Direct listings have been a hot topic in the news lately, particularly in light of the recent submission of proposals to the U.S. Securities and Exchange Commission (SEC) by the New York Stock Exchange (NYSE) (and indications that NASDAQ intends to submit a proposal) to expand the direct listing process in order to allow a simultaneous capital raise. Until quite recently, direct listings were considered a novelty to be used only by so-called “unicorns,”[1] which generally consist of large, well-established companies possessing a recognized public brand. They were a means for a company that did not need to raise capital for operations to go public by allowing for a registered sale of securities by its existing shareholders without the use of an underwriter. The music streaming service Spotify used a direct listing to go public last year on the NYSE; Slack, a workplace communications tool, also went public in June of this year utilizing a direct listing.
The reality is that the U.S stock markets have been contracting since the dot-com bust 20 years ago. There are significantly fewer public companies due, in large part, to the difficulty and expense of going public and maintaining compliance. This shrinkage also is the result of high-growth companies having the option to remain private because of large pools of available venture capital and private equity money which allows for such companies to continue to operate without the need for public disclosures and ongoing oversight by regulatory authorities. Further, the decrease in the number of listed public companies is traceable not only to fewer public offerings, but also is the result of a significant number of going-private transactions led by private equity funds.
But now the NYSE and NASDAQ, in an effort to expand the number of companies trading on their exchanges, are exploring ways to attract more of these companies to the public markets.
On November 26th, the NYSE filed a proposed rule change with the SEC seeking to permit companies to directly list shares on its own behalf on the NYSE in order to raise capital and issue new securities in connection with such listings – but without a traditional underwriting process. The proposal would allow for direct listing to also simultaneously include secondary sales by its shareholders to facilitate investment exits.
The recent NYSE proposal sought to eliminate the current requirement for the company to “demonstrate that it has $250 million in market value of publicly-held shares at the time of listing” for direct primary listings by the company of shares to be sold on its own behalf so long as the company sold at least $250 million in the opening auction on the first day of listing, or the company can demonstrate that shares sold by the company in the opening auction, plus the realized market value of its publicly-held shares immediately prior to the time of the initial listing, realized an aggregate market value of at least $250 million. The NYSE indicated in its rule change proposal that in the case of a primary listing, the sale of $250 million in shares in the opening auction would ensure that there are at least $250 million in shares in the public hands after the first trade.
The NYSE proposal also sought a 90-day trading grace period to satisfy the requirement that the company have at least 400 round lot holders and at least 1.1 million publicly-held shares at the time of listing in connection with either a selling shareholder direct listing or a primary direct listing. The NYSE proposal indicates that they believe while these requirements are not a barrier to a listing in a typical IPO, since a direct listing arrangement lacks the assistance of offering underwriters involved in the distribution process to satisfy these requirements, achieving this threshold at the time of listing creates a hurdle that the NYSE believes would be satisfied within a reasonable time period after the listing -- provided the listing is of a sufficient size.
The SEC quickly rejected the NYSE’s proposed rule change on December 6th, but did not provide insight into its reasoning behind the rejection. On December 11th, the NYSE submitted a revised proposal and reportedly is committed to continuing to work with the SEC to amend its rules to allow for direct capital raises.[2] NASDAQ is also reportedly working with the SEC to expand direct listings. The SEC recently approved a NASDAQ rule change allowing secondary direct listings on behalf of a company’s existing shareholders on the NASDAQ Capital Market and NASDAQ Global Market. Direct listings previously were only permitted on the NASDAQ Global select market.
The process for a direct offering is simpler than for an IPO but does not necessarily reduce or mitigate the need for the same level of diligence; there is still required compliance with all of the anti-fraud provisions of the securities laws. A company must still file a registration statement with the SEC on Form S-1 (or F-1 for foreign filers) and still must engage investment bankers to act as financial advisors to the issuer. Moreover, the SEC does the same level of review and goes through its regular comment process on the registration statement. Finally, the company has the same potential liability exposure under the federal securities laws and SEC rules.
There are, however, different considerations, discussed below, in terms of how the addition of a simultaneous capital raise with a direct listing could impact securities litigation.
Potential Sources and Types of Liability
Offers and sales of securities in SEC-regulated companies – whether such stock is being offered to the public through initial or secondary offerings, or through a direct listing – continue to be governed by the federal securities laws, and most significantly, by the 1933 Act.[3]
As is the case for initial and secondary public offerings, in the context of direct listings, the company and its directors, as well as those of its officers who signed the registration statement, continue to face primary liability under Section 11 of the 1933 Act. The liability standard is effectively a strict liability standard for the company, although the individual defendants may be able to avail themselves of a “due diligence” defense if they can establish that they reasonably relied on the so-called “expertised” portions of the registration statement prepared by the issuer’s auditors and outside counsel.
The potential for 1933 Act liability in connection with direct listings already has been demonstrated by the filing of a securities action against Slack Technologies, Inc., following its direct listing on the NYSE. That shareholder action already has highlighted several of the likely battleground areas likely to be litigated in securities litigation against direct listing companies.[4] Some of these areas include:
- Where some but not all of the company’s issuers were registered, with the remainder exempt from registration under Rule 144, can the plaintiffs adequately plead and prove the traceability requirement of a Section 11 cause of action (i.e., showing that the purchased securities at issue are traceable to the challenged registration statement)?
- In the absence of set offering price (a recognized feature of IPOs and secondary offerings), is there another recognized basis for measuring damages allegedly sustained by the plaintiff class?[5]
Further, given the recent U.S. Supreme Court decision in Cyan, potential direct listing plaintiffs may seek to litigate their investor claims in state court venues where more liberal and less onerous pleadings standards apply to 1933 Act liability, including the “traceability” defense asserted in the Slack shareholder action.
Other issues that could be litigated in the context of direct listing securities litigation could include, for example, a challenge to the true “independence” of the financial advisor that valued the shares to be listed in the context of a market value, or whether companies can be fairly alleged to have manipulated sales and value data to meet the NYSE’s requirements for demonstrating minimum market values for publicly-held shares.
And finally, in cases where significant investors, such as private equity investors, are using the direct listing to exit their investments in a company, potential plaintiffs and their lawyers likely will be looking carefully to determine whether the direct listing terms were objective and fair, or whether the exiting investors exerted improper influence over management and the board to expedite or unfairly value the company’s stock to allow the exiting investor to monetize the investment on favorable or less-than-arm’s-length terms.
D&O Insurance Implications
As is often the case with D&O insurance, insurers are being asked to underwrite new kinds of risk around direct listings without the benefit of a clear track record of court decisions outlining these new approaches to D&O liability or defenses, or understanding why and how legal or rulemaking changes alter the behavior of the parties the insurers are being asked to cover. But that is, after all, the nature of the insurers’ business, and now is the time for D&O insurance underwriters to ask questions that might help them better understand and mitigate, where appropriate, unintended risk exposures, while they are insuring new kinds of expected risk.
Some questions D&O insurers might ask could include, for example, the following:
- Does the prospective insured’s expectations of cost-savings from a direct listing extend to cost-savings other than the projected costs of hiring an offering underwriter? If so, what are those costs, and what risk protection did those costs typically provide to the company?
- Given the emphasis on cost savings, will the prospective insured be hiring financial and legal advisors that are competent in advising on direct listing offerings? The need for competent, sophisticated advice is particularly essential in providing tailored risk factor warnings unique to the company, as well as disclosing known adverse company trends, in Form S-1 filings.
- Are members of the prospective insured’s board of directors designees of substantial investors in the company and, if so, do any of those investors expect to use a direct listing vehicle to reduce or exit their investment in the company during the contemplated policy period?
- In the absence of a roadshow to prospective investors, how, specifically, does the company expect to educate prospective investors about the company and its prospects? Who inside and outside the company is involved in those discussions, and who has prepared the written materials used to script those discussions?
Conclusion
Increasing pressures on companies and stock exchanges to facilitate investment liquidity are driving companies, exchanges and ultimately, regulators such as the SEC, to consider and implement new approaches to respond to such pressures. Although the rules around direct listings are likely to take shape and change over a period of time, direct listings can be expected to be necessary features of a dynamic equity marketplace that demands investment liquidity over the long run. The Spotify and Slack direct listings are the first test cases for investors and D&O insurers to better understand the strengths and weaknesses of the direct listing approach and to anticipate clarity and direction from the courts on the applicability of existing securities regulation laws and SEC rules to this developing area.
[1] In the venture capital industry, a unicorn refers to a privately-owned startup company that reaches a $1 billion market value.
[2] In this filing, the NYSE lowered the minimum amount companies would need to sell in a primary direct listing to $100 million from $250 million in its initial proposal. To date the SEC has declined to comment on the NYSE’s new proposal.
[3] Such sales generally do not fall within the exemption from registration requirements under the 1933 Act applicable to the public resale of securities previously received through private placements or other exempt offerings.
[4] See Law 360, “Slack’s Direct Listing Tests Limits of Securities Act,” by Francis McConville, Alex Coquin and Charles Wood (December 10, 2019).
[5] Id. In this article, the authors, who regularly represent shareholder plaintiffs, argue that a “value-based” analysis should be deemed an acceptable alternative measure of damages in direct listing cases.
