principal shareholders have been charged or convicted of any charges involving fraud, embezzlement, insider trading, or any other matter concerning dishonesty.”[x]   

Industry lawyers are accustomed to regulatory inquiries asking whether an individual has ever been convicted of or pled guilty or nolo contendere in a foreign court to a misdemeanor or felony; whether a foreign financial regulatory authority ever found an individual to have made false statements, engaged in fraudulent conduct, violated investment-related regulations, etc.[xi] Notwithstanding that these latter items are on an application form used by individuals seeking to become registered persons, they indicate a standard of regulatory inquiry that corporate clients should expect will be applied to them during the NASDAQ listing process. One common pitfall is that corporate practitioners frequently fail to appreciate that the NASD’s inquiry as to an individual’s background is not limited to the five-year horizon reflected in the federal regulations cited above.   

Corporate attorneys are often struck as to the difference between the precise requirements (and years of statutory interpretation and caselaw) involved in the registration process at the Commission, and the more elastic requirements (and relatively limited statutory interpretation and caselaw) involved in the listing process at NASDAQ. Worse, in recent years the listing process and attendant administrative appeals process at NASD has been overhauled. As a result, lawyers reviewing even somewhat recent statutory history or caselaw become frustrated with the changes in departmental names and functions, and the revised interplay between the NASD staff, departments, and hearing panels.   

In furthering a client’s NASDAQ listing application, lawyers may find themselves searching in the regulatory night with the equivalent of a lit match.  How do you obtain information about foreign criminal or regulatory violations? What happens where a jurisdiction does not distinguish between misdemeanors and felonies? What if your client claims that he was victimized by a political prosecution in a formerly or currently communist country? What if the individual’s former attorney is deceased?  Some of the necessary due diligence will likely require practitioners to familiarize themselves with the Commission’s or NASD’s interpretive rulings, or with the instructions to the relevant form, e.g., a “felony, for jurisdictions that do not differentiate between a felony or misdemeanor, is an offense punishable by a sentence of at least one year imprisonment and/or a fine of at least $1,000.”[xii]  However, from a practical perspective, your diligent efforts may well put you in the uncomfortable role of uncovering information that either proves a control person lied about his/her background or reveals a previously unknown embarrassing matter. Worse, thepractical impact of your investigation may well be that your corporate client will be denied a NASDAQ listing or its current listing jeopardized. 

In any event, let’s examine two of the leading cases involving NASDAQ qualitative requirements. Where possible I have included relevant dates to demonstrate the “relevancy” of so-called aged criminal/regulatory matters and to indicate the delays inherent in exhausting one’s administrative remedies. 

JJFN: The propensity issue 

In 1997, the Commission affirmed the NASD's decision to deny an issuer's request that its securities be included on the NASDAQ SmallCap market because the issuer's controlling shareholder, paid consultant, and promoter has been convicted of felony tax law violations.[xiii]   JJFN, a Delaware corporation, was organized in late 1995. David Miller was a "key person" who had been engaged as a "financial consultant" to JJFN since its inception and was deemed the Company's "promoter." As of June 30, 1996, Miller and members of his family owned or controlled more than half of the 15.96 million JJFN shares then outstanding.  

In April 1992, Miller pled guilty to three felony tax fraud charges, admitting that in 1983, 1984, and 1985 he filed, and conspired with others to file, false federal tax returns on behalf of a company of which he was the president and chief executive officer. Miller was sentenced in October 1992 to 20 months in prison, fined $ 40,000, and assessed the costs of his incarceration. He entered federal prison in December 1992, was paroled in December 1993, and was released from custody in May 1994. 

On February 1, 1996, JJFN applied to the NASD for inclusion of its securities in the NASDAQ SmallCap Market. By letter dated July 22, 1996, NASDAQ staff denied JJFN's application based on Miller's association with the Company. The staff asserted that, given Miller's "regulatory history" and the "potential influence and control he may exercise over the Company . . . it would be to the detriment of the investing public"[xiv] to list JJFN's shares on the NASDAQ SmallCap Market. 

JJFN appealed the staff's decision to the NASDAQ Listing Qualifications Panel ("Qualifications Panel"). On August 22, 1996, the Qualifications Panel found that Miller's "involvement in [JJFN] both as a shareholder and as a consultant is substantial."[xv] The panel determined that Miller's felony tax fraud convictions "related to his role as the officer of a company."[xvi] The panel further explained that it was affirming the staff's denial of JJFN's application "in order to preserve and strengthen the quality of and public confidence in the market, and in order to protect prospective investors and the public interest."[xvii]

In late August 1996, JJFN appealed the Qualifications Panel's decision to the NASDAQ Listing and Hearing Review Committee ("Review Committee"). On December 20, 1996, the Review Committee affirmed the Qualifications Panel's decision to deny inclusion of JJFN's securities in the NASDAQ SmallCap Market. Although the Review Committee noted Miller's offers to terminate his consulting contract with JJFN, to sell his JJFN shares, and to place the shares held by his family in a voting trust, it found that Miller "appear[s] to play an essential role in [JJFN]" and that JJFN is "dependent on [Miller's] expertise."[xviii] The Review Committee voiced its concern that Miller's "past violative conduct might indicate a propensity to engage in conduct detrimental of [sic] public investors."[xix]  JJFN appealed to the Commission on January 21, 1997.

Possibly cognizant of a need to rationalize Miller’s filing of false tax returns as securities industry related misconduct, the Commission’s decision stressed that Miller's conviction for tax fraud legitimately may be considered by the NASD to be evidence of a propensity for future conduct violative of securities laws or regulations. Further, the Commission underscored that both the tax and the securities regulatory schemes depend on the honor, candor, and integrity of regulated persons to report accurately to the regulatory authority the information sought by such authority.  

JJFN also asserted that Miller's conviction was not relevant because it was "remote in time." Although the Commission conceded that the conduct on which the conviction was based occurred more than ten years earlier, Miller admitted to a pattern of conduct violative of the tax laws that persisted for three years. In addition, the 1992 conviction itself and Miller's resulting prison term (which ended in 1994) were relatively recent to the 1996 application for listing. The Company argued that Miller's conviction must be viewed in light of his entire career, which "has been unmarked by any escutcheon except his tax conviction."[xx] Contrary to this assertion, however, this Commission noted that it had twice brought enforcement actions against Miller or entities with which he is associated.  

JJFN further asserted that the NASD's denial of JJFN's application constituted the "de facto promulgation" of a new rule barring absolutely the inclusion in NASDAQ of issuers that have control persons or key personnel who have been convicted of a felony. The Commission disagreed with that contention and sustained the NASD's determination. Notwithstanding the Commission’s discomfort with the allegation concerning the imposition of an unwritten rule against any felon, the simple fact is that JJFN represents a striking expansion of the more circumspect language of the Criteria Order: “a person with a history of significant securities or commodities violations.”[xxi]  Miller was a felon but the facts do not necessarily support the contention that he had a history of securities or commodities violations, let alone a “significant” history of same.  Regardless of the Commission’s protestations to the contrary, it appears that the emerging message isall felons beware. 

DHB: An uneasy feeling 

Finally, in what many view as the seminal case on this issue, the Commission affirmed the NASD's decision to deny an issuer's request that its securities be included on the NASDAQ SmallCap market, because the stock bid price did not meet the required minimum and the issuer's controlling shareholder, officer, and director had a history of securities law violations.[xxii]  

On December 18, 1992, in settlement of an injunctive complaint filed by the Commission, David Brooks consented to a permanent injunction by the United States District Court for the Southern District of New York, against aiding and abetting violations of Section 15(b) and 15(f) of the Securities Exchange Act of 1934 and Rule 15b3-1 thereunder. On December 23, 1992, Brooks consented to an order in which the Commission barred him from association with any broker, dealer, municipal securities dealer, investment adviser, or investment company, with a right to apply after five years to become so associated. In addition, Brooks consented to an order directing that he not cause, directly or indirectly, any broker or dealer registered with this Commission to fail to disclose in its Form BD information and documents concerning the broker-dealer and its associated persons, as required by Commission rule. Brooks also consented to a further order directing that he not cause, directly or indirectly, any broker or dealer registered with this Commission to fail to establish, maintain, or enforce written policies and procedures reasonably designed to prevent the firm's and its associated persons' misuse of material non-public information. Brooks was also ordered to pay, jointly and severally with Jeffrey Brooks Securities ("JBS") and Jeffrey Brooks (his brother), a civil penalty of $405,000. 

On October 22, 1992, shortly before Brooks agreed to the bar order, he organized DHB Capital Group, Inc. (DHB) as a holding company. Brooks is the controlling shareholder of the Company, as well as the Chairman of the Board, Chief Executive Officer, and Director. On July 15, 1994, the DHB filed the application for inclusion in the NASDAQ SmallCap Market that is at issue in the appeal. 

In August 1994 the NASD staff advised DHB the then inside bid price on the Over-The-Counter ("OTC") Bulletin Board for DHB’s securities was 2-9/16, a price below the required minimum bid price of $ 3.00 per share. The NASD staff also denied the application because of Brooks' history of securities law violations. DHB's subsequent appeal to the NASDAQ Listing Qualifications Committee ("Qualifications Committee") resulted in the same decision to deny inclusion, largely on the basis of the consent injunction entered against Brooks in 1992, the serious nature of the allegations made by the Commission in 1992, and the Commission's bar order. 

In March 1995, the NASD Hearing Review Committee ("Review Committee") affirmed the Qualifications Committee's decision not to include DHB's securities in the NASDAQ SmallCap Market. In addition to the bid price issues, the Committee further found that, "given the extremely serious nature of the SEC allegations made against Brooks, and the fact that he was only recently enjoined," exclusion of DHB from the NASDAQ SmallCap Market "is necessary to protect investors and the public interest and to maintain public confidence" in the NASDAQ SmallCap Market. 

The Commission concluded, in pertinent part, that the NASD's reliance on Brooks' disciplinary history as a further basis for denial was appropriate: 

The facts remain that Brooks has a history of serious securities law violations [Ed: footnote omitted] and a significant ownership interest in DHB, and proposes to retain his position as a DHB director. We do not find it unreasonable that the NASD, reviewing both Brooks' past conduct and his proposed level of involvement in DHB, remains uneasy about the potential for illicit conduct in connection with the operation of DHB or the market for its securities, and unwilling to expose public investors to that possibility.[xxiii] 

In what has now become a much-cited position, the Commission concluded that 

Investors are entitled to assume that the securities in the system meet the system's standards and that "the risk associated with investing in NASDAQ is market risk rather than the risk that the promoter or other persons exercising substantial influence over the issuer is acting in an illegal manner." [Ed: footnote omitted] Even in cases where the NASD has delisted a security from the NASDAQ Smallcap Market (in contrast to denying initial inclusion as in this case), we have acknowledged that, while exclusion from a quotation system may hurt existing investors, primary emphasis must be placed on the interests of prospective future investors. [Ed: footnote omitted] [xxiv]

CONCLUSION 

Even if all the proverbial numbers add up, NASDAQ may still not be willing to list your corporate client if the qualitative factors are lacking.  Unfortunately, client counseling on such matters is often reduced to a guessing game: NASD might agree to that if you also do this. The most common points of contention between NASD staff and applicants are

Clients should be prepared to negotiate these issues and have a game plan as to whether they are prepared to settle largely on the staff’s terms or litigate the matter administratively. Finally, with the pending demutualization of NASDAQ from the NASD practitioners may soon be confronted with different administrative procedures and varying concerns.