On August 26th, the Securities and Exchange Commission (“SEC”) approved a New York Stock Exchange (“NYSE”) proposal allowing issuers to raise capital via direct listings.[i] This ruling substantially expands the potential use and relevancy of direct listings and allows issuers to avoid Section 11 liability in a securities issuance, circumventing investor protections. The SEC has temporarily stayed the rule pending an objection filed by a prominent investor group.[ii]
Palantir Technologies, a data-analytics company valued at $20 billion, has already announced that it plans to use the direct listing process to go public as early as next month.[iii] Nasdaq is likewise releasing its own proposal to the SEC, which is broadly similar to the NYSE’s proposal and would allow companies to raise capital through a direct listing.[iv] Careful consideration should be given to the NYSE’s new rule and its potential implications for securities litigation.
What is a Direct Listing?
A direct listing has to date been defined as the sale of existing, outstanding shares by shareholders through an online platform without the use of an underwriter.[v] In contrast, an Initial Public Offering (“IPO”) is when a company issues new and/or existing shares to the public with the help of an underwriter. There are three key differences between a direct listing and a traditional IPO. First, an IPO allows a company to raise new capital, whereas a direct listing does not. Second, a direct listing allows an issuer to save on underwriting fees by selling shares directly to investors, bypassing the need for underwriters to price and market the securities. Third, existing shareholders in a direct listing are not typically subject to traditional lock-up periods of an IPO,[vi] which means that existing shareholders are free to sell their company shares at the same time as the company.
What Does the New Rule Allow?
As discussed, NYSE rules previously allowed companies to sell only existing shares on a direct listing platform, not new shares. This limited the universe of companies that could benefit from a direct listing to cash rich companies looking to give early investors an opportunity to cash out. Only a handful of companies have used a direct listing to date, including Spotify and Slack Technologies.[vii]
The new rule allows issuers to raise new capital by issuing shares via a direct listing.[viii] The main limitations of the rule are:
- A company must sell at least $100 million worth of shares on the first day of listing. [ix]
- The aggregate market value of the publicly held shares prior to the listing and the value of the shares sold by the company in the offering must be at least $250 million. [x]
- Publicly held shares are defined as those held by persons other than officers and affiliates of the company (shareholders holding more than 10% of shares).[xi]
- The company must have at least 400 round lot shareholders.[xii]
Section 11 Implications
To sue under Section 11 of the 1933 Securities Act, plaintiffs must prove standing by demonstrating they either purchased securities directly through an IPO or made aftermarket purchases they can directly trace to the registration statement containing a material misstatement or omission.[xiii] However, it is nearly impossible to trace shares bought in the secondary market to a registration statement due to the broker dealer net settlement system used by the Depository Trust Company (“DTC”), wherein shares purchased by a broker on behalf of an investor plaintiff are held in a common pool.[xiv]
In a direct listing, both registered and unregistered shares, such as those eligible to be sold by early investors under Rule 144, are listed and sold simultaneously, making tracing nearly impossible.
The SEC addressed tracing concerns of the new rule by the following three arguments, which are addressed in turn.
- Tracing is an issue in all types of offerings because of aftermarket purchases, so this issue is not unique to direct listings.
- While partly true, creating an even bigger loophole for issuers to completely avoid Section 11 liability will only leave investors more vulnerable.
- A recent case, Slack Technologies, indicates that companies may still be liable under Section 11 for a direct listing.
- Slack is likely inconsistent with current precedent. There, the court held the plaintiff class had standing despite being unable to trace shares to Slack’s registration statement.[xv] The Slack court justified its decision by claiming that a narrower reading of “such security” would “completely obviate the remedial penalties of Sections 11, 12 and 15” and eliminate civil liability for issuers.[xvi] But the tracing requirement does not preclude shareholders from a remedy, as they can still sue under Rule 10(b)(5).[xvii] In fact, the tracing requirement serves as a condition for accessing the relaxed liability requirements provided by Congress under Section 11.[xviii] In the leading decision on this issue, Judge Friendly held that the Section 11 language of “such security” refers only to securities issued under a registration statement, and that any other reading is inconsistent with the statute’s scheme and legislative history.[xix]
- In a primary direct listing, all company shares will be sold in an opening auction which may make tracing easier.
- If new and existing shares are sold simultaneously, tracing will still be nearly impossible as described above.
In considering the application of this new rule, the SEC should aim to strike a balance between creating flexibility and cost savings for issuers and protecting investors. The current rule simply allows issuers to completely avoid Section 11 liability by issuing new shares and existing shares at the same time, making it untenable as a matter of policy. Though, as discussed above, investors are not left completely without remedy as they may still sue under the heightened requirements of Rule 10(b)(5).
Instead, the SEC should consider introducing a system of unique identifiers in the direct listing process to make tracing possible. For example, using blockchain technology to store information about direct listing purchasers would resolve the tracing problem.[xx] Alternatively, the SEC could introduce new legislation or amend Section 11 to regulate direct listings given the rise of this new issuing platform.
[i] Order Granting Approval of a Proposed Rule Change, as Modified by Amendment No. 2, to Amend Chapter One of the Listed Company Manual to Modify the Provisions Relating to Direct Listings, Securities Exchange Act of 1934, Release No. 89684 (August 26, 2020).
[ii] Alexander Osipovich, NYSE Direct Listings Hit Snag as Investor Group Raises Concerns, Wall St. J. (Sept. 1, 2020), https://www.wsj.com/articles/nyse-direct-listings-hit-snag-as-investor-group-raises-concerns-11599000009?mod=searchresults&page=1&pos=2.
[iii] Alexander Osipovich, NYSE’s Plan for New IPO Alternative Wins Green Light From SEC, Wall St. J. (Aug. 26, 2020), https://www.wsj.com/articles/nyses-plan-for-new-ipo-alternative-wins-green-light-from-sec-11598479804; Erin Griffith, Palantir Technologies Files to Go Public, N.Y. Times (Jul. 6, 2020), https://www.nytimes.com/2020/07/06/technology/palantir-technologies-ipo.html.
[vi] A Current Guide to Direct Listings, Gibson Dunn (Dec. 13, 2009), https://www.gibsondunn.com/a-current-guide-to-direct-listings/.
[vii] Alexander Osipovich, Investor Advocates See Risks in Silicon Valley’s Favorite IPO Alternative, Wall St. J. (Jan. 3, 2020), https://www.wsj.com/articles/investor-advocates-see-risks-in-silicon-valleys-favorite-ipo-alternative-11578047400.
[viii] Order, supra note 1.
[ix] Guide, supra note 5.
[xiii][xiii] 15 U.S.C.A. § 77k (West); DeMaria v. Andersen, 318 F.3d 170, 178 (2d Cir. 2003).
[xiv] Abbey v. Computer Memories, Inc., 634 F. Supp. 870, 873 (N.D. Cal. 1986).
[xv] Pirani v. Slack Techs., Inc., 445 F. Supp. 3d 367, 381 (N.D. Cal. 2020).
[xvi] Id at 380.
[xvii] Abbey, supra note 13, at 875; Slack, supra note 14, at 380.
[xviii] Abbey, supra note 13, at 875.
[xix] Barnes v. Osofsky, 373 F.2d 269, 272 (2d Cir. 1967).
[xx] Nathan Reiff, Blockchain Explained, Investopedia (Feb. 1, 2020), https://www.investopedia.com/terms/b/blockchain.asp.