Delisting 101

In this episode of Industry Focus: Tech, host Dylan Lewis and Motley Fool contributor Evan Niu explain exactly what it means for a company to be delisted.

Tune in to find out why a company might be delisted, and why it's usually, but not always, a bad thing; the many benefits of being listed on an exchange; some sneaky ways that floundering companies might play with their financials to remain listed, without fixing the problems that led to the delisting danger in the first place; and more.

A full transcript follows the video.

This was recorded on Feb. 1, 2018.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, February 16, and we're doing a rundown on delisting. I'm your host, Dylan Lewis, and I'm joined on Skype by senior tech specialist Evan Niu. Evan, what's going on?

Evan Niu: Not a whole lot.

Lewis: Astute listeners may notice that last week's Tech show and this week's show are both on fairly evergreen topics, and that's because we pre-recorded them.

Niu: You're going out of town for a little while.

Lewis: Yeah, I have to cover my bases here. Listeners, I will be out of town from the 2nd through the 20th. I'm going to be traveling to India for a friend's wedding. So, last week's episode and this episode were both recorded ahead of time. We're actually recording this on the 1st. So, if any earth-shattering tech news came out during that period, we will be sure to hit it once I come back. But, in the meantime, we're going to be having a little discussion about delisting. This might be a topic that people aren't all that familiar with. If you're an investor, frankly, it's something you don't really want to have any personal experience with. Right, Evan?

Niu: [laughs] Yeah, it's not really a good thing. Most delistings are bad. There's a few circumstances when they're not really negative, and they're not really good, but they're just not bad.

Lewis: And what we're talking about here when we say delisting is basically a stock being taken off of an exchange.

Niu: Right. For example, a company could voluntarily delist itself in an exchange, which would usually be in a situation if they're getting acquired, or if, let's say, they're going private, which usually means they're being acquired by a private equity firm or something. Sometimes, companies also decide to change which exchange they trade on, in which case they delist from one then list on another. For example, T-Mobile switched a year or two ago, I forget which way, either from NASDAQ to New York or New York to NASDAQ. It doesn't really make a huge difference. In the vast majority of cases, delisting is absolutely a bad thing, because it usually means the company is failing to meet some of the basic listing requirements, which could be things like filing reports with the FCC in a timely manner, maintaining a minimum share price, meeting minimum financial metrics on revenue or shareholder equity, among a few other requirements.

Lewis: And similar to the index discussion that we had last week, these exchanges have certain requirements in place, and in some ways, being on a public exchange is a stamp of legitimacy, so these requirements are basic hurdles that companies should cover that are theoretically in place to also protect the average investor.

Niu: Right. And exchanges are very heavily regulated. There's a lot of investor protections built into there. And there's a certain amount of prestige for getting your stock listed on a major exchange, which is why, for example, when companies go public, they do the ceremonial ringing of the opening bell and they have a big party of celebration to celebrate it. And there's a little bit of prestige there.

Lewis: You mentioned some of the elements that are requirements. A couple of specific examples from the New York Stock Exchange, their delisting document says a company will be considered to be below compliance standards if the average closing price of a security as reported on the consolidated tape is less than $1 over a consecutive 30-day trading period. Which is a mouthful, and that's a ton of legalese, but basically, if a stock is trading down in penny stock territory, the company is put on notice and then has a certain amount of time, I believe it's six months after being notified, to have their share price above $1 for an extended period of time to maintain their status on the exchange. Similarly, there's a market cap requirement for the New York Stock Exchange. Again, this is from their delisting document, talking about how if a stock's average global market cap over a consecutive 30-day trading period is less than $50 million, and at the same time, stockholder equity is less than $50 million, it will be considered below compliance. So, these are things that are, in some ways, protectionist. Also something that maintains the prestige of the exchange itself. 

Evan, if you are holding a stock that gets delisted, what happens? Where do the shares actually go?

Niu: If a stock actually goes all the way and gets delisted, it's usually, as you mentioned, one of these bad scenarios, they can still trade over the counter on the bulletin boards, the OTCBB, or on the pink sheets. Both are a lot less regulated, but the pink sheets are even worse. There's really not a whole lot of regulation on the pink sheets. I've always considered it like the wild, wild west, because a lot can happen, and not in a good way.

Lewis: Yeah. This space we're talking about, the pink sheets and the OTC shares, is really a space that is ripe for speculation and price manipulation. We have a lot of cautionary pieces on fool.com talking about penny stocks, and this is the space we're talking about, where if a stock is small enough, if shares are cheap and the market cap is small enough, the share price can pretty easily be manipulated by a couple of really buzzy PR pieces, or some news that comes out of nowhere that doesn't seem to have legitimacy. And that's where average investors can get swept up in pump-and-dump schemes.

Niu: Right. You have to be really careful any time you're trading things in the pink sheets or over the counter. The best example of stuff that you don't need to worry too much about are, a lot of foreign companies, if they have ADRs listed here but they're not on the major exchange, large foreign companies might sometimes trade over the counter, and that's not really a big deal. That's fine, because these are large, well-known companies. A couple of examples, Samsung trades over the counter, the ADR trades over the counter, and Samsung is obviously a humongous company, it's not like it's some crazy penny stock. Tencent is one of the largest Chinese tech companies in the world. They trade over the counter, the ADR does. So, there are certainly some examples of over-the-counter stocks that you don't have to worry about. But, at the same time, penny stocks that are trading on the counter, you want to watch out for those.

Lewis: And the stuff that we're talking about on today's show, for the vast majority of the stocks that the average investor holds, certainly in my portfolio, I'm looking at fairly large-cap companies, very established businesses, that aren't going to fall into that sub $50 million market cap territory. But if you're an investor that's working in that space, what should you be watching for when it comes to delisting, and maybe, why a company is being delisted?

Niu: I think that's the key thing. If your stock is being delisted, the absolute most important thing to look at is why, what is it that's causing it. And if they're failing to meet some of these base requirements, then certainly that's a bad thing. And when you see a notice that your stock is at risk of being delisted, that's not a notice you want to get, because it's almost always a bad thing. Certainly, if you get news that your stock is getting acquired by some big company for a 50% premium and your stock will get delisted, you're not going to really mind hearing that news.

Lewis: Actually, on the flip side, on the bad side of delisting, one of the reasons that I was kind of interested in doing this show was, in the flurry of blockchain news that has come out over the last couple of month with the rise of Bitcoin and that coming into the consciousness, we say that news from Long Island Tea Co changing their news to Long Blockchain, and the massive, meteoric rise of their market cap and stock in the time that followed after that announcement. A Bloomberg piece came out, and I think this is something that Market Foolery mentioned at one point closer to the actual news, a Bloomberg piece noted that the company was dangerously close to being delisted prior to them making this Long Blockchain announcement. So, if you are watching companies that are in the smaller market cap space, these micro-cap and small-caps, and you see them making big, flashy announcements full of buzzwords that are empty on execution, that might be a company that's circling the drain, could be delisted, and is desperately looking for ways to avoid it.

Niu: Right, or it could be a reverse stock split to artificially raise your share price.

Lewis: Yeah. If an exchange has a minimum share price requirement -- like I said, the New York Stock Exchange does, as does the NASDAQ -- and a company is at risk of falling below that, they can do a little bit of financial engineering to make sure that they're above it. That's not to say that the company should be delisted, or would want to avoid being delisted. But if you see a company saying, "We're going to do a reverse stock split," that's just shuffling the number of slices, it's not really making a material change to the business. If it's struggling and on a general downward trajectory, that's certainly not going to change with them doing the reverse stock split.

Niu: Right. And, obviously, a reverse stock split does not affect the market cap, which, as we mentioned, there are requirements on market cap, so a reverse stock split would only affect the share price, not the market cap.

Lewis: And I'm less skeptical of a company doing a reverse stock split to stay alive on the exchanges, because that's something that gives them more life and isn't really materially changing the business. I'm not a huge fan of things on the administrative side that might cost money and effort but don't actually do anything for the business, which is what anything in the stock split realm does, but what it does do is buy a company time. That said, if you see a company doing this, it may be a red flag, it might be something that you might want to watch, because you could be on the path to having your shares delisted down the road.

Niu: Right.

Lewis: Evan, we have been dogging companies that get delisted and talking about the requirements for what it takes to stay on these exchanges. Why don't we take a look at the flipside here, and the benefits of being listed in the first place?

Niu: I think that's a useful angle to look at it, because obviously, if you delist, you lose all these benefits. The most important benefit, I think, is really just greater liquidity. And there's a lot of benefits related to market mechanics that all tie into liquidity. For example, market depth is one, which is a measure of liquidity that gauges the market's ability to sustain large orders without impacting the market price. And this is important if you have a broadened investor base. And certainly, when companies go public, by definition they broaden their investor base quite a bit. So then, you have a lot of market participants, and these investors are going to want to be able to buy and sell their shares, and ideally not impact the price too much. 

And this also relates to price continuity, which is a measure of market depth that basically means you can have small price changes as the market fluctuates. For example, if you don't have price continuity, the price can jump around quite a bit. Let's look at an extreme example. Let's say some stock is being offered at $50, but the next best offer is $60. If you put an order in that blows through both of those offers, the price jumps $10, which is obviously not a good thing and contributes to volatility. So, ideally, the next best offer is just a few pennies higher, which would allow relative price continuity. And that's the case for most stocks listed on the exchange. The next highest offer is just a couple of pennies higher, so you're not going to have these wild swings.

Lewis: Yeah, if you're looking at your online brokerage and you look at any mid- to large-cap company, the bid-ask spread between what you can buy and what people are looking to sell shares for is often not very large.

Niu: Right. The spread itself will just be pennies, but even if you look at just one side, either the bids or the offers, within those orders, you're going to have a lot of orders backing up. So, at the best offer, there will be a bunch of orders, and the next best offer will be typically a penny more or maybe two pennies. That's a good thing for investors, because it allows you to actually have a lot of liquidity.

Lewis: What about price discovery, Evan?

Niu: Another benefit is you have price discovery. The market is an extremely powerful price discovery tool. You have millions and millions of investors every day, both long and short, out there in the market voting with their wallets on what a stock should be worth. And it's incredibly useful for an investor, to be able to readily look up what their stocks are worth at any time and get a quote and know that they can sell them at those prices very easily. Now, in contrast, if you're a private company that's not listed on an exchange or anything, private company valuations are typically negotiations between small groups of people -- investment bankers, CFOs, venture capitalists. And while these people are very intelligent, and they know what they're doing, it's still a relatively small number of people that are basically deciding what the company is worth. 

And that can cut both ways, because of course, the market can overreact, both positively and negatively. Bubbles can form, you can get hyped-up things. But, generally, it's more efficient for price discovery. Now, that being said, I'm not going to say I'm a huge proponent of the efficient market hypothesis, personally. But in general, that's a benefit for investors. If you hold a stock, you I want to know what the stock is worth, and you want to know you can go sell it. And that also ties into employees for these companies, because oftentimes employees get shares as compensation. And without being to cash out those shares, that's not good for those employees, because the compensation benefits and retention benefits are severely undermined if you don't really have that liquidity.

Lewis: Yeah. If you're at a private company, there's a chance that you get valuation rounds maybe quarterly or twice a year or something like that from a valuation firm. And it might be that there are fairly steep jumps or dives based on the previous round of the valuation. You may go from a $30 valuation one quarter down to a $25, and you don't have more of a gradient to that. It can be very sharp adjustments to what you hold and what it's worth. Additionally, the ability to get rid of those shares at some point, or the ability to have a market available where you can buy and sell private company shares, is very often determined by the board. It's not something that's constantly available, you don't have liquidity events every day.

Niu: Right, exactly. I think another important benefit is simply better access to capital markets. If a company needs to raise capital through debt or stock offerings, being on the exchange and having access to those investors and being able to raise money when you need it to grow the business or for whatever reason, is also a huge benefit.

Lewis: You have to love those opportunities for shareholder dilution, right? [laughs] That's a page from Tesla's book right there.

Niu: Yeah, right? [laughs] 

Lewis: And maybe that's something we'll cover next time I'm going to be out of town for an extended period of time, shareholder dilution. That's another evergreen topic that's always worth diving into, Evan. Evan, I think that pretty much does it for delisting and the benefits of being listed on an exchange. Anything else before I let you hop off?

Niu: No, I think we're good.

Lewis: Alright. Listeners, that does it for this episode of Industry Focus. If you have any questions or you just want to reach out and say hey, you can shoot us an email over at [email protected], or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes or check out The Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Shout out to Austin Morgan for all his work behind the glass. He lobbied hard for some pop filters for the microphones in the studios. I'm hoping my P's and B's start sounding a little bit better right there -- that's a perfect example, I just hit that B pretty hard. Listeners, if I still sound atrocious, please let me know. For Evan Niu, I'm Dylan Lewis. Thanks for listening and Fool on!