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One of the side effects of the 1990s Internet/technology boom was an increase in young companies going public. With new listings and the creation of startup companies came a boon to corporate lawyers and those working in the Internet technologies field. However, this bounty was not without its unsavory side. The skyrocketing stock prices of the techno-craze attracted many questionable characters with criminal and regulatory histories to our securities markets. Although recent headlines depict Wall Street as infested by organized crime and criminal enterprises, the overwhelming majority of industry participants do not have criminal backgrounds. Nonetheless, corporate practitioners may foolishly assume that all individuals on a client’s management team or on a board of directors lack any criminal history. Unfortunately, such a false sense of security has caused problems — serious problems — for companies listed with, or currently seeking listing on, Nasdaq. Future historians may well conclude that the 1990s bull market prompted the demutualization of the stock markets and further dehomogenized Wall Street’s boardrooms and executive suites. The Ivy Leaguer now sits next to the college dropout. Mainstream companies are frequently stewarded by wizened veterans of top B-schools; however, upstart Internet/technology firms are just as likely to be managed by kids who started in their parents’ garage and declined to pursue a college degree. Another tell-tale difference is that while many directors and executives of traditional publicly traded companies have side-stepped occasional brushes with the law (either through influence or the benefits of privilege), the new generation of corporate helmsmen may not have been so fortunate. This is not necessarily an indication that the newcomers are more apt to be disreputable; rather, it is more plausible that listed companies now better reflect America at large, complete with youthful indiscretions, DWIs, bounced checks and, yes, even felony convictions. Therein lies the issue, fraught with social and ethical dilemmas: Can or should there be a balancing test applied to permit former felons or individuals with serious regulatory violations a role on the boards or in management of publicly traded companies? NEED FOR CLARIFICATION On April 6, 1994, the National Association of Securities Dealers Inc. filed a proposed rule change with the Securities and Exchange Commission that was subsequently approved June 3, 1994 (Criteria Order). [FOOTNOTE 1]The express purpose of the NASD proposal was to clarify its discretionary authority under Schedule D of its bylaws [FOOTNOTE 2]allowing for the exclusion of an issuer from its listing, Nasdaq. [FOOTNOTE 3] Why did the NASD need such clarification? For most securities professionals, the issue seemed to have been fully addressed nearly 20 years ago in In the Matter of Tassaway Inc., Securities Exchange Act Release No.11291, 1975 SEC LEXIS 2057 (1975), when the commission held that the NASD is vested with discretionary authority to deny an issuer’s request that its securities be included in Nasdaq, and that in undertaking such considerations, the self-regulatory organization’s (SRO) primary emphasis must be placed on the interests of prospective future investors. [FOOTNOTE 4] Prior to this decision, the majority of listing denials had been based on so-called quantitative issues, e.g., market capitalization, public float, minimum bid price, number of shareholders, etc. However, in the years following Tassaway, the NASD was increasingly confronted with qualitative issues, e.g., control persons with felony histories, directors subject to commission injunctions, vice presidents involved in stock-promotion frauds, etc. Consequently, there was concern as to whether Tassawaywas broad enough to cover the panoply of qualitative issues. Ultimately, the NASD found itself asking the same question: Do we really want these types of companies listed on Nasdaq? Accordingly, the Criteria Order states: The NASD is concerned about an increase in recent years in the number of applications for inclusion in NASDAQ by issuers that are managed, controlled or influenced by persons with a history of significant securities or commodities violations. In particular, the NASD is concerned about issuers substantially influenced by persons who have previously been the subject of a significant sanction for violations of state or federal securities laws, self-regulatory organization (“SRO”) rules and regulations, or the subject of a felony conviction in connection with the purchase or sale of securities or commodities. The NASD believes that applications from these issuers for inclusion in NASDAQ reflect a pattern of activity in which persons with a history of securities or commodities violations seek to continue their violative conduct in the securities markets through the management, control or influence of a publicly-held company. The NASD has indicated that a case-by-case review of issuer applications has previously resulted in denials of certain applications pursuant to the “catch-all” provision of Part II, Section 3(a)(3) of Schedule D. [FOOTNOTE 5] ZERO TOLERANCE In submitting its proposal, the NASD appears to have taken great pains to avoid the criticism that it sought to impose a blanket prohibition against all former criminals, tortfeasors and regulatory violators seeking a directorship or managerial position with a Nasdaq issuer. On the surface, the proposal establishes a two-part analysis: � Is there an individual with a “history of significant securities or commodities violations?” � Does such an individual intend to exercise management, control or influence over a Nasdaq issuer/candidate? Assuming that the answer to both questions is “yes,” I believe the NASD has implemented an irrebuttable presumption that listing 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. [FOOTNOTE 6]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.” [FOOTNOTE 7] 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 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. [FOOTNOTE 8] NONDISCLOSURE AND DUE DILIGENCE As many practitioners have learned, unfortunately, clients often lie about regulatory violations or securities-related convictions. On the other hand, in some nondisclosure 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 federal, state and local court criminal records, and the records of regulatory agencies. Disclosures should generally be followed up by obtaining underlying documents: complaints, answers, decisions, etc. However, efforts to perform even cursory inquiries may pose some unusual problems. Practitioners involved in the 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. Item 401 states in part: 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. [FOOTNOTE 9] In addition to criminal disclosures, Regulations S-K and S-B also require information concerning orders, judgments or decrees that enjoined, barred or suspended the individual from involvement in any business, securities or banking activities. Furthermore, the checklist provided to companies interested in being listed on Nasdaq specifically urges applicants to “determine whether any of the Company’s officers, directors, or principal shareholders have been charged with or convicted of any crimes involving fraud, embezzlement, insider trading, or any other matter concerning dishonesty.” [FOOTNOTE 10] Industry lawyers are accustomed to regulatory inquiries asking whether an individual has ever been convicted of or pleaded guilty or nolo contendere in a foreign court to a misdemeanor or felony, or whether a foreign financial regulatory authority has ever found an individual to have made false statements, engaged in fraudulent conduct or violated investment-related regulations. [FOOTNOTE 11]These inquiries represent a standard inquiry that corporate clients should expect will be applied to them during the Nasdaq listing process. However, one common pitfall that corporate practitioners fall into is that they frequently fail to appreciate that the NASD’s inquiry into an individual’s background is not limited to the five-year horizon reflected in the federal regulations cited above. Corporate attorneys are often struck by the difference between the precise requirements (and years of statutory interpretation and case law) involved in the registration process at the commission and the more elastic requirements (and relatively limited statutory interpretation and case law) involved in the listing process at Nasdaq. Making matters worse is that in recent years, the listing process and attendant administrative appeals process at the NASD has been overhauled. As a result, lawyers reviewing even somewhat recent statutory history or case law will likely become frustrated with the changes in departmental names and functions, and the revised interplay among 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.” [FOOTNOTE 12]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, the practical impact of your investigation may well be that your corporate client will be denied a Nasdaq listing, or its current listing may be 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 had been convicted of felony tax law violations. [FOOTNOTE 13]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 pleaded 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 finished his parole in May 1994. On Feb. 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” [FOOTNOTE 14]to list JJFN’s shares on the Nasdaq SmallCap Market. JJFN appealed the staff’s decision to the Nasdaq Listing Qualifications Panel. On Aug. 22, 1996, the qualifications panel found that Miller’s “involvement in [JJFN] both as a shareholder and as a consultant is substantial.” [FOOTNOTE 15]The panel determined that Miller’s felony tax fraud convictions “related to his role as the officer of a company.” [FOOTNOTE 16]The panel 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.” [FOOTNOTE 17] In late August 1996, JJFN appealed the qualifications panel’s decision to the Nasdaq Listing and Hearing Review Committee. On Dec. 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 offer to terminate his consulting contract with JJFN, sell his JJFN shares and 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.” [FOOTNOTE 18]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.” [FOOTNOTE 19]JJFN appealed to the commission Jan. 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 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 10 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.” [FOOTNOTE 20]Contrary to this assertion, however, the 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 completely barring issuers that have control persons or key personnel who have been convicted of a felony from inclusion in Nasdaq. 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.” [FOOTNOTE 21]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, the message seems to be, “All 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. [FOOTNOTE 22] On Dec.18, 1992, to settle an injunctive complaint filed by the commission, David Brooks consented to a permanent injunction by the U.S. District Court for the Southern District of New York against aiding and abetting violations of �� 15(b) and 15(f) of the Securities Exchange Act of 1934 and Rule 15b3-1 thereunder. On Dec. 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, any information or 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 misuse of material nonpublic information by the firm or its associates. 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 Oct. 22, 1992, shortly before David 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, DHB filed its application for inclusion in the Nasdaq SmallCap Market. In August 1994, the NASD staff advised DHB that 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 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 resulted in the same decision denying 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 affirmed the qualifications panel’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 [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.” [FOOTNOTE 23] 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.” [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.” [FOOTNOTE 24] 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: The NASD might agree to that if you also do this. The most common points of contention between NASD staff and applicants are: � How much stock a control person with regulatory/criminal history may retain, and � How much control that individual may exercise over the operations of the listed company. 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. Bill Singer is the regulatory partner of the securities industry law firm of Singer Frumento LLPin New York. This article represents the personal views of Mr. Singer. He may be reached at [email protected] com. � 2000 Bill Singer. ::::FOOTNOTES:::: FN1Order Approving Proposed Rule Change to Provide the NASD with Discretionary Authority to Exclude an Issuer from the NASDAQ Stock Market or Impose Additional or More Stringent Criteria for Inclusion in the NASDAQ Stock Market, Securities Exchange Act Release No. 34-34151 (June 3, 1994), 1994 SEC LEXIS 1692 (June 3, 1994) (“Criteria Order”). FN2On Jan. 11, 1996, the commission approved a wholesale revision of the NASD’s rules and regulations structure (“Manual”). Accordingly, former Schedule D to the bylaws is now found under the 4000 Rules series of the Nasdaq Stock Market. Specific reference is cited to Rule 4300 series: Qualification Requirements for NASDAQ Stock Market Securities (“NASDAQ � will exercise broad discretionary authority over the initial and continued exclusion of securities in NASDAQ in order to maintain the quality of and public confidence in its market.”); Rule 4330: Suspension or Termination of Inclusion of a Security and Exceptions to Inclusion Criteria; and the Rule 4800 series: Procedures for Review of NASDAQ Listing Determinations. FN3Criteria Order, 1994 SEC LEXIS 1692 at page 1. FN4 SeeCriteria Order at page 13; In the Matter of the Application of AIR L.A. Inc. and CVD SERVICES Inc. for Review of Action Concerning the Operations of the NASDAQ Stock Market Taken by the National Association of Securities Dealers Inc., Securities Exchange Act Release No. 34-34491, 1994 SEC LEXIS 2385 (1994). FN5Criteria Order at pages 3-4. FN6 Id. at page 5. See17 CFR � 240.3a51-1, Securities Exchange Act of 1934 Rule 3a51-1: Definition of Penny Stock; 17 CFR � 240.15g-2 through 240.15g�9, Securities Exchange Act of 1934 Rules 15g-2 through 15g-9. FN7Criteria Order at page 5. FN8Criteria Order at pages 17-18. FN9Regulation S-K, 17 CFR 229, Item 401(f) and (g) Regulation S-B, 17 CFR 228 Item 401(d). FN10“Going Public and Listing on the U.S. Securities Markets, Appendix D (Due Diligence Examination Outline) I(B)(2),” http://www. nasdaq.com /about /going_public.stm. FN11“Uniform Application for Securities Industry Registration or Transfer, Rev. Form U-4, Items 23A, B and D” (8/1/1999) (Form U-4) FN12 Id. at page 1, Explanation of Terms FN13Order Dismissing Review Proceedings, In the Matter of the Application of JJFN Services Inc., for Review of Action Taken by the National Association of Securities Dealers Inc., Securities Exchange Act Release No. 39343, 1997 SEC LEXIS 2393 (1997). FN14 In the Matter of JJFN, at Pages 5-6. FN15 Id. FN16 Id. FN17 Id. FN18 Id.at pages 6-7. FN19 Id. FN20 Id. at page 8. FN21Criteria Order at page 14. FN22Order Dismissing Review Proceedings , In the Matter of the Application of DHB Capital Group Inc., for Review of Action Taken by the National Association of Securities Dealers Inc.,Securities Exchange Act Release No. 37069, 1996 SEC LEXIS 989 (1996). FN23 In the Matter of JJFN, at pages 12-13. FN24 Id.at pages 14-15.

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