NYSE Persistence Pays Off—SEC Approves Primary Direct Listings

Cydney S. Posner is special counsel at Cooley LLP. This post is based on a Cooley memorandum by Ms. Posner.

Persistence pays off. In June, the NYSE filed Amendment No. 2 to its application for a proposed rule change to allow companies going public to raise capital through a primary direct listing. Yesterday, the SEC approved that rule change. Prior to this new approval, under NYSE rules, only secondary sales were permitted in a direct listing, which meant that companies that had conducted direct listings looked more like well-heeled unicorns, where the company was not necessarily in need of additional capital. The new rule change is likely to be a game changer for the traditional underwritten IPO. So much so, in fact, that Nasdaq has now also submitted an application to permit companies to conduct direct listings with capital raises.

The path to SEC approval was a bit rocky. A little over a week after the NYSE’s initial application was filed, as reported by CNBC and Reuters, the SEC rejected the proposal, and it was removed from the NYSE website, causing a lot of speculation about the nature of the SEC’s objection and whether the proposal could be resurrected. At the time, an NYSE spokesperson confirmed to CNBC that the proposal had been rejected, but said that the NYSE remained “‘committed to evolving the direct listing product…This sort of action is not unusual in the filing process and we will continue to work with the SEC on this initiative.’” (See this PubCo post.) The NYSE did persevere, and the proposal was refiled in December with some clarifications and corrections. But then—silence. In January and February, the NYSE had four meetings with SEC staff, including folks in Chair Clayton’s office, presumably to make the case for the proposal. A number of public comment letters, of divided opinion, were submitted. Apparently, the SEC remained unconvinced, designating a longer period to decide, and then in late March, issued an Order instituting proceedings to determine whether to approve or disapprove the proposed rule change. Undaunted, the NYSE filed Amendment No. 2, which is discussed in more detail in this PubCo post. The NYSE appears to be rather pleased by the positive outcome—as described by NYSE Vice Chair John Tuttle, “Innovation, disruption, and problem-solving are part of the NYSE’s DNA.”

Essentially, a “direct listing” involves a registered sale directly into the public market with no intermediary underwriter, no underwriting commissions (just advisory fees) and no roadshow or similar expenses. The initial pricing is set during the opening auction, not by agreement among the company and underwriters, as in a traditional IPO. What’s more, with direct listings, companies may be on their own when it comes to any marketing effort, otherwise typically provided by the bankers, and there may be only limited banker support of the stock price in the aftermarket. Of course, under the secondary-only structure in effect prior to the approval, there were also no proceeds to the company, which put a definite crimp in the potential popularity of direct listings, as only companies that did not need to raise capital for their own use were likely to opt for that alternative.

But, since the splashy market debuts of at least two companies via selling-shareholder direct listings, there has been a vociferous call from many VCs and others for alternative on-ramps to public-company status, such as direct listings. Those that favor direct listings complain about the cost and rigidity of the traditional underwriting commission structure. And insiders are often especially pleased with direct listings because, ­unlike with underwritten IPOs, there is typically no “lockup period,” and shareholders are free to sell their shares right away.

In its Order, the SEC had taken issue with various aspects of the NYSE proposal, including the proposed 90-day grace period to comply with the initial distribution requirements (400 round lot holders and 1.1 million publicly held shares), contending that the grace period risked undermining fair and orderly markets and could lead to companies’ being delisted relatively soon after their listing. In addition, the SEC questioned the NYSE’s assumption, under the original proposal, that a company would have met the applicable $100 million aggregate market value of publicly held shares requirement—how would the company know at the time of approval if it would sell at least $100 million in market value of shares in the opening auction on the first day of trading? Finally, among other issues, the SEC also objected that, as potentially the only or a dominant seller, the listing company could be in a “position to uniquely influence the price discovery process.” The burden, the SEC observed, was on the NYSE to demonstrate the proposal was consistent with the Exchange Act and related rules.

Apparently, the NYSE met that burden. Amendment No. 2 eliminated the controversial grace period to meet the initial distribution standards. In addition, in an effort to overcome offering size and liquidity concerns and offer comfort regarding the achievement of fair and orderly markets, the revised proposal attempted to provide more certainty and assurance regarding the process, specifying how a primary direct listing would qualify for listing and describing the mechanics of how the primary direct listing would be effected or would not proceed if threshold requirements were not satisfied.

As before, in a primary direct listing (which may include a selling shareholder component), the NYSE will consider a company to have met the applicable requirement for $100 million aggregate market value of publicly held shares if, in the opening auction on the first day of trading, the company will sell shares with a market value of at least $100 million. Where the market value of publicly held shares to be sold by the company is less than $100 million, the NYSE will consider the company to have met its requirement if the aggregate market value of the shares the company will sell in the opening auction, together with the shares that are eligible for inclusion as publicly held shares immediately prior to the listing, is at least $250 million, with market value for the aggregate of the shares “calculated using a price per share equal to the lowest price of the price range established by the issuer in its registration statement.” Officers, directors or more than 10% holders (prior to the opening auction) will be able to purchase shares sold in the opening auction by the company or by other shareholders or may sell their own shares in the opening auction and in trading after the opening auction, so long as the trading is consistent with Reg M and general anti-manipulation provisions. The NYSE asserted that, because of the requirement for a minimum of $100 million in publicly held shares (which is much higher than the $40 million minimum requirement for a traditional underwritten IPO) and the “neutral nature of the opening auction process,” a company conducting a primary direct listing will have an adequate public float and liquid trading market after the completion of the opening auction. In addition, the requirements to have 400 shareholders of round lots and 1.1 million publicly-held shares outstanding at the time of initial listing, and the requirement to have a price per share of at least $4.00 at the time of initial listing will be maintained.

The new rules also adds a new “order type,” the IDO Order, which is a limit order, traded only in a primary direct listing, to sell the quantity of shares offered by the issuer, as disclosed in the prospectus in the effective registration statement, with the limit price equal to the low end of the price range established in the effective registration statement; all better-priced (lower-priced) sell orders must be sold at that price. (Unlike a direct secondary listing, the registration statement for a primary direct listing will have to include a price range within which the company anticipates selling its shares.) The IDO Order may not be cancelled or modified and must be executed in full. Accordingly, the primary direct listing can be effected only if the auction price is within the range specified in the effective registration statement, and only if the entire quantity of shares in the IDO Order that the company seeks to sell can be sold within that price range.

The Designated Market Maker will determine the auction price within the range and will be required to manually facilitate the auction. Additional requirements will apply to the DMM conducting the direct listing, including establishing that the “Indication Reference Price” will be the lowest price in the range set in the effective registration statement. In effect, the DMM will be responsible for determining whether the direct listing can proceed: the auction will not be able to proceed if the auction price is outside the range or if there is insufficient buy interest to satisfy both the IDO Order and all better-priced sell orders in full. In addition, when the auction price is set at the low end of the range (the limit price of the IDO Order), the IDO Order will have priority over other orders at that price, thereby increasing the potential for the IDO Order to be executed in full and the primary direct listing to proceed.

Under the new rule, in either a primary or secondary direct listing, any services provided by a financial advisor to the issuer or the DMM must be provided consistent with all federal securities laws, including Reg M and other anti-manipulation requirements, and FINRA has been engaged to monitor compliance. Finally, because of the importance of the DMM, the new rule provides that, if a DMM is unable to manually facilitate a direct listing auction, the NYSE will not proceed with the listing.

In approving the application, the SEC maintained that many of the changes included in Amendment No. 2 “support a finding that the proposal is consistent with the Act.” More specifically, the SEC

“believes that the following aspects result in a proposal for a Primary Direct Floor Listing that 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: (i) addition of the IDO Order type and other requirements which address how the issuer will participate in the opening auction; (ii) discussion of the role of financial advisors; (iii) addition of the Commentary that provides that specified activities are to be conducted in a manner that is consistent with the federal securities laws, including Regulation M and other anti-manipulation requirements; (iv) retaining of FINRA to monitor compliance with Regulation M and other anti-manipulation provisions of the federal securities laws and NYSE Rule 2020; (v) clarification of how market value will be determined for qualifying the company’s securities for listing; and (vi) elimination of the grace period for meeting certain listing requirements.”

In addition, the SEC was satisfied that, because the proposed requirement for aggregate market value of publicly held shares was comparable to or higher than the aggregate market value of publicly held shares required by the NYSE for initial listing in other contexts, the NYSE’s requirement would provide “a reasonable level of assurance that the company’s market value supports listing on the Exchange and the maintenance of fair and orderly markets.” The SEC was also comforted that “using the lowest price in the price range established by the issuer in its registration statement to determine the minimum market value is a reasonable and conservative approach given that… the Primary Direct Floor Listing will not proceed at a lower price.” The SEC also believed that “the IDO Order and related clarifications…assure that the method by which the issuer participates in the opening auction is clearly defined, that the issuer is not in a position to improperly influence the price discovery process, and that the auction is otherwise consistent with the disclosures in the registration statement. [The SEC] believes that the IDO Order requirements…help to mitigate concerns about the price discovery process in the opening auction and would provide some reasonable assurance that the opening auction and subsequent trading promote fair and orderly markets and that the proposed rules are designed to prevent manipulative acts and practices, and protect investors and the public interest….”

Commenters on the proposed rule change had expressed concerns that the absence of traditional underwriter due diligence and liability in direct listings generally would increase risks for investors, decrease investor protections and make more vulnerable shareholder rights under Section 11 of the Securities Act. In response, the SEC, agreeing with the NYSE, observed that the Securities Act “does not require the involvement of an underwriter in registered offerings. Moreover, given the broad definition of ‘underwriter’ in the Securities Act, a financial advisor to an issuer engaged in a Primary Direct Floor Listing may, depending on the nature and extent of the financial advisor’s activities and on the facts and circumstances, be deemed a statutory ‘underwriter’ with respect to the securities offering, with attendant underwriter liabilities.” (Note that the SEC objected to the assertion by one commenter that financial advisors, exchanges, control shareholders and directors involved in a direct listing would automatically incur statutory underwriter liability under the Securities Act.) In addition, given financial advisors’ reputational interests and potential liability, the SEC contended that they would be “incentivized to engage in robust due diligence, notwithstanding the lack of a firm commitment underwriting agreement.” The SEC also pointed to the important roles played by issuers and other gatekeepers in assuring that disclosures are materially accurate and complete.

Another concern raised by commenters was the difficulty of tracing shares back to the registered offering to pursue claims under Section 11. The SEC, however, contended that the problem of tracing is “not exclusive to Primary Direct Floor Listings but rather is a recurring issue, particularly in the context of aftermarket securities purchases. Purchasers in a registered offering may face difficulty tracing their shares back to the registration statement whenever a company conducts a registered offering for less than all of its shares.” For example, even in the context of traditional firm commitment offerings, the availability of Rule 144 sales “may result in concurrent registered and unregistered sales of the same class of security at the time of an exchange listing, leading to difficulties tracing purchases back to the registered offering.” At the present time, the SEC was aware of only one case that had considered the issue in the context of direct listings and, in that case, the court allowed the plaintiffs to pursue Section 11 claims. Indeed, the SEC noted, the fact that, in a primary direct listing, all company shares will be sold in the opening auction, makes “it potentially easier to trace those shares back to the registration statement than in other contexts.” Accordingly, the SEC did not believe that permitting primary direct listings “poses a heightened risk to investors, and finds that the proposed rule change is consistent with investor protection.”

The SEC also identified a number of potential benefits associated with primary direct listings, including the possibility that, because the securities would be allocated based on matching buy and sell orders, some investors may be able to receive initial share allocations who might not otherwise receive an initial allocation in a firm commitment underwritten offering. In addition, because the price of securities in a primary direct listing will be determined based on market interest and the matching of buy and sell orders, some have suggested that price discovery may be more accurate than when the offering price is negotiated by the issuer and the underwriters in a firm commitment underwritten offering.

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.

For subsequent updates, see this post.

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