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FINRA and the Stock Exchanges Take Aim at Underwriters to Address Small-Cap IPO “Ramp and Dump” Schemes

FINRA, NYSE and NASDAQ issue alerts to their members on the recent trend of significant unusual price increases on the day of or shortly after the IPOs of small-cap issuers, most of which involve issuers with operations in China and other foreign countries, as part of so-called “ramp and dump” schemes, and place the obligation to battle the schemes on underwriters as “gatekeepers to the public markets.”

On November 17, 2022, the Financial Industry Regulatory Authority (“FINRA”) issued a special alert to FINRA members concerning the heightened threat of fraud in small capitalization initial public offerings (“IPOs”). At the same time, both the New York Stock Exchange (“NYSE”) and the NASDAQ Stock Market ("NASDAQ") released separate notices to their members expressing similar regulatory scrutiny in connection with small-cap IPOs. In Regulatory Notice 22–25, FINRA observed the recent trend of significant unusual price increases on the day of or shortly after the IPOs of certain small-cap issuers, most of which involve issuers with operations in China and other foreign countries, as part of so-called “ramp and dump” (also known as pump and dump) schemes. FINRA noted that these schemes are characterized by a common fact pattern bearing a number of ramp and dump red flags (as described in more detail below), including the presence of numerous nominee brokerage accounts that invest in the small-cap IPOs and subsequently engage in apparent manipulative limit order and trading activity that culminates in the sale of shares to unsuspecting retail investors, some of whom are victims of social media scams.

Although FINRA states that its Regulatory Notice does not create new legal or regulatory requirements or new interpretations of existing requirements, it squarely places the obligation to battle such schemes on underwriters as “gatekeepers to the public markets.” According to the Regulatory Notice, underwriters must “continuously evaluate and adapt their supervisory systems as well as compliance and risk management programs to ensure that they are monitoring for and addressing this threat.” FINRA ties this obligation to underwriters via their exposure to private civil liability under Sections 11 and 12 of the Securities Act of 1933 subject to their affirmative due diligence defense for misstatements or omissions in IPO prospectuses. Accordingly, FINRA points directly to the underwriters’ lead role in screening for bad actors, particularly when dealing with offshore participants in the underwriting and foreign broker-dealers receiving allocations of shares. This interpretation is unusual, as the due diligence defense normally relates to statements in a prospectus, not to diligence on IPO investors.

NYSE and NASDAQ Reactions

Since at least September 2022, NASDAQ has been reacting to ramp and dump red flags through its initial listing review of small-cap issuers and, in some cases, delaying its final decision to trade until after the pricing of an offering and allocation of the shares. NASDAQ’s focus – similar to FINRA’s indicators noted below – has been on the initial share allocations to syndicate members and accounts receiving allocations from the managing underwriter and the syndicate firms in the IPO. This information is typically provided to NASDAQ by the managing underwriter and syndicate firms. According to NASDAQ’s Equity Regulatory Alert #2022-9, “when gatekeepers such as underwriters engage in misconduct or otherwise are derelict in their duties, confidence is diminished and investors suffer.” NYSE Regulatory Memorandum 22-18 also described its observation of extreme volatility in the aftermath of certain recent IPOs and enumerated some of the same red flags that could negatively influence its initial listing decisions.

Ramp and Dump Red Flags

Employing these marketplace observations, the FINRA Regulatory Notice specifies that the most common indicators or “red flags” of a manipulative ramp and dump IPO scheme are:

  • Small market capitalization and limited public float – FINRA observed that each IPO typically raised less than $25 million and valued each issuer at less than $100 million, with the IPO typically issuing fewer than 20 million shares. While most schemes involve IPOs, FINRA also noted similar characteristics in up-listings to exchanges.
  • Foreign issue – FINRA observed that many issuers or their operating subsidiaries or affiliates maintained primary operations in China or other foreign countries.
  • Foreign broker-dealers – FINRA observed that foreign broker-dealers, primarily based in Hong Kong, have been allocated a significant number, sometimes as much as 90% or more, of the shares. This practice effectively limits the supply of the public float available to the market on the day of the IPO and during the price increase phase of the ramp and dump scheme.
  • Concentrated allocations of IPO shares – FINRA observed that underwriters and selling group members, including foreign broker-dealers, may be allocating the majority of the IPO shares to a small number of investors, leading to a concentration of shares being held in very few hands and making these listings vulnerable to price manipulation.
  • Nominee accounts – FINRA observed that nominee brokerage accounts opened in the names of individuals but controlled by an undisclosed person or group, primarily for foreign residents, have been opened at U.S. broker-dealers to invest in the IPOs and to later place manipulative orders in trades to inflate aftermarket prices. These accounts raise many potential concerns for FINRA including identity theft, funding for initial IPO customer accounts being financed by the issuer, its affiliates or any third parties, and centralized control by an undisclosed principal over a large number of nominee accounts who pre-arranges coordinated trading.
  • Foreign omnibus accounts – FINRA observed that omnibus accounts at U.S. broker-dealers maintained for foreign financial institutions, including foreign broker-dealers, have been liquidating large numbers of shares of the small-cap issuers at the peak of price spikes associated with suspected ramp and dump schemes.
  • Significant price spikes and drops – FINRA observed that most shares of issuers that are the subject of suspected ramp and dump schemes experienced significant price increases in the opening trade on an exchange and in continuous trading on the day of, or days immediately following, the exchange listing. These price increases did not appear to be driven by news or material events. After the spike, the price quickly declined to a level at or even below the original offering price.
  • Allegations of social media scams – FINRA observed that investors in securities that are the subject of suspected ramp and dump schemes have complained about scams that begin with seemingly misdirected text messages or messages on a social media app leading to a “relationship” between the victim and bad actor. After a relationship is established, the bad actor will make a recommendation to the victim to place limit orders in certain securities at a specific time and place.

Suggested Underwriter Responses to the Threat

In response to the apparent ramp and dump schemes, FINRA has advised underwriters in its Regulatory Notice that they should consider their obligations under the Bank Secrecy Act, its implementing regulations and FINRA Rule 3310 (anti-money laundering ("AML") compliance program) by:

  • maintaining customer identification programs to verify the identity of each customer;
  • verifying the identity of the beneficial owners of legal entity customers;
  • establishing due diligence programs for corresponding accounts for foreign financial institutions, including omnibus accounts held for foreign financial institutions;
  • establishing policies and procedures that can be reasonably expected to detect and cause the reporting of suspicious transactions conducted or attempted by, at or through U.S. broker-dealers to the U.S. Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”); and
  • implementing appropriate risk-based procedures for conducting ongoing customer due diligence, including to understand the nature and purpose of customer relationships for the purpose of developing a customer risk profile, and to conduct ongoing monitoring to identify suspicious transactions.

FINRA also suggested that underwriters consider compliance with FINRA Rules 5130 and 5131. Rule 5130 generally restricts, among other things, broker-dealers (or persons associated with them) from selling shares of a new issue to an account in which a restricted person has a beneficial interest. Rule 5131 addresses abuses in the allocation and distribution of new shares, including prohibiting the practice of “spinning,” which is the allocation of new issues by a firm to executive officers and directors of the firm’s current, former or prospective investment banking clients.

Next Steps

Following the FINRA, NYSE and NASDAQ alerts, underwriters of small-cap IPOs will be expected to review their existing AML programs and to establish, maintain and enforce written practices, policies and procedures reasonably designed to detect, prevent and report manipulative ramp and dump schemes, particularly related to customer due diligence measures. Firms receiving initial allocations in a small-cap IPO may wish to consider establishing written supervisory policies that prevent their clients from trading the IPO shares on the first day of trading on the exchange. Underwriters may also consider preparing questionnaires and other documents for their underwriting syndicate (in addition to their FINRA Rule 5130 and 5131 questionnaires), with emphasis on foreign broker-dealers, to determine the status of their accounts receiving share allocations in order to respond to the exchanges. In all events, underwriters should expect to play a larger role in the initial listing process for small-cap issuers and expect more direct information requests from the exchanges about their book building standards. Compliance officers and management of these underwriters should be aware that regulators view underwriters’ IPO diligence obligations in retrospect, meaning that it is not what the firm knew in fact but what it could reasonably have been expected to know.

Additionally, FINRA requires underwriters, when warranted, to make Suspicious Activity Report filings with the SEC and to immediately report potential fraud to FINRA, the SEC and other law enforcement authorities.

FINRA has made clear that underwriters that fail to update their AML programs may face enforcement activity. See, e.g., ViewTrade Securities, FINRA AWC No. 2018058605501 (Aug. 23, 2022). This threat has ample precedent in FINRA’s numerous enforcement proceedings brought with respect to failure to observe red flags in reverse mergers and trading in omnibus accounts. See, e.g., FINRA Regulatory Notice 21-03 (Feb. 10, 2021), In re Glendale Securities, Inc., Complaint No. 2016049565901 (FINRA NAC Oct. 6, 2021).

On a larger scale, it is unclear whether the actions of FINRA and the stock exchanges will serve to chill the small-cap IPO market (in a similar fashion seen following the SEC’s proposed SPAC rule amendments), potentially turning away investors in an already weak IPO market. Renaissance Capital recently reported in its November 2, 2022 “IPO Icebreakers: a look at past slowdowns in US IPO activity” that “just 66 IPOs have priced thus far in 2022, an 81% drop from this time last year, and only 18 have raised over $50 million.” This statistic indicates that 48 IPOs, or 73%, of the IPOs in 2022 have raised less than $50 million, leaving one to wonder what impact these ramp and dump schemes have on legitimate smaller IPOs in the market today.

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