The Lowdown on SEC Approval of the NYSE Primary Direct Listing Proposal

Direct listings, the most promising disruptor of IPOs, received a significant boost this week, thanks to the U.S. Securities and Exchange Commission (SEC) ruling on a petition from the Council of Institutional Investors.

Most common in the tech industry, direct listings have been put to the test four times in the last two years. Spotify and Slack paved the early path with their direct listings in 2018 and 2019, respectively. Earlier this year, Palantir and Asana used direct listings as an alternative to the traditional underwritten IPO and have continued to generate an enormous amount of media attention in their own right.

The SEC on Tuesday finally approved the New York Stock Exchange (“NYSE”) initiative to allow for primary direct listings, putting an end to a long-running drama. The NYSE has sought to expand the options for direct listings. It began on December 11, 2019 by applying for SEC approval of a rule change to amend provisions in Chapter One of the NYSE Listed Company Manual relating to direct listing. The initial proposal was rejected, with the SEC citing concerns over investor protection and pricing mechanisms.

The NYSE persisted with a modified proposal. After nine months, the SEC’s Division of Markets and Trading approved a change to listing requirements to allow primary direct listings on August 26, 2020. However, the approval encountered immediate resistance from a prominent investor advocacy group, the Council of Institutional Investors. On August 31, the CII filed notice with the SEC to challenge the rule change before the full Commission could approve it, citing concerns over investor protection and the role of financial advisers. These advisers appeared to perform roles similar to those of traditional firm commitment underwriters, but the CII claimed they escaped the statutory liability that accompanies such a role under federal securities laws.

The SEC has rejected the CII’s concerns and found that the rule changes sufficiently protect investors and do not diminish alternative means for holding other gatekeepers liable. The SEC concluded that existing regulation and securities laws are strong enough to ensure that these “financial advisers” behave responsibly.

The NYSE noted that traditional underwriters are not required under the Securities Act, though they help ensure the success of primary offerings. The NYSE also argued that assigning the gatekeeping role solely to investment bankers excluded other important groups, such as the boards of directors, senior management, and independent accountants.  In addition, direct listing still requires the registration of the offering and the accompanying oversight by the SEC and the NYSE.

In its decision to allow the rule change, the SEC stressed that financial advisers may face statutory “underwriter” liability, depending on the facts and circumstances in a future proceeding. For the commission, this and the reputational risk of not performing well were sufficient incentives for advisers to engage in robust due diligence. It is worth noting that, for their direct listings, the previously mentioned four companies used prominent investment banks, each of which is frequently used as an underwriter, as their advisers.

The SEC also noted that, even in the absence of any statutory underwriter, the amount of recoverable damages by investors would remain unaffected, and other gatekeepers would still face liability. Finally, in addressing concerns over the traceability of shares for Section 11 claims, the SEC found the concerns presented by the CII were not unique to primary offerings via direct listing. The primary traceability concerns stem largely from other exempt transactions, particularly under Rule 144, which are not directly related to direct listings of either kind.

With this order, the SEC has cleared the last obstacle to primary offerings via direct listing on the NYSE. However, the SEC may be opening the door for a larger corporate governance issue.

Direct listings do not allow shareholders to force sunset provisions into companies’ equity structures. The CII has argued that these provisions are a way to limit founder power post-IPO. The CII is not alone in its opposition to dual-class structures.

At the same time, there is significant pressure on so-called unicorns – startups valued at $1 billion or more –  to include in their IPOs mandatory sunset provisions for any dual-class share structure. While sunset provisions have been criticized, there is no incentive to include them in direct listings, despite the probable benefit to investors in the long-term. During a traditional IPO, such structures would likely draw criticism from potential investors and questions from underwriting investment banks. However, direct listings do not have to follow the traditional IPO process, including roadshows that are directed at major institutional investors. Therefore, with direct listings, there is little need for compromise.

Primary direct listings might appeal to unicorns, which have long track records of being able to raise large sums of capital from private markets. Such listings can provide liquidity to employees and early investors and cut costs typically associated with an IPO. More important, they also may, for better or worse, allow founders to maintain tighter control over management, control they might otherwise lose in a traditional IPO.

This post comes to us from Professor Anat Alon-Beck, Professor Robert Rapp, and Mr. John Livingstone at Case Western Reserve University School of Law. It is based on their paper, “Investment Bankers as Underwriters: Barbarians or Gatekeepers? a Response to Brent Horton on Direct Listings,” available here.