Direct Listing on the New York Stock Exchange: “Undertaking” Underwriting
NOTE: This has been updated on September 4, 2020, at noon.
On August 26, 2020, the U.S. Securities and Exchange Commission (“SEC”) approved (an approval now stayed) a proposed rule change to amend Chapter One of the Listed Company Manual of the New York Stock Exchange LLC (“NYSE”) to allow primary direct listings of securities on the NYSE. This change to the Listing Manual will allow a company to list its securities for trading on the NYSE to raise capital for the company WITHOUT going through an underwritten public offering. This development was of sufficient significance for American capital markets to warrant an article on the first page of the “Business & Finance” section of The Wall Street Journal the following day. It was clear, as discussed in the Journal article, that the NYSE initiative received considerable opposition. Indeed, as set out in SEC Release No. 34-89684, dated August 26, 2020, approving the NYSE proposal (the “Approving Order”), the proposed change was originally filed with the SEC on December 11, 2019, amended on December 13, 2019, and then again on June 22, 2020. Further, CNBC and Reuters reported that the SEC rejected the original NYSE proposal, although the SEC’s reasoning at that time remains somewhat “murky.” In any event, the NYSE decided to persevere. It is yet to be determined whether Benjamin Franklin’s postscript to Alexander Pope’s maxim will prove to be accurate: “To err is human; to forgive divine; to persist is devilish.”
One of the proposal’s opponents, the Council of Institutional Investors (“CII”), on August 31, 2020, notified the SEC by letter that the CII intended to petition the SEC to review its August 26th Order approving primary direct listing. The SEC notified the NYSE that day of the CII action and that the SEC would stay the effectiveness of its Order pending review.
The Origins and Functions of Securities Underwriting
In the London coffee house founded by Edward Lloyd in 1686 men would gather, drink coffee, and agree (sometimes alone, but often in groups) to finance the costs of particular ventures, most typically a sea voyage, with the financiers taking on some part of the risk of loss (storms, shipwrecks, pirates, naval battles and the like), in return for a “premium,” reflecting something of the profit projected to be obtained from successful completion of the venture. As the investing financiers would write their names on the insurance documentation below the description of the venture they became known as “Underwriters.” Over time, the same title was applied to financiers who helped a company sell its securities to investors. Securities underwriters would buy the company’s securities first and then resell them to investors, receiving compensation in the form of the difference (the “spread”) between what the underwriter paid for the security and the price paid to the underwriter by the investors. Over time, two types of underwritten public offerings developed: i) the “firm commitment” offering, where the underwriter commits to buy the company securities at a stated price; and ii) “best efforts,” where the underwriter agrees only to use its best efforts to sell the securities, and the compensation is simply a commission for the selling effort, not a security price differential.
Although securities underwriters originally functioned almost exclusively as distribution agents, concentrating on selling the securities, eventually social rules related to their occupations imposed some obligations of honesty and fairness on underwriters. By the time the Securities Act of 1933 was passed, securities underwriters would be liable for any material misstatement or material omission in any documentation used to sell the securities, without the need to prove any fraudulent intent. Underwriters did have a defense – they could show that they conducted a “reasonable investigation” in connection with the preparation and usage of those documents. This became known as the “due diligence” requirement, which was underscored in one of the two great bowling alley litigations from the 1960s, Escott v. BarChris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968), a case reputedly “widely viewed as requiring significantly higher standards of care in the preparation of …[selling documents] than prevailed before the decision.” Comment, Easing The Burden Of “Due Diligence,” Under Section 11, 117 U. Penn. L. R. 735 at 736 (1969). Indeed, as The Wall Street Journal reported on 14 May 1968, p 1, col. 6, most troubling to the financial community was the suggestion that “nearly everyone involved …[in creating selling documents] must check every material fact himself by plodding through company records.” [In the other bowling alley case, Colonial Realty Corp. v. Brunswick Corp., 337 F. Supp. (S.D.N.Y. 1971), the key issue was whether there had been adequate disclosure of material information about the financing costs of the defendant’s pinsetter subsidiary.] In any event, it is apparent that at least under the statutory scheme of the American securities laws, a securities underwriter is “A,” and perhaps “The,” key “gatekeeper of the quality and reliability of the information provided to investors. With a direct listing, there is NO underwriter. One may well invoke the Biblical question: who shall be the shepherd who will protect the investor flock from the Wolf (dare one say, “Of Wall Street”)?
The Development of “Private” Securities Markets
As more and more companies began with funding raised privately from investors, not infrequently those focused on exploiting advances in technology and backed by venture capital firms, investors sought liquidity for their holdings, even before a public offering of the companies’ securities or an outright sale of the company. After the collapse of the values of companies in the so-called “dot com bust,” investors sought a mechanism to allow the sale of their holdings. After almost a decade of one-off transactions, in 2009 two new entities, SecondMarket and SharesPost began operations as intermediaries offering a means to facilitate transactions on their respective electronic marketplaces. SharesPost reported some $2 billion in trades from 2009 to 2014. SecondMarket reported $1.5 billion in trades in 2013 alone. Then in 2014, Nasdaq launched the Nasdaq Private Market as a joint venture with SharesPost. The lengthening of the start-up lifecycle forced investors to seek greater liquidity earlier by selling in the private secondary market. In addition, the Jumpstart Our Business Startups (“JOBS”) Act of 2013 greatly increased the number of shareholders a company could have and still be treated as a private company (i.e., the company was not forced to register its securities with the SEC) from 500 to 2,000 (excluding employees). This change substantially increased the depth of potential buyers in the private market and, accordingly, the trade volume. Nasdaq bought out SharesPost's interest in late 2015, and at the same time acquired SecondMarket.
Selling Securityholders Direct Listings
In February 2018, the SEC approved a proposed rule change submitted by the NYSE to amend the Listing Manual to allow the direct listing of a company’s securities on the NYSE, without the participation of an underwriter, where the company could not raise capital by selling its securities. Rather, only existing shareholders of the company were permitted to sell their securities. This is, of course, a logical extension of the “private” security market, but significantly enhanced by allowing shareholders who wish to sell, to do so into the deep trading capacity of the Exchange. The NYSE described such direct listings as involving “… [a] listing without a related underwritten offering upon the effectiveness of a registration statement [filed with the SEC, just as in a traditional public offering] registering only the resale of shares sold by the company in earlier private placements.” Once its securities are listed, the company becomes subject to the reporting and governance requirements applicable to public companies, including periodic reporting requirements under the Securities Exchange Act of 1934, as amended; and the governance standards required by the NYSE for Exchange-listed companies. Clearly, there are some significant benefits to using the direct listing process, including the absence of underwriting fees and the lack of any lock-up agreements restricting the ability of security holders to sell. But direct listings also present particular issues.
First, how is the opening trading price to be determined where no underwriter has conducted a “roadshow” to learn investor interest and set a price? The NYSE amended Listing Manual rule requires the company to retain a financial advisor to assist the company in “price finding.” Second, without an underwriter how can the trading, including pricing, be stabilized to prevent market manipulation and/or unexpected gyrations in price, volume, or both? In addition to requiring a financial advisor, the NYSE rule requires the following: i) recent third party valuation that the company has at least $250 million in the aggregate market value of the publicly held securities; ii) either adjusted pre-tax income for three years in excess of $10 million, with at least $2 million in each of the last two years and positive income in each of the three years -OR- global market capitalization of at least $200 million; and iii) at least 400 round lot (i.e., at least 100 shares) securities holders, at least 1.1 million public securities, and minimum opening price of at least $4.00. The NYSE rule also establishes a series of tests of the independence of the valuation agent. Generally, an agent does NOT meet the independence requirement IF the agent has any other relationship to the company or any affiliate of either the company or the agent. Several Nasdaq platforms have generally comparable requirements. Two major technology companies, Spotify AB and Slack Technology, Inc., used the Selling Securityholder Direct Listing process to become publicly traded, Spotify in February 2018 and Slack in June 2019. Each of these companies was already quite profitable, with sufficient capital resources that it did not need to raise money in the course of becoming public.
Primary Direct Listings
According to the financial press, venture capitalists, especially those active in Silicon Valley, urged for expansion of the direct listing procedure to permit a company itself to raise capital in the listing process. They argued that this would free direct listing from the constraints of having to be a cash-rich company in order to use the process. The Council of Institutional Investors and other money managers opposed the proposed NYSE rule change, fearing that in a direct listing of company securities, it would not be possible for a buyer to trace the purchased securities directly back to the company as opposed to any other party on the “sell-side.” They asserted that this lack of privity would prevent the buyer from asserting claims under Section 11 of the Securities Act of 1933, as amended, the same Section cited in the Barchris case noted above. Opponents also noted the absence of an underwriting investment bank to act as a “stabilization agent” to prop up prices in case its price declined sharply after the listing. Further, critics such as the American Securities Association also pointed to the potential diminution of “due diligence” and inflated security pricing, as the company would not be subject to an underwriter’s oversight when preparing selling documents or negotiating the offering price. The new NYSE rule requires the following for primary direct listing: the company must have publicly held securities worth at least $100 million if the company will sell at least $100 million on the first day of listing; or where the aggregate market value of securities the company will sell and the securities eligible for inclusion as publicly-held securities, held immediately prior to the listing, is at least $250 million, where that market value is using the lowest price per security in the range of prices for the listing, as set forth in the registration statement. The company must have at least 400 security holders holding round lots, 1.1 million publicly-held securities outstanding as of the time of listing and the price per share has to be at least $4.00. The company and/or directors and officers may participate in stabilization activities, so long as those activities comply with SEC Regulation M.
The new NYSE rule creates a new type of order, an Issuer Direct Offering Order (“IDO Order”), which is a limit order issued by the company that cannot be canceled or modified, but rather must be executed in full; and that sets a limit on the lowest price at which the securities may be sold, which in turn is the low end of the price range established in the registration statement. Accordingly, the listed securities may be sold only within the price range disclosed in the registration statement, and only if the entire number of securities listed ARE sold within that price range. The rule also requires a designation by the company of a Designated Market Maker (“DMM”), which will effectuate a direct listing auction of the securities MANUALLY. Thus, the listing would not proceed if the auction price is below that set in the IDO Order, OR if there is insufficient buyer interest to satisfy both the IDO Order and all better-priced sell orders. The DMM must establish an Indication Reference Price for the opening price, during the pre-opening of the Exchange. That Price must be based on the most recent transaction price during recent sustained trading on a “private” security market, or if none, then a price determined by the Exchange in consultation with the company’s financial adviser. The NYSE has confirmed that it has retained FINRA to monitor compliance with these listing process requirements, including SEC Regulation M and all other federal securities laws. The SEC cites these provisions: including the pricing mechanism, the independence requirements for the financial adviser, and the FINRA oversight as the basis for concluding that the NYSE rule “is reasonably designed to be consistent with the protection of investors and the maintenance of fair and orderly markets, as well as the facilitation of capital formation.” In addition, the Commission noted that the required aggregate value of publicly-held securities is comparable to or higher than those required by the rules of the Exchange for other types of initial listing. Responding to comments submitted by objectors, the SEC agreed with the NYSE that the Securities Act of 1933, as amended, does not require the participation of an underwriter.
Further, the Commission observed that, depending on the nature and extent of the financial adviser’s activities, the financial adviser may be deemed an underwriter under Section 2 (11) of the 1933 Act. The SEC also addressed concerns about being able to trace listed securities to the company, noting that the same issue arises even in a firm commitment underwritten offering when unregistered securities being sold under SEC Rule 144 may not be able to be traced. The Commission noted that it was aware of only one court case where the matter was raised against a company that used direct listing. In that case, the court allowed Section 11 claims to proceed. Finally, the SEC notes that the use of matching buy and sell orders, as is done in a direct listing, may make it easier for smaller investors to receive initial securities allocations than in a firm commitment offering, where the book-runner(s) controls distribution. Some have also suggested that price discovery using the direct listing process may be more accurate in determining the buyer's appetite than the firm commitment negotiations between the company and its underwriter.
Palantir Technologies, Inc., a data-analytics company, announced last week that it would shortly become a public company using the direct listing process, although according to the Wall Street Journal of August 27, 2020, (p B 1, col 2) the company will not be seeking to raise funds for itself. On August 24, 2020, Nasdaq filed a proposed rule change with the SEC to allow primary direct listings of securities on Nasdaq. To quote a seasoned observer of the capital markets, “Time will tell whether the primary direct listing becomes a popular, or at least a standard, alternative for companies looking to access the public markets.” Cydney S. Posner, in a Cooley LLP blog dated August 27, 2020, “NYSE perseverance pays off-SEC approves primary direct listings.” And “Time” will also tell whether the NYSE’s and/or Nasdaq (assuming that the SEC will approve the Nasdaq proposal) primary direct listing processes will protect the investor flock from the Wolf, or if the “burying” (viz. undertaking) of the Underwriter has left the sheep unguarded.
According to public statements by its Executive Director, the CII seeks SEC action to establish a system of traceable securities to overcome hurdles to claims that arose in litigation over the Slack Technology offering. The NYSE announced that it would urge the SEC to affirm its Order and request that the SEC to lift the stay immediately. It is not known how long the SEC review process will take.