Today, the Commission approved a new listing rule from the New York Stock Exchange (“NYSE”) which fundamentally shifts how companies can access the public markets.[1] The new listing standard will allow primary direct listings of companies seeking to go public and, importantly, raise capital outside of the traditional initial public offering (“IPO”) process.[2] NYSE’s proposal represents what could have been a promising and innovative experiment. Unfortunately, the rule fails to address very real concerns regarding protections for investors. As a result, we are unable to support this specific approach.[3]
Before delving into the specifics, we believe it is important to acknowledge that the current IPO process is far from perfect. Among other things, the structure often imposes relatively high fees on issuers. Market participants and the Commission should continue to explore ways to innovate and modernize the IPO process, but it need not be at the expense of fundamental investor protections.
Part of the underlying problem we confront today is that the Commission has chipped away at the public securities market year after year. Exemption after exemption from foundational Securities Act requirements has allowed, if not incented, companies to remain in the private market longer.[4] Thus, today many companies go public later in their lifecycle, if at all.[5] For some that do go public, the primary motivation may be to allow insiders to exit their positions, rather than raising significant additional capital. This private market proliferation results in 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.
As a result, it is all the more important for the Commission to shift focus toward attracting more listings in the public market. Direct listings could meaningfully contribute to that effort. Unfortunately, investors in primary direct listings under NYSE’s approach will face at least two significant and interrelated 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.
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Loss of an Underwriter and Corresponding Due Diligence
The NYSE proposal would permit companies to raise new capital without using a firm-commitment underwriter.[6] Allowing companies to access the public markets for capital raising without the use of a traditional underwriter very well may have benefits, including allowing flexibility for companies in determining which services would be most useful for them as they go through the registration and listing process.[7]
However, we must also consider the risks to investors that could result from removing traditional underwriters from the equation. Most notably, underwriters provide an important independent check on the quality of the registration statement. They are incented to do their job well because if they do not, they are subject to strict liability under Section 11 and Section 12(a)(2) of the Securities Act,[8] not to mention reputational risk associated with the sale of these new securities to their clients. If underwriters are removed from the equation, investors will lose a key protection: a gatekeeper incented to ensure that the disclosures around these opportunities are accurate and not misleading.
We understand that certain financial advisors involved in a primary direct listing may meet the statutory definition of an underwriter and thus trigger the above incentives and concomitant protections. However, it is currently unclear what types of involvement would result in meeting the statutory definition. Sophisticated institutions that advise on primary direct listings may be incented to structure their participation to avoid such status. This would allow them to limit or avoid legal liability, thus greatly reducing their incentive to conduct robust due diligence.
Had we acted with greater deliberation, we could have considered or debated possible approaches to mitigating these increased risks to investors. In particular, we should have provided guidance addressing what might trigger status as a statutory underwriter for other market participants involved in a primary direct listing. This guidance could have been targeted to the anticipated roles of financial advisors involved in a primary direct listing offering, given their potential role as one of the main market participants to guide companies through the listing process.[9] We support considering what guidance is needed in the future as primary direct listing market practices evolve.[10]
Diminished Ability for Shareholders to Recover Damages
Primary direct listings could also exacerbate existing challenges investors face in recovering losses for false or inaccurate statements made in public offerings. One crucial obstacle investors must overcome arises from a judicial doctrine known as “traceability.” Courts have required that shareholders seeking to recover for false or inaccurate statements in a registration statement be able to “trace” the shares they own to those actually sold by the company pursuant to the relevant registration statement.[11] Because a primary direct listing may often also involve concurrent sales by other shareholders, tracing a trade directly back to the issuer becomes extremely difficult.[12] While traceability issues can exist in traditional IPOs,[13] there is an increased likelihood of such issues in a primary direct listing where there are no “lock-up” agreements precluding sales by insiders at the time of the IPO.[14] The rule proposal will exacerbate an existing concern regarding traceability by facilitating the sale of both shares that are, and are not, subject to a registration statement in the same public offering.
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Had we determined to grapple with these concerns, there are several measures that could and should have been considered to craft an order that would have protected investors while preserving the potential benefits of direct listings. For example, we 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.[15] There could be numerous other ideas here, but there has been little or no engagement or debate around potential mitigation.[16]
Unfortunately, the Commission has not candidly assessed the potential benefits and drawbacks of retail investor participation in primary direct listing IPOs.[17] We should have engaged in a deeper debate and analysis to consider options for mitigating the risks to investors before approving today’s order. 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.[18]
[1] The Commission has found that NYSE has met its burden to show that the rule proposal is consistent with the Exchange Act. See Exchange Act Release No. 90768 (Dec. 22, 2020); File No. SR-NYSE-2019-67 (“Approval Order”). Section 6(b(5) of the Exchange Act requires that the rules of a national securities exchange be designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest; and are not designed to permit unfair discrimination between customers, issuers, brokers, or dealers, or to regulate by virtue of any authority conferred by the Exchange Act matters not related to the purposes of the Exchange Act or the administration of an exchange. See 15 U.S.C. § 78f(b)(5).
[2] NYSE’s proposed rule would permit a company that has not previously had its common equity securities registered under the Exchange Act to list its common equity securities on the exchange at the time of effectiveness of a registration statement pursuant to which the company would sell shares itself in the opening auction on the first day of trading on the exchange in addition to, or instead of, facilitating sales by selling shareholders. NYSE listing standards will impose certain requirements on these offerings, including thresholds for aggregate market value of publicly-held shares and parameters around its calculation, and a new order type (the “Issuer Direct Offering Order”). See Notice of Filing of Proposed Rule Change to Amend Manual, Securities Exchange Act Release No. 89148, File No. SR-NYSE-2019-67 (June 24, 2020), 85 FR 39246 (June 30, 2020).
[3] Benefits cited for this proposed rule include the potential to broaden the scope of investors that are able to purchase securities in an initial public offering, at the initial public offering price; permitting an alternative way to price securities offerings that may better reflect prices in the aftermarket, and thus promote possible efficiency in IPO pricing and allocation; the orderly distribution and trading of shares; and the fostering of competition. We believe investor concerns implicated by this rule proposal include potential weakening of due diligence to be performed on direct listings, lack of guidance around the role of market participants who will assist companies in the listing process, and a further erosion of investors’ ability to bring Section 11 claims with the absence of a statutory underwriter and facilitation of both unregistered and registered shares to be offered to the public at the same time.
[4] For a recent example of this trend, see Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets, Release Nos. 33-10884; 34-90300; IC-34082 (Nov. 2, 2020), available at https://www.sec.gov/rules/final/2020/33-10844.pdf.
[5] For an overview of this issue, see Frank Partnoy, “Death of the IPO” (Nov. 2018), available at https://www.theatlantic.com/magazine/archive/2018/11/private-inequity/570808/.
[6] Notice of Filing of Proposed Rule Change to Amend Manual, Securities Exchange Act Release No. 89148, File No. SR-NYSE-2019-67 (June 24, 2020), 85 FR 39246 (June 30, 2020).
[7] For an overview, see Robert Jackson Jr., “The Middle-Market IPO Tax” ( April 25, 2018), available at https://www.sec.gov/news/speech/jackson-middle-market-ipo-tax.
[8] 15 U.S.C. § 77k; 15 U.S.C. § 77l(a).
[9] The Commission did in fact receive public comment asking that we clarify that financial advisors and others involved in a direct listing do incur statutory liability as underwriters, but the Commission has failed to address those concerns and provide clarity on this critical issue. See Letter dated March 5, 2020 from Christopher A. Iacovella, American Securities Association to the Honorable Jay Clayton, Chairman, U.S. Securities and Exchange Commission, available at https://www.sec.gov/comments/sr-nyse-2019-67/srnyse201967-6911312-211231.pdf.
Such guidance could, for example, have laid out salient factors the Commission would consider in determining whether someone was acting as an underwriter in the context of a primary direct listing and possible considerations market participants could take into account when assisting a company through the listing process.
[10] We have no doubt that the staff will carefully scrutinize primary direct listings for investor protection concerns going forward. However, even the most careful review of registration statements is no substitute for an underwriter’s due diligence. The loss of this protection is our most urgent concern with today’s order. The increased risks that a direct listing model poses to retail investors can and should be addressed now, before investors learn the hard way when these risks materialize.
[11] See, e.g., In re Century Aluminum Co. Sec. Litig., 729 F.3d 1104 (9th Cir. 2013) (citing Barnes v. Osofsky, 373 F.2d 269 (2d Cir. 1967)).
[12] To bring a claim under Section 11 or Section 12(a)(2), courts may require shareholders to “trace” their shares to the registration statement containing the alleged misrepresentations or omissions. This may be difficult, if not impossible, in the context of a primary direct listing when some shares are sold by the issuer pursuant to a registration statement and other shares, not covered by the registration statement, are concurrently sold by company insiders. We acknowledge that there have been longstanding concerns about investors’ ability to seek remedy under Section 11 of the Securities Act as judicial precedent over the years has required that an investor be able to trace back shares to a particular registration statement. This has proven difficult as our markets have become electronic. See, e.g., Krim v. pcOrder.com, Inc., 402 F.3d 489 (5th Cir. 2005).
[13] See Commission Approval Order at 33 (“Petitioner’s concerns regarding shareholders’ ability to pursue claims pursuant to Section 11 of the Securities Act due to traceability issues are not exclusive to nor necessarily inherent in Primary Direct Floor Listings”). However, the fact that traceability obstacles already exist is not reason to further exacerbate this problem for shareholders.
[14] See Letter dated July 16, 2020 from Jeffrey P. Mahoney, Council of Institutional Investors to the Honorable Jay Clayton, Chairman, U.S. Securities and Exchange Commission, available at https://www.sec.gov/comments/sr-nyse-2019-67/srnyse201967-7435112-220582.pdf.
[15] See 15 U.S.C. § 7262(b) (requiring public companies to have an auditor attestation and report management's assessment of the company’s internal controls).
[16] The Commission’s Approval Order notes that NYSE expects to issue guidance reminding financial advisors involved in primary direct listings that they must not act in a manner inconsistent with Regulation M and other anti-manipulation provisions of the federal securities. This generic reminder about obligations under the federal securities laws is simply inadequate to provide any additional level of investor protection, nor does it mitigate the range of concerns raised in a primary direct listing.
[17] One drawback that has not been holistically addressed is the potential for increased volatility. If early experience is any guide, primary direct listings could involve companies generating a great deal of media excitement, making the market more reactive to news about the company. This heightened attention may also draw interest from investors who typically do not participate in IPOs, which may further increase price volatility in these listings as these market participants buy and sell out of positions. Such volatility may be exacerbated by the lack of underwriter price support in the initial days of secondary market trading following the primary direct listing. It may be further exacerbated if companies allow their insiders to sell their shares in an IPO without being constrained by so-called “lock-up” agreements that often delay such selling in traditional IPOs. See “Direct Listings Fall From Favor With Tech Cash Crunch Deeping”, (March 25, 2020) (describing generally volatility in recent direct listings), available at https://www.bloomberg.com/news/articles/2020-03-25/direct-listings-fall-from-favor-with-tech-cash-crunch-deepening; see also “The Latest and Greatest on Direct Listings: Direct Listings + Capital Raise, Lock-up Agreements, COVID-19 and More”, Fenwick (Aug. 31, 2020) (discussing recent market practice on this issue), available at https://www.fenwick.com/insights/publications/the-latest-and-greatest-on-direct-listings-direct-listings-capital-raise-lock-up-agreements-covid-19-and-more.
In addition, the order misapprehends a potential benefit to investors. The Commission states that primary direct listings may broaden the scope of investors, including retail investors, who are able to purchase securities in an IPO at the IPO price, rather than in after-market trading. True enough, but “the IPO price” under a primary direct listing is likely to offer retail investors no better a deal than they currently get with a firm-commitment offering because they will pay the opening price determined by the market. In most firm-commitment offerings, deals are structured to create a “pop” in the price once secondary trading occurs. As a result, clients of the underwriter who buy at the IPO price can have real economic advantages. And retail investors have traditionally been able to buy shares only after this “pop” occurs. Direct listings, however, are designed to begin trading at a price determined by the market immediately, rather than after initial sale to an underwriter and its clients. Thus, while retail investors will now be able to purchase at the initial offering price, they will not get the benefits that accrue to underwriters and their clients in a firm-commitment offering.
[18] We want to thank the staff in the Division of Corporation Finance, the Division of Trading and Markets, and the Office of the General Counsel for their hard work on this order.
