Christmas Came Early For Startups

The SEC approved NYSE initiative to allow for primary direct listings        

One thing is clear: Bill Gurley is surely a happy camper today. 

The noted venture capitalist gleefully Tweeted today that the Securities and Exchange Commission approved the ability to add primary capital (fundraising) to a direct listing. 

“It’s very exciting to see the SEC enable innovation in this way,” he said. “A wonderful 2020 Xmas present to the founders, employees, & investors at VC-backed startups.” 

This change may lead to a disruption of the traditional initial public offering (IPO) landscape entirely, gift-wrap not included. Are startups going to use it? Time will tell. 

What’s all the fuss?

Well, today, the U.S. Securities and Exchange Commission (SEC) finally approved the New York Stock Exchange (NYSE) initiative to allow for primary direct listings. 

We exhaustively covered the drama a couple months back. 

The NYSE launched this initiative by applying to the SEC for approval for a rule change to amend Chapter One of the NYSE Listed Company Manual to modify the provisions related to direct listing. The NYSE initially proposed allowances for primary direct listings, only to be unceremoniously rejected in 2019. 

The NYSE persisted with a modified proposal. After nine months of trying, the SEC’s Division of Markets and Trading approved a change to listing requirements to allow primary direct listings. The road for private companies to use direct listings to raise new capital was cleared…for five days. That’s when the Council of Institutional Investors  (CII) filed notice with the SEC to challenge the rule change in an attempt to overturn the approval process before the full Commission. 

In their filing, the CII raised several concerns regarding the new rule, with considerable emphasis on the uncertain role of “financial advisors” and whether investor protection is compromised. The SEC rejected the CII’s concerns today. The SEC found that the rule changes sufficiently protect investors. The SEC holds that the existing regulation and securities laws provide enough requirements for these “financial advisors” to behave responsibly. 

The NYSE noted that the involvement of traditional underwriters is not required under the Securities Act, despite the necessity of their presence for primary offerings to be successful. They also argued assigning the gatekeeping role solely to investment bankers left out the other critical groups, such as the board of directors, senior management, and independent accountants, to say nothing of the registration and oversight with the SEC itself. 

What about the bankers?

This means that the SEC sided with the NYSE, going so far as to state that financial advisors may face statutory “underwriter” liability, depending on the particularized facts and circumstances in a future proceeding. For the Commission, this was deemed to be sufficient incentive for advisors to engage in robust due diligence. 

The SEC also noted, even in the absence of any statutory underwriter, the amount of recoverable damages by investors would remain unaffected. Finally, in addressing concerns over the traceability of shares for Section 11 claims, the SEC found the issues presented by the CII were not unique to primary offerings via direct listing. 

They acknowledged the evolution of judicial requirements on the subject of traceability, particularly with the forthcoming decision from an interlocutory appeal before the Ninth Circuit, but found the lack of demonstrative precedent in the context of traceability problems in direct listings to be compelling.

With this order, the SEC has cleared the last obstacle to primary offerings via direct listing on the NYSE. A similar proposal by the NASDAQ

NDAQ
has been filed and, with this ruling, it is likely to be approved. This disruption appears to be permanent.

What about Corporate Governance?

The risks associated with direct listings now shift from an initial offering to the long-term governance implications. With direct listings, whether primary or secondary, there is no capability to force sunset provisions into companies’ equity structures, a method viewed by the CII as a potential avenue for limiting founder power post-IPO. They have long opposed dual-class structures, instead endorsing the position of “one share, one vote.”

At the same time, there is significant pressure on unicorns—companies valued at $1 billion—going public via traditional IPOs with dual class shares to include mandatory sunset provisions into their charters, terminating after a certain number of years. While such mandatory structures have faced some justly deserved criticism, there is no incentive to implement these provisions in direct listings, despite the probable benefit to investors in the long-term. 

With unique capital and ownership structures remaining in place following direct listings, the possibility of a board of directors being unable to sufficiently monitor and oversee management practices is a practical governance question that must be answered before direct listings can be seen as a truly disruptive force in the IPO market.

Primary direct listings might be highly appealing to unicorn companies, which have long track records of being able to raise large sums of capital from private markets. They will be able to provide liquidity to their employees and early investors and save on the costs typically associated with an IPO. More importantly, it may also provide an avenue for founders to maintain tighter control over the management of their company, control which they would run the risk of losing in a traditional IPO. 

This change may very well be one of the first meaningful disruptions to the IPO process in decades. In other words, it’s a big deal. Primary offerings by direct listings might eliminate the involvement of investment banking underwriters, and instead permit issuers to engage the assistance of “financial advisers” who play no traditional underwriter role in the offering. 

In the traditional IPO process, these investment bankers serve a variety of functions including valuation analyses, engaging in “book building,” deciding on the price in conjunction with the issuer, going on road shows to market the securities, engaging in the actual selling of the offering, and stabilizing the offering itself. This might be absent in primary direct listings.

To find more on these developments and our recommendations, see my recent piece with Prof. Robert Rapp and John Livingstone in the SMU Law Review Forum: Investment Bankers as Underwriters: Barbarians or Gatekeepers? A Response to Brent Horton on Direct Listings and my recent piece in Forbes.