[This post has been updated to reflect the joint statement of Commissioners Allison Lee and Caroline Crenshaw, posted today.]

On August 26, the SEC’s Division of Trading and Markets took action, pursuant to delegated authority, to approve a proposed NYSE rule change that would allow companies going public to raise capital through a primary direct listing.  (See this PubCo post.) Five days later, that rule change hit a “snag,” as the WSJ put it—the SEC notified the NYSE that the approval order had been stayed because the SEC had received a notice of intention to petition for review of the approval order. The petition, submitted by the Council of Institutional Investors, was granted in September.  Yesterday, after cancelling the open meeting scheduled to address the NYSE rule, the SEC approved, by a vote of three to two, the NYSE’s proposed rule change, as amended. According to the NYSE President, the approval “is a game changer for our capital markets, leveling the playing field for everyday investors and providing companies with another path to go public.” Will primary direct listings now replace SPACs as the favored alternative offering format? Some have even suggested that the approval “will ‘unquestionably’ usher in the end of traditional initial public offerings.” That remains to be seen.

Commissioner Elad Roisman supported the proposal as an innovative alternative. While he recognized that primary direct listings may not include all the features of traditional underwritten IPOs, nevertheless, because direct listings are still registered offerings, “the anti-manipulation provisions of the federal securities laws will still apply, and there will be a variety of participants involved in the initial offering who will all be performing important gatekeeper functions, including an issuer’s financial adviser, which in the direct listings to date have been the same investment banking firms that are also involved in traditional initial public offerings.” In addition, he observed that the proposed auction mechanism for price discovery “is designed to provide fair and efficient pricing for participating investors.”

Not surprisingly, Commissioners Allison Lee and Caroline Crenshaw dissented. In their joint statement, posted today, they suggest that the proposal “could have been a promising and innovative experiment,” but it “fails to address very real concerns regarding protections for investors.”

But first they have a more profound problem with the current state of the securities laws. In their view, the SEC has “chipped away at the public securities market year after year,” loosening exemptions and allowing—even incenting—companies to stay private. The result is “far fewer investment opportunities for retail investors in the public markets, where there is a more level playing field and where information asymmetries and other power imbalances are alleviated.” (This is a trend that a number of others have also identified, focusing on the loss of opportunity for retail investors to participate in the real growth of private companies that now occurs substantially pre-IPO.) Companies that do go public often do so, not to raise capital, but rather to allow insiders to sell their shares at good prices.  This trend makes it even more important for the SEC to encourage more public offerings, and primary direct listings could have been a step in that direction—but for two problems: “first, the lack of a firm-commitment underwriter that is incentivized to impose greater discipline around the due diligence and disclosure process, and second, the potential inability of shareholders to recover losses for inaccurate disclosures due to so-called ‘traceability’ problems.”

Not that, in their view, the current system is all that great—for one thing, it imposes “relatively high fees on issuers.” Raising capital without a traditional underwriting could have provided more flexibility.  However, the absence of underwriters, in their view, means the loss of an important gatekeeper—incented by potential strict liability under Section 11 and Section 12(a)(2) as well as reputational risk—who seeks to ensure the accuracy of disclosures. They characterize the loss of this protection as their “most urgent concern” with the approval order. Although they acknowledge that certain financial advisors involved in the process could be deemed to be “underwriters” with the same incentives as traditional underwriters, nevertheless, the types of conduct that would lead to a determination of “underwriter” status are not clear, and sophisticated financial advisors could seek to structure their involvement to avoid that determination, “greatly reducing their incentive to conduct robust due diligence.”  They would support providing guidance to address the level of involvement or types of conduct that might trigger status as a statutory underwriter for other market participants in primary direct listings, particularly financial advisors.  

Second, there is the traceability problem, which is exacerbated in direct listings because they often also involve concurrent sales by other shareholders and because insiders have typically not had to sign “lock-up” agreements that preclude sales for a period of time post-IPO.  Although tracing issues may also plague traditional IPOs, these factors compound the problem in primary direct listings. They also note the potential for increased volatility resulting from a combination of media excitement, lack of underwriter price support at the commencement of secondary trading and the absence of lock-ups.

 Unfortunately, they contend, there was “no engagement or debate around potential mitigation” of these challenges. For example, they suggest, the SEC

“could have required directors to retain a financial advisor, who would provide additional independent advice.  Another possibility is precluding use of this process by any issuers that do not provide ongoing auditor attestations and reports about management’s assessment of its internal controls (so called “non-404(b) issuers”), because such attestations provide an important investor protection….There is no question that NYSE’s proposal presents promising innovations, which makes the artificial rush to approval all the more regrettable.  Revitalizing the public markets is not a zero-sum game between innovation and investor protection.  As it stands, however, NYSE has not met its burden to show that that the proposed rule change is consistent with the Exchange Act.”

Background. You might recall that the path to approval of primary direct listings by the SEC was a bit rocky.  A little over a week after the NYSE’s initial application was filed, the SEC rejected the proposal, and it was removed from the NYSE website, causing a lot of speculation about the nature of the SEC’s objection and whether the proposal could be resurrected.  But the NYSE persevered, and the proposal was refiled in December with some clarifications and corrections. But then—silence. In January and February, the NYSE had four meetings with SEC staff, including folks in SEC Chair Jay Clayton’s office, presumably to make the case for the proposal.  A number of public comment letters, of divided opinion, were submitted. Apparently, the SEC remained unconvinced, designating a longer period to decide, and then in late March, issued an Order instituting proceedings to determine whether to approve or disapprove the proposed rule change, citing a number of problems with the proposal.  Undaunted, the NYSE filed Amendment No. 2, which sought to respond to the issues raised in the OIP.  Then finally, a positive outcome.  As NYSE Vice Chair John Tuttle crowed (justifiably) about the approval by the Division of Trading and Markets, “problem-solving” is “part of the NYSE’s DNA.”  Good thing. (The problems cited in the OIP, the NYSE’s response in Amendment No. 2 and the Division’s rationale in approving the proposal are discussed at length in this PubCo post.)

There has been a vociferous call from many VCs and others for alternative on-ramps to public-company status, such as direct listings.  Those that favor direct listings complain about the cost and rigidity of the traditional underwriting commission structure. Indeed, some of the largest investment banks submitted favorable comment letters to the SEC regarding the proposal. Generally, these favorable letters supported the availability of alternative formats that offer choices to issuers, encouraging more companies to participate in the public markets. (See, e.g., this letter and this letter.)  Notably, however, the majority of comment letters opposed the proposal, including two letters in opposition submitted by the Council of Institutional Investors (here and here).  CII contended, among other things, that primary direct listings would reduce shareholder protections for several reasons—potential liquidity issues, potential low aggregate market value of publicly held shares at the time of listing, the company’s being the only seller in the opening auction and a lack of clarity with regard to Securities Act liability—principally as a result of difficulty in tracing shares purchased back to the registration statement and the absence of an offering price.

Apparently, CII was more than a little displeased by the approval of the NYSE rule change by the Division. On August 31, CII advised the SEC of its intent to file a petition for review of the order of approval by the full SEC.  CII’s executive director told Pensions & Investments that “CII took the unusual step after rising concern over traceable shares.” Litigation regarding a recent direct listing “raised the issue of whether investors can challenge a misleading registration statement if they cannot trace their shares to those offered in the registration statement. CII has urged the SEC to address this issue by establishing a system of traceable shares as a key component its long-overdue proxy plumbing project….We think the SEC should fix the proxy infrastructure before approving an expansion of the direct listing regime.”  A tall order by any account.

The SEC granted CII’s petition for review, and refused to lift the stay. At the time, an NYSE spokesperson characterized direct listings to the WSJ as “an innovative new path to the public markets.”  Not surprisingly, the general counsel of CII had a different take on the matter: “Given the importance of this change to the market, shouldn’t the full commission take a look at this rather than just have the staff make this decision?” he asked Law360.

The NYSE proposal. Under the NYSE proposal as set forth in Amendment No. 2, in a primary direct listing (which may include a selling shareholder component), the NYSE will consider a company to have met the applicable requirement for $100 million aggregate market value of publicly held shares if, in the opening auction on the first day of trading, the company will sell shares with a market value of at least $100 million. Where the market value of publicly held shares to be sold by the company is less than $100 million, the NYSE will consider the company to have met its requirement if the aggregate market value of the shares the company will sell in the opening auction, together with the shares that are eligible for inclusion as publicly held shares immediately prior to the listing, is at least $250 million, with market value for the aggregate of the shares “calculated using a price per share equal to the lowest price of the price range established by the issuer in its registration statement.” Officers, directors or more than 10% holders (prior to the opening auction) would be able to purchase shares sold  in the opening auction by the company or by other shareholders or may sell their own shares in the opening auction and in trading after the opening auction, so long as the trading is consistent with Reg M and general anti-manipulation provisions.  The NYSE believes that, because of the requirement for a minimum of $100 million in publicly held shares  (which is much higher than the $40 million minimum requirement for a traditional underwritten IPO) and the “neutral nature of the opening auction process,” a company conducting a primary direct listing would have an adequate public float and liquid trading market after the completion of the opening auction. In addition, under Amendment No. 2, the requirements to have 400 shareholders of round lots and 1.1 million publicly-held shares outstanding at the time of initial listing, and the requirement to have a price per share of at least $4.00 at the time of initial listing would be maintained.

The amendment also adds a new “order type,” the IDO Order, and describes how it would be executed in a primary direct listing. The IDO Order will be a limit order, traded only in a primary direct listing, to sell the quantity of shares offered by the issuer, as disclosed in the prospectus in the effective registration statement, with the limit price equal to the low end of the price range established in the effective registration statement, and all better-priced (lower-priced) sell orders must be sold at that price. (Unlike a direct secondary listing, the registration statement for a primary direct listing will have to include a price range within which the company anticipates selling its shares.)  The IDO Order could not be cancelled or modified and must be executed in full.  Accordingly, the primary direct listing could be effected only if the auction price were within the range specified in the effective registration statement, and only if the entire quantity of shares in the IDO Order that the company sought to sell could be sold within that price range. The Designated Market Maker would determine the auction price within the range and would be required to manually facilitate the auction. 

Additional requirements will apply to the DMM conducting the direct listing, including establishing that the “Indication Reference Price” will be the lowest price in the range set in the effective registration statement. In effect, the DMM will be responsible for determining whether the direct listing could proceed: the auction could not proceed if the auction price were outside the range or if there were insufficient buy interest to satisfy both the IDO Order and all better-priced sell orders in full. In addition, the amendment requires that when the auction price is set at the low end of the range (the limit price of the IDO Order), the IDO Order will have priority over other orders at that price, thereby increasing the potential for the IDO Order to be executed in full and the primary direct listing to proceed.

The amendment stresses that, in either a primary or secondary direct listing, any services provided by a financial advisor to the issuer or the DMM must be provided consistent with all federal securities laws, including Reg M and other anti-manipulation requirements, and FINRA has been engaged to monitor compliance. Finally, because of the importance of the DMM, the NYSE proposes that if a DMM is unable to manually facilitate a direct listing auction, the NYSE would not proceed with the listing.

The SEC Order. In the Order, after conducting a “de novo review of NYSE’s proposal,”  the SEC “determined that NYSE has met its burden to show that the proposed rule change is consistent with the Exchange Act.” In particular, “based on that record, the Commission concludes that, consistent with Section 6(b)(5) of the Exchange Act, NYSE’s proposal will prevent fraudulent and manipulative acts and practices, promote just and equitable principles of trade, remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, will protect investors and the public interest; and will not permit unfair discrimination between customers, issuers, brokers, or dealers, and is not designed to regulate by virtue of the Exchange Act matters not related to the purposes of the Exchange Act or the administration of an exchange.”

In the Order, the SEC maintains that the changes the NYSE made in Amendment No. 2 address the concerns that had been raised by the Division in the OIP. (See this PubCo post). For example, the SEC believes that, because the proposed market value standard for a primary direct listing is at least two and a half times greater than the market value standard for underwritten IPOs, the NYSE has met its burden to show that the proposed aggregate market value of publicly held shares requirement provides “a reasonable level of assurance that the company’s market value supports listing on the Exchange and the maintenance of fair and orderly markets.” In addition,  the SEC found that the IDO Order and related clarifications “help to clearly define the method by which the issuer participates in the opening auction, to prevent the issuer from being in a position to improperly influence the price discovery process, and to design an auction that is otherwise consistent with the disclosures in the registration statement.” Cautions that services provided by financial advisors and the DMM must be conducted consistent with Reg M and other anti-manipulation requirements, as well as the retention of FINRA to monitor compliance, “will also help to ensure compliance by participants in the direct listing process with these important provisions of the federal securities laws and that the proposed changes are consistent with preventing manipulative acts and practices, and protecting investors and the public interest.” According to the SEC, these provisions in Amendment No. 2: “(i) help to ensure that the issuer cannot unduly influence the opening price through a new order type that cannot be modified or canceled; (ii) highlight that financial advisors involved with direct listings cannot violate the anti-manipulation provisions of the Exchange Act, including Regulation M; and (iii) highlight that the Exchange has retained FINRA pursuant to a regulatory services agreement to monitor compliance with Regulation M and other anti-manipulation provisions of the federal securities laws.” As a result, the SEC concluded “that the proposal, as amended by Amendment No. 2, supports a finding that the proposal is consistent with the Exchange Act.”

The SEC notes that several commenters favored the proposed expansion of direct listings to permit primary offerings, allowing issuers alternative formats consistent with their objectives “so long as they protect the integrity of the markets and are fair and clear to investors, using transparent processes.”   The SEC also acknowledges the concerns raised by commenters, particularly the concern that the “lack of traditional underwriter involvement in direct listings generally would increase risks for investors, suggesting that direct listings circumvent the traditional due diligence process and traditional underwriter liability.”  In addition, commenters expressed concerns that “shareholder legal rights under Section 11 of the Securities Act may be particularly vulnerable in the case of direct listings, and that investors in direct listings may have fewer legal protections than investors in IPOs.” Although the petitioner, CII, acknowledged that tracing issues may also arise in the context of successive offerings and simultaneous registered and unregistered sales, CII contended that the “proposal compounds the problems shareholders face in tracing their share purchases to a registration statement” and that the proposal posed heightened risks.  In response, the SEC notes, the NYSE argued that “the Section 11 and traceability concerns are due to the potential lack of lockup agreements, which are neither prohibited nor required by the proposal or any other law or regulation, rather than to anything inherent in direct listings themselves or the Exchange rules permitting them to be listed.” In addition, the NYSE contended that the traceability requirement may create difficulties under Section 11 in many situations that do not involve direct listings. The NYSE also observed that only one court had addressed the issue, and had concluded that, at the pleading stage, plaintiffs could still pursue their claims even if they could not definitively trace the securities they acquired to the registration statement (although, as noted in the Order, the case is on appeal).

In its analysis, the SEC contended that there is nothing in the Securities Act requiring the involvement of an underwriter in registered offerings. Moreover, depending on the facts and circumstances, a financial advisor to the issuer engaged in a primary direct listing could be deemed a statutory “underwriter” with respect to the securities offering, and therefore has incentives, driven by liability concerns as well as reputational interests, to engage in robust due diligence. And, in any event, investors “would not be precluded from pursuing any claims they may have under the Securities Act for false or misleading offering documents, nor would the absence of a statutory underwriter affect the amount of damages investors may be entitled to recover.”  In addition, officers, directors and accountants, with their attendant liability, also play important roles in conducting due diligence. The SEC did not agree with commenters that “direct listings would ‘rip off’ investors, reduce transparency, or involve reduced offering requirements or accounting methods that are not ‘up to code with the public markets.’” 

With regard to traceability, the SEC contended, echoing the view of the Division, that the issue can arise “anytime securities that are not the subject of a recently effective registration statement trade in the same market as those that are so subject.” Concerns regarding tracing are not unique to primary direct listings, the SEC contended, and courts have denied standing on the basis of lack of traceability in contexts outside of direct listings. In addition, tracing is not set forth in Section 11, and tracing standards are judicially developed and may vary “depending on the particular facts of the distribution and judicial district.” Further, the SEC did not “expect any such tracing challenges in this context to be of such magnitude as to render the proposal inconsistent with the Act. We expect judicial precedent on traceability in the direct listing context to continue to evolve.”

The SEC also believes that the proposal will offer benefits to investors, allowing some investors to purchase securities who might not otherwise receive an initial allocation in a firm commitment underwritten offering. By providing an alternative way to price securities offerings that may better reflect prices in the aftermarket, the proposal could provide for efficiencies in pricing and allocation. The SEC also found that the NYSE proposal “will facilitate the orderly distribution and trading of shares, as well as foster competition, which is clearly consistent with the purposes of the Exchange Act.” Accordingly, the SEC found that, “on balance,” the proposed rule change “is designed to, among other things, prevent fraudulent and manipulative acts and practices and to protect investors and the public interest,” and approved the proposal.

Happy holidays! Happy new year!

Posted by Cydney Posner