When stocks are soaring and initial public offerings (IPOs) are raking in the money, it can seem like a bull market will never end. Nevertheless, market downturns are inevitable and when the fall from grace occurs - as it has many times in the stock market's history - textbook conditions for delisting can be created. Here we examine how and why delisting occurs and what this change in status means - for both the company being delisted and the individual investors that hold its stock.
 
Getting Listed 
You can think of major stock exchanges such as the New York Stock Exchange (NYSE) and the Nasdaq as exclusive clubs. To get listed on a major exchange like the Nasdaq, a company must meet the minimum standards required by the exchange. On the Nasdaq Global Market, for example, a company must pay a $25,000 application fee in 2010 before its stock can even be considered for listing, and it can expect to pay between $125,000 and $225,000 in listing fees if successful.

As for other requirements, companies must meet minimum standards such as minimum stockholder's equity and a minimum number of shareholders, among many other things. Turning again to the Nasdaq Global Market as an example, a company must have at least 1.1 million public shares outstanding worth a total of at least $8 million and a share price of at least $4 per share before it can be considered for listing on the exchange. There are numerous other rules that apply, but until a company reaches these minimum thresholds, it has no chance of being listed on the Nasdaq. Similar requirements exist for the NYSE and other reputable exchanges around the world.

Why the Prerequisites?
Stock exchanges have these requirements because their reputations rest on the quality of the companies that trade on them. Not surprisingly, the exchanges want only the cream of the crop - in other words, the companies that have solid management and a good track record. Thus, the minimum standards imposed by major exchanges serve to restrict access to only those companies with a reasonably credible business and stable corporate structure. Any top university or college has strict entrance requirements; top exchanges work the same way. (For further reading, try Getting To Know Stock Exchanges and The Tale Of Two Exchanges: NYSE And Nasdaq.)

Staying Listed
However, an exchange's duty to maintain its credibility isn't over once a company becomes successfully listed. To stay listed, a company must maintain certain ongoing standards imposed by the exchange. These requirements serve to reassure investors that any company listed on the exchange is a suitably credible firm, regardless of how much time has passed since the firm's initial listing. To fund their ongoing scrutiny, exchanges charge periodic maintenance fees to listed companies. On the Nasdaq Global Market, annual listing fees in 2010 range from approximately $30,000 to $100,000 (higher fees are charged to companies with more shares outstanding). To extend the university analogy, these ongoing requirements are much like the minimum grade point averages students must maintain once admitted, and the annual listing fees are like paying tuition.

For stock exchanges, the ongoing minimum standards are similar to the initial listing standards, but they're generally a little less stringent. In the case of the Nasdaq Global Market, one ongoing standard that a listed company must meet is to maintain 750,000 public shares outstanding worth at least $1 million - anything less could result in a delisting from the Nasdaq.

In other words, if a company messes up, the exchange will kick the company out of its exclusive club. A stock that has experienced a steep price decline and is trading below $1 is very risky because a relatively small price movement could result in a huge percentage swing (just think - with a $1 stock, a difference of $0.10 means a change of 10%). In low volume penny stocks, the fraudsters flourish and stocks are much more easily manipulated; major exchanges don't want to be associated with this type of behavior, so they delist the companies that are liable to be affected by such manipulation. (To learn more, see The Lowdown On Penny Stocks and Catching A Lift On The Penny Express.)

How Delisting Works
The rules for delisting depend on the exchange and which listing requirement needs to be met. For example, on the Nasdaq, the delisting process is set in motion when a company trades for 30 consecutive business days below the minimum bid price or market cap. At this point, Nasdaq's Listing Qualifications Department will send a deficiency notice to the company, informing it that it has 90 calendar days to get up to standard in the case of the market value listing requirement or 180 calendar days if the issue is regarding the minimum bid price listing requirement. The minimum bid price requirement, which is $1, and the market value requirement (minimum $5 million, provided other requirements are met) are the most common standards that companies fail to maintain. Exchanges typically provide relatively little leeway with their standards because most healthy, credible public companies should be able to meet such requirements on an ongoing basis.

However, while the rules are generally considered to be written in stone, they can be overlooked for a short period of time if the exchange deems it necessary. For example, on September 27, 2001, the Nasdaq announced that it was implementing a three-month moratorium on price and market value listing requirements as a result of the market turbulence created by the September 11, 2001, terrorist attacks in New York City. For many of the approximately 400 stocks trading under $1, the freeze expired on January 2, 2002, and some companies found themselves promptly delisted from the exchange. The same measures were taken in late 2008 in the midst of the global financial crisis, as hundreds of Nasdaq-listed companies plunged below the $1 threshold. The Nasdaq makes other exceptions to its rules by extending the 90-day grace period for several months if a company has either a net income of $750,000, stockholders' equity of $5 million or total market value of $50 million.

What Delisting Means for the Company
When a stock is officially delisted in the United States, there are two main places it can trade:
  • Over the Counter Bulletin Board (OTCBB) - This is an electronic trading service offered by the Financial Industry Regulatory Authority (FINRA, formerly the NASD); it has very little regulation. Companies will trade here if they are current in their financial statements.
  • Pink Sheets - Considered even riskier than the OTCBB, the pink sheets are a quotation service. They do not require that companies register with the Securities and Exchange Commission (SEC) or remain current in their periodic filings. The stocks on the pink sheets are very speculative.
Delisting doesn't necessarily mean that a company is going to go bankrupt. Just as there are plenty of private companies that survive without the stock market, it is possible for a company to be delisted and still be profitable. However, delisting can make it more difficult for a company to raise money, and in this respect, it sometimes is a first step towards bankruptcy. For example, delisting may trigger a company's creditors to call in loans, or its credit rating might be further downgraded, increasing its interest expenses and potentially even pushing it into the red.

How Does It Affect You?
As a shareholder, you should seriously revisit your investment decision in a company that has become delisted; in many cases, it may be better to cut your losses. A firm unable to meet the listing requirements of the exchange upon which it is traded is quite obviously not in a great position. Each case of delisting needs to be looked at on an individual basis. However, being kicked out of an exclusive club such as the NYSE or the Nasdaq is about as disgraceful for a company as it is prestigious for it to be listed in the first place. 

Even if a company continues to operate successfully after being delisted, the main problem with getting booted from the exclusive club is the trust factor. People lose their faith in the stock. When a stock trades on the NYSE or Nasdaq, it has an aura of reliability and accuracy in reporting financial statements. When a company's stock is demoted to the OTCBB or pink sheets, it loses its reputation. Pink sheet and OTCBB stocks lack the stringent regulation requirements that investors come to expect from NYSE and Nasdaq-traded stocks. Investors are willing to pay a premium for shares of trustworthy companies and are (understandably) leery of firms with shady reputations. 

Another problem for delisted stocks is that many institutional investors are restricted from researching and buying them. Investors who already own a stock prior to the delisting may be forced by their investment mandates to liquidate their positions, further depressing the company's share price by increasing the selling supply. This lack of coverage and buying pressure means the stock has an even steeper climb ahead to make it back on to a major exchange. (See, What happens to my shares of a company that just received a delisting notice?)

The Bottom Line
Some argue that delisting is too harsh because it punishes stocks that could still recover. However, allowing such companies to stay listed would result in the major exchanges simply diluting the caliber of the companies that trade on them and degrading the respectability of the companies that maintain the listing requirements. Therefore, if a company that you own is delisted, it may not spell inevitable doom, but it is certainly a black mark on that company's reputation and, if the company can't recover, a sign of diminishing returns down the road.