oversight

Securities Regulation: Actions Taken to Improve Nasdaq Listing Procedures

Published by the Government Accountability Office on 1999-04-26.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                United States General Accounting Office

GAO             Report to the Ranking Minority Member
                Committee on Commerce
                House of Representatives


April 1999
                SECURITIES
                REGULATION
                Actions Taken to
                Improve Nasdaq
                Listing Procedures




GAO/GGD-99-53
GAO                United States
                   General Accounting Office
                   Washington, D.C. 20548



                   General Government Division



                   B-281373

                   April 26, 1999

                   The Honorable John D. Dingell
                   Ranking Minority Member
                   Committee on Commerce
                   House of Representatives

                   Dear Mr. Dingell:

                   This report responds to your request that we determine whether the
                   Securities and Exchange Commission (SEC) and Nasdaq Stock Market,
                   Inc. (Nasdaq) have implemented the recommendations in our report,
                   Securities Regulation: Oversight of SRO’s Listing Procedures Could Be
                   Improved (GAO/GGD-98-45, Feb. 6, 1998). We made our recommendations
                   to improve the oversight and operations of Nasdaq’s Listing Qualifications
                   Department (NLQ). As also requested, we include information on the
                   status of Nasdaq’s response to recommendations SEC made as part of its
                   oversight of NLQ and information on the status of Nasdaq’s new
                   automated Risk Scoring Compliance System (RSCS).

                   SEC and Nasdaq have implemented our report’s two recommendations.
Results in Brief   First, SEC’s Office of Compliance Inspections and Examinations (OCIE)
                   developed and issued its first report to SEC Commissioners on significant,
                   open recommendations resulting from OCIE inspections. OCIE’s report
                   included not only recommendations involving listings programs, but also
                   those from OCIE inspections of various other self-regulatory organization
                                                 1
                   (SRO) regulatory programs. Bringing open, significant inspection
                   recommendations to the attention of SEC Commissioners, and letting the
                   SROs know that this is being done, provides additional incentive for SROs
                   to comply with OCIE recommendations. Second, NLQ has started
                   preparing quarterly reports to Nasdaq’s management that provide
                   statistical measures of the listing program’s results. The report contains
                   information pertaining to three primary NLQ activities, including
                   (1) exception granting and administration, (2) application review, and
                   (3) compliance monitoring. Routinely reporting these overall program
                   statistics to Nasdaq management should help to keep officials informed

                   1
                    National securities exchanges and registered securities associations, along with registered clearing
                   agencies and the Municipal Securities Rulemaking Board, are collectively termed SROs under Section
                   3(a)(26) of the Securities Exchange Act of 1934.




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             about whether the listings program is achieving results appropriate to
             program goals.

             Nasdaq and SEC officials said that Nasdaq has addressed all 27 of the
             recommendations resulting from OCIE’s 1997 inspection of NLQ. SEC
             officials told us that they would follow up on three of these
             recommendations during the next OCIE inspection of Nasdaq to ensure
             that the actions taken have been effective. For example, SEC
             recommended that to remain listed on Nasdaq, companies receiving “going
             concern” audit opinions must submit business plans that demonstrate their
                                             2
             ability to continue in business. Nasdaq reported that it would require such
             companies to submit business plans. Nasdaq officials said they used these
             business plans to focus the companies’ attention on issues raised by the
             going concern opinions and compliance with listing requirements.
             However, Nasdaq officials reported that OCIE recognizes that Nasdaq
             would refrain from making subjective determinations regarding the
             potential success of the business plans while the companies are still in
             compliance with listing requirements.

             Nasdaq officials told us that they have made substantial progress in their
             development of RSCS. They said that they expect RSCS to be implemented
             into Nasdaq’s compliance monitoring program some time during mid-1999.
             They said that RSCS is to help NLQ analysts more quickly detect problem
             companies that are falling out of compliance with Nasdaq listing
             requirements.

             Nasdaq is the subsidiary of the National Association of Securities Dealers
Background   (NASD) that is responsible for developing, operating, and maintaining
             systems, services, and products for the Nasdaq over-the-counter securities
             market. It is also responsible for formulating regulatory policies and listing
             requirements applicable to this market. The Nasdaq unit responsible for
             administering its program to list companies on the Nasdaq market is NLQ.

             NASD is the largest SRO in the United States, with a membership that
             includes virtually every broker-dealer in the nation that does securities
             business with the public. NASD is subject to SEC oversight and is
             responsible for ensuring that its members comply with federal securities
             laws and NASD rules. NASD, through its regulatory subsidiary NASD
             Regulation, Inc., is responsible for regulating Nasdaq’s over-the-counter
             securities market. NASD develops rules and regulations, conducts

             2
              A going concern opinion may be issued as a result of an external auditor’s review of a company’s
             financial status that raises questions about the company’s ability to remain in business.




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                         regulatory reviews of members’ business activities, and designs and
                         operates marketplace services and facilities.

                         Nasdaq began operation in 1971 as the first electronic, screen-based stock
                         market for over-the-counter securities. Nasdaq enables securities firms to
                         execute transactions for investors and for themselves in an environment of
                         real-time trade reporting and automated market surveillance. As of
                         December 1998, more than 5,580 securities were traded on Nasdaq,
                         representing about 5,100 companies. In addition to its screen-based
                         operations, Nasdaq is distinguished from stock exchanges by its use of
                         multiple market makers—independent dealers who openly compete with
                         one another for investors’ orders in each Nasdaq security. Nasdaq has two
                         tiers: the Nasdaq National Market, where about 3,900 of Nasdaq’s larger
                         companies are listed and traded; and the Small Cap Market, where about
                         1,200 smaller emerging growth companies are traded.

                         Our February 1998 report made two recommendations for improving the
                         oversight and operations of NLQ. First, we recommended that OCIE
                         periodically report the status of all open, significant recommendations in
                         its oversight inspections to the SEC Commissioners. Second, we
                         recommended that SEC require NASD to develop management reports
                         based on overall program statistics to demonstrate NLQ’s operating
                         results.

                         In August 1997, OCIE completed a periodic compliance inspection of NLQ.
                         The SEC staff made 27 recommendations for improving NLQ’s review of
                         listing applicants and the compliance status of listed companies. The
                         inspection report placed special emphasis on five of these
                         recommendations.

                         Our objectives were to determine whether SEC and Nasdaq have
Objectives, Scope, and   implemented our recommendations and to determine the actions Nasdaq
Methodology              has taken to respond to SEC’s inspection recommendations. We also
                         determined the operational status of RSCS. We interviewed SEC and
                         Nasdaq officials and reviewed applicable documents regarding these
                         matters.

                         To determine whether our recommendations have been implemented, we
                         met with appropriate SEC and Nasdaq officials; examined OCIE’s August
                         20, 1998, information memorandum to SEC Commissioners; and examined
                         reports of Nasdaq Listing Qualifications Program Statistics for the quarters
                         ended June 30 and September 30, 1998. To determine the status of
                         Nasdaq’s compliance with OCIE’s inspection recommendations, we met



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                           B-281373




                           with appropriate SEC and Nasdaq officials, reviewed documents relating
                           to SEC’s follow-up to the 1997 inspection, and reviewed NLQ procedures.
                           To assess the operational status of RSCS, we obtained a briefing on and
                           demonstration of RSCS from Nasdaq officials.

                           We obtained written comments on a draft of this report from SEC and
                           Nasdaq (see apps. I and II, respectively); and their comments are discussed
                           at the end of this letter. We did our work in Washington, D.C., between
                           October 1998 and March 1999 in accordance with generally accepted
                           government auditing standards.

                           In August 1998, in response to our recommendation, OCIE submitted an
SEC and Nasdaq             information memorandum to the SEC Commissioners that included the
Developed Reports in       status of significant open recommendations resulting from OCIE
Response to Our            inspections of the securities SROs. The memorandum provided
                           background and operational information on OCIE’s SRO inspection
Recommendations            program and a discussion of the status of open recommendations that
                           OCIE considered significant. The purpose of our recommendation was to
                           keep the commissioners informed and to provide an additional incentive
                           for SROs to comply with OCIE recommendations. OCIE’s memorandum
                           addressed recommendations from all OCIE SRO inspection programs.
                           These included inspections of SRO listing programs, as well as other SRO
                           activities, such as

                       •   arbitration;
                       •   broker-dealer examination;
                       •   financial surveillance and enforcement; and
                       •   trading surveillance, investigation, and enforcement.

                           OCIE indicated that it would annually report the status of all open,
                           significant recommendations to the Commissioners.

                           In August and November 1998, NLQ sent Nasdaq management quarterly
                           statistical summary reports on the progress of the Nasdaq listing program.
                           These summaries used statistical information as indicators of the
                           effectiveness of Nasdaq’s listing program. The reports provided
                           information pertaining to three primary activities within NLQ—exception
                           granting and administration, application review, and compliance
                           monitoring. For example, the reports for the quarters ended June 30, 1998,
                           and September 30, 1998, indicated that the number of issuers granted
                           exceptions as a percent of those requesting exceptions to Nasdaq’s listing
                           requirements generally had diminished. They also indicated that the




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                        B-281373




                        percentage of issuers removed from the listings for failing to comply with
                        the terms of their exceptions increased.

                        The quarterly report is expected to support NLQ’s primary objective of
                        promoting the integrity of the Nasdaq Stock Market through the consistent
                        application of Nasdaq’s listing requirements. The report was developed in
                        response to our recommendation that NASD use statistics to demonstrate
                        NLQ’s operating results and evaluate program effectiveness.

                        In August 1997, OCIE reported on its inspection of NLQ and made
Nasdaq Has Acted to     recommendations for improving Nasdaq’s review of applicants for listing
Comply with SEC’s       and companies already listed. In total, OCIE made 27 recommendations to
Recommendations         improve the operations of the Nasdaq listing program. OCIE officials told
                        us that Nasdaq had addressed all of the 27 recommendations. They
                        reported that they intend to follow up on three of the recommendations to
                        ensure that the actions taken have been effective.

                        OCIE’s inspection report highlighted its recommendations in five key
                        areas. OCIE recommended that NLQ:

                      • implement procedures requiring its analysts to closely scrutinize the value
                        of unaudited assets and the value of audited assets that are unusual or of
                        questionable value;
                      • train its analysts to thoroughly investigate and evaluate disclosures made
                        by issuers in public filings and press releases and require its analysts to
                        routinely conduct investigations into the backgrounds of those individuals
                        involved with issuers, including independent accountants and
                        underwriters;
                      • implement procedures to require companies that receive going concern
                        opinions to set forth a business plan demonstrating their ability to
                        continue business operations in compliance with listing requirements;
                      • create a uniform, concise compilation of its basic review procedures; and
                      • modify its program to monitor listed companies to enable NLQ to more
                        quickly detect companies that are falling out of compliance.

                        In responding to each of these recommendations, Nasdaq has made
                        various procedural and program changes. Nasdaq officials reported that
                        Nasdaq has revised its procedures manuals to include detailed written
                        procedures for valuing assets. For example, they said the procedures now
                        document Nasdaq’s practice to consider requesting corroboration of the
                        value of assets if the issuer’s financial statements contain nonperforming
                        assets, assets related to discontinued operations, significant percentages
                        of intangible assets, undeveloped natural resources, or assets acquired



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related to nonmonetary transactions. However, unless unusual
circumstances exist, Nasdaq staff are to continue to rely upon asset
valuations that have been validated by a company’s independent auditor.
To improve its ability to investigate issuers and company information,
Nasdaq created the Nasdaq Listing Investigations Department (NLI) in July
1997. NLI is responsible for doing in-depth investigations into Nasdaq-
listed issuers. Nasdaq officials told us that NLI has experienced legal and
accounting staff dedicated to this effort. Nasdaq reported that as of mid-
February 1999, NLI had initiated about 85 investigations. About 20 of these
have involved, at least in part, questions concerning asset valuation.
Nasdaq reported that, in several instances, these investigations caused
companies to restate their financial statements. Other investigations have
                                                                            3
focused primarily on the adequacy and accuracy of issuers’ press releases.
Nasdaq officials said that although a number of these investigations are
ongoing, the ultimate disposition has ranged from requiring or encouraging
clarifying or corrective public disclosures to removing companies from the
listings, at least in part, because of their misleading press releases.

To address issues related to companies receiving going concern opinions,
Nasdaq officials reported that they would require these companies to
submit business plans. Specifically, Nasdaq would require companies
receiving going concern opinions from their auditors to provide business
plans that show how the company intends to continue business operations
in compliance with listing requirements. SEC stated that this should allow
better communication between Nasdaq and issuers about the chances of
continued listing, given operating problems that caused the companies to
receive going concern opinions. Nasdaq officials said they used these
business plans to focus the companies’ attention on issues raised by the
going concern opinions and compliance with listing requirements. Nasdaq
officials also reported that OCIE recognizes that Nasdaq would refrain
from making subjective determinations regarding the potential success of
the business plans while the companies are still in compliance with listing
requirements. They also reported that they have heightened their scrutiny
of companies that receive going concern opinions. For example, they said
they can identify companies that have going concern opinions in an
automated information system, called the Issuer Support Services system.
They said they note which companies have going concern opinions on
Nasdaq’s filing review form, which Nasdaq uses for reviewing periodic
filings, and they assign higher risk factors to these companies in Nasdaq’s

3
 Nasdaq’s Market Watch Department has primary responsibility for timely review of companies’ press
releases and, when appropriate, may implement temporary trading halts in a company’s stock for the
dissemination of material news.




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                        B-281373




                        new RSCS. Further, they said all Nasdaq hearing memoranda involving
                        noncompliant companies reflect the presence of going concern opinions.

                        To make Nasdaq procedures manuals more uniform and concise, Nasdaq
                        officials have revised the manuals and included indexes and tables of
                        contents. These officials said Nasdaq reviews its compliance program
                        quarterly and updates the manuals as needed. NLQ has provided OCIE and
                        us with copies of the revised manuals.

                        To more quickly detect companies that may be subject to compliance
                        problems, Nasdaq began developing its automated RSCS in January 1997.
                        Nasdaq officials reported that RSCS is to monitor, among other things,
                        significant changes in the value or composition of a company’s assets.
                        Also, in June 1997, Nasdaq established an electronic interface with SEC’s
                        Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system,
                        which provides real-time access to issuer filings. Nasdaq officials said that
                        this will enable Nasdaq to evaluate issuer filing delinquencies on a
                        substantially accelerated basis. They said financial data obtained through
                        EDGAR is used to update Nasdaq’s database, allowing Nasdaq to focus
                        more quickly on an issuer’s compliance with listing requirements.

                        OCIE officials told us that they intend to follow up during OCIE’s next
                        NLQ inspection to ensure that Nasdaq corroborates asset valuations,
                        evaluate Nasdaq’s approach to going concern opinions, and assess
                        Nasdaq’s handling of companies with filing delinquencies. With respect to
                        delinquent filings, OCIE recommended that Nasdaq remove companies
                        from its listings after a specified number of delinquencies. Nasdaq reported
                        that it believes the issue of companies with chronic delinquent filings
                        should be aggressively addressed. However, Nasdaq officials told us that
                        they were concerned that changing listing requirements to remove
                        companies after a specified number of delinquent filings would imply a
                        “safe harbor” for companies that have received fewer than the specified
                        number. They said the filing requirement could be better enforced on a
                        case-by-case basis. OCIE officials told us that the next inspection of
                        Nasdaq’s listings department is scheduled for August 1999.

                        Nasdaq officials told us that they have made substantial progress in their
RSCS Is Scheduled for   development of RSCS. They said that they expect RSCS to be implemented
Implementation During   into Nasdaq’s compliance monitoring program some time during mid-1999.
Mid-1999                They said they had experienced some technical difficulties with RSCS, but
                        they have continued to fine-tune the system and increase its technological
                        capabilities. They said the purpose of RSCS is to help NLQ analysts more




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                      B-281373




                      quickly detect companies with potential compliance problems that might
                      require additional scrutiny.

                      Nasdaq designed RSCS to assign risk scores to companies by evaluating
                      various factors called “alert items.” Alert items are indicators that Nasdaq
                      has identified as predictors of potential problems at a company or with
                      some aspect of a company’s securities on the Nasdaq market. Specific alert
                      items include data on changes in trading volume, share price, or total
                      shares outstanding; listing requirement statistics, such as net tangible
                      assets, market capitalization, or market value of public float; and the
                      auditor’s opinion of the company’s financial statements. Each alert item is
                      associated with a threshold value. Data for a company are evaluated
                      against each of these thresholds; and if the threshold is exceeded, the alert
                      item for that company is assigned a score. Scores for each alert item
                      associated with a company are totaled. The companies with the highest
                      scores are those that may require more diligent monitoring by NLQ
                      analysts.

                      Nasdaq officials said that they are obtaining most of the data required for
                      RSCS from databases available within NASD. They said the exact items
                      included in the final RSCS depend, in part, on the availability of external
                      data.

                      SEC and Nasdaq promptly responded to both of our February 1998
Conclusions           recommendations. In addition, OCIE and Nasdaq have worked closely to
                      implement and resolve any differences concerning OCIE’s inspection
                      recommendations. As a result, OCIE has stated that it is satisfied that
                      Nasdaq has addressed all of its recommendations. OCIE’s plans to follow
                      up on three recommendations should help ensure that Nasdaq has
                      appropriately responded to those recommendations.

                       It is too early to tell whether RSCS can provide effective early warning of
                      companies that may be falling out of compliance with Nasdaq listing
                      requirements. If effective, RSCS could help analysts identify troubled
                      companies that need additional scrutiny.

                      SEC and Nasdaq generally agreed with and had no substantive comments
Agency Comments and   on this report. They orally provided technical comments, which we
Our Evaluation        incorporated where appropriate. Their written comments are shown in
                      appendixes I and II, respectively.




                      Page 8                              GAO/GGD-99-53 Oversight of Listing Procedures
B-281373




As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 10 days from its
issue date. At that time, we will send copies to Representative Tom Bliley,
Chairman, Committee on Commerce; the Honorable Arthur Levitt,
Chairman, SEC; Mr. Frank Zarb, Chairman, NASD; and other interested
parties. We will also make copies available to others upon request.

Major contributors to this report are listed in appendix III. Please contact
me at (202) 512-8678 if you or your staff have any questions.

Sincerely yours,




Richard J. Hillman
Associate Director, Financial Institutions
and Markets Issues




Page 9                               GAO/GGD-99-53 Oversight of Listing Procedures
Contents



Letter                                                                                                1


Appendix I                                                                                           12

Comments From the
Securities and
Exchange Commission
Appendix II                                                                                          14

Comments From the
Nasdaq Stock Market,
Inc.
Appendix III                                                                                         15

Major Contributors to
This Report




                        Abbreviations

                        EDGAR       Electronic Data Gathering and Retrieval
                        NASD        National Association of Securities Dealers
                        NLI         Nasdaq Listing Investigations Department
                        NLQ         Nasdaq Listing Qualifications Department
                        OCIE        Office of Compliance Inspections and Examinations
                        RSCS        Risk Scoring Compliance System
                        SEC         Securities and Exchange Commission
                        SRO         self-regulatory organization




                        Page 10                            GAO/GGD-99-53 Oversight of Listing Procedures
Page 11   GAO/GGD-99-53 Oversight of Listing Procedures
Appendix I

Comments From the Securities and Exchange
Commission




              Page 12      GAO/GGD-99-53 Oversight of Listing Procedures
Appendix I
Comments From the Securities and Exchange Commission




Page 13                                GAO/GGD-99-53 Oversight of Listing Procedures
Appendix II

Comments From the Nasdaq Stock Market,
Inc.




              Page 14     GAO/GGD-99-53 Oversight of Listing Procedures
Appendix III

Major Contributors to This Report


                        Michael A. Burnett, Assistant Director
General Government      Edwin J. Lane, Evaluator
Division, Washington,   David P. Tarosky, Senior Evaluator
D.C.




                        Page 15                            GAO/GGD-99-53 Oversight of Listing Procedures
Page 16   GAO/GGD-99-53 Oversight of Listing Procedures
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