United States: NYSE Takes Another Crack At Primary Direct Listings—will It Succeed?

In late November last year, the NYSE filed with the SEC a proposed rule change that would have allowed companies going public to raise capital through a primary direct listing. Under current NYSE rules, only secondary sales are permitted in a direct listing.  As a result, thus far, companies that have embarked on direct listings have looked more like well-heeled unicorns, where the company was not necessarily in need of additional capital.  The new proposal seemed to be a potential game changer for the traditional underwritten IPO. (See this PubCo post.)  However, as reported by CNBC and  Reuters, a little over a week later, the SEC rejected the NYSE's 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 is giving it another go and has just filed Amendment No. 2.   Will it be enough to convince the SEC?

Essentially, a "direct listing" involves a registered sale, currently permitted only by selling shareholders, directly into the public market with no intermediary underwriter, no underwriting commissions (just advisory fees) and no roadshow or similar expenses.  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 current structure, there are also no proceeds to the company, which has put a definite crimp in the potential popularity of direct listings, as only companies that do not need to raise capital for their own use are 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 underwriting commission structure.  And insiders are often especially pleased with direct listings because, ­unlike with underwritten IPOs, there is no "lockup period," and shareholders are free to sell their shares right away.

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In response to the December proposal, some of the largest investment banks submitted favorable comment letters to the SEC regarding the December proposal. Generally, these favorable letters supported the availability of alternative formats that offer choices to issuers, encouraging more companies to participate in the public markets. (See, e.g., this letter and this letter.)  Notably, however, the majority of comment letters opposed the proposal, including two letters in opposition submitted by the Council of Institutional Investors ( here and here).  The letter from CII was critical of the proposal because, it argues, it would reduce shareholder protections for several reasons—a lack of clarity with regard to Securities Act liability (principally as a result of difficulty in tracing shares purchased back to the registration statement and the absence of an offering price), potential liquidity issues, potential low aggregate market value of publicly held shares at the time of listing, and the company's being the only seller in the opening auction.  The American Securities Association, which also submitted two letters ( here and here), echoed the issues raised by CII and added its concerns regarding the absence of a rigorous underwriting due diligence process and the lack of clarity regarding the potential liability of financial advisors.

In response to these criticisms, the NYSE argued, among other things,  that the absence of underwriter liability was not a "loophole," but rather "a design feature of the regulatory regime."  In direct listings, other gatekeepers, such as directors, senior management and independent accountants would "have the same economic incentive as underwriters to participate in the diligence process in order to avoid securities law liability," and the due diligence process would be the responsibility of those gatekeepers. The NYSE saw no reason to believe that companies that use the primary direct-listing approach would "over time, perform any better or worse than companies that proceed through an underwritten public offering."  In addition, a company undertaking a primary direct listing would still need to publicly file a registration statement, which, as with underwritten offerings, would expose any weaknesses in the company's business model.

The December NYSE proposal is summarized in this PubCo post.  However, in light of Amendment No. 2, a few key points bear repeating here.  For primary direct listings, the NYSE had proposed that a company would qualify for listing by selling at least $100 million in market value of shares in the opening auction; however, a company could still qualify even if it sold shares in the opening auction with a market value of less than $100 million so long as the aggregate of the market value of publicly held shares immediately prior to listing together with the market value of shares sold by the company in the opening auction were at least $250 million. The proposal would also have modified the distribution requirements. Currently, a company is required to have at least 400 round lot holders and 1.1 million publicly held shares at the time of listing, which can be a challenge for a private company in a direct listing. Under the proposal, so long as the company sold at least $250 million in market value of shares in the opening auction on the initial listing date, it could have commenced trading and would have a 90-trading-day grace period to demonstrate compliance with the distribution requirements. Any company that failed to meet the distribution standards within the grace period would not have been compliant and would have needed to submit a compliance plan. Failure to meet the distributions standards by the end of six months would have subjected the company to suspension and delisting.

In its Order, the SEC took issue with various aspects of the NYSE proposal. With respect to the proposed 90-day grace period to comply with the initial distribution requirements (400 round lot holders and 1.1 million publicly held shares), the SEC contended that the NYSE

In addition, the SEC questioned the NYSE's assumption, under the original proposal, that a company will have met the applicable $100 million aggregate market value of publicly held shares requirement if the company sells at least $100 million in market value of shares in the opening auction on the first day of trading. It was unclear how the NYSE could

Finally, the SEC observed, because, under the proposal, the listing company could be the only seller (or a dominant seller) participating in the opening auction, it could be

The burden, the SEC noted, is on the NYSE to demonstrate the proposal is consistent with the Exchange Act and related rules.

How does Amendment No. 2, filed last week by the NYSE, address these perceived deficiencies?   First, the revised proposal eliminates the controversial grace period to meet the initial distribution standards. Second, in an effort to overcome offering size and liquidity concerns and offer comfort regarding the achievement of fair and orderly markets, the revised proposal attempts 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 described by the NYSE Vice Chair in this TechCrunch article, the description provides "a very granular, mechanical breakdown of how we would execute this type of transaction....Most of that surrounds how new shares are numbered, valued and priced in a direct listing."

As before, in a primary direct listing (which may include a selling shareholder component), the NYSE would 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. Under the amendment, 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) would 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 believes 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 would have an adequate public float and liquid trading market after the completion of the opening auction. In addition, under Amendment No. 2, 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 would be maintained.

The amendment would also add a new "order type," the IDO Order, and describes how it would be executed in a primary direct listing. The IDO Order would be 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, and 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 would have to include a price range within which the company anticipated selling its shares.)  The IDO Order could not be cancelled or modified and must be executed in full.  Accordingly, the primary direct listing could be effected only if the auction price were within the range specified in the effective registration statement, and only if the entire quantity of shares in the IDO Order that the company sought to sell could be sold within that price range. The Designated Market Maker would determine the auction price within the range and would be required to manually facilitate the auction.  Additional requirements would apply to the DMM conducting the direct listing, including establishing that the "Indication Reference Price" would be the lowest price in the range set in the effective registration statement. In effect, the DMM would be responsible for determining whether the direct listing could proceed: the auction could not proceed if the auction price were outside the range or if there were insufficient buy interest to satisfy both the IDO Order and all better-priced sell orders in full. In addition, the amendment would require that when the auction price is set at the low end of the range (the limit price of the IDO Order), the IDO Order would 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.

The amendment stresses that, 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 NYSE proposes that if a DMM is unable to manually facilitate a direct listing auction, the NYSE would not proceed with the listing.

It remains to be seen whether the changes in Amendment No. 2 will suffice to persuade the SEC to allow the NYSE to proceed with primary direct listings.  If the SEC does, whether or not the availability of primary direct listings completely upends the conventional underwritten route, many believe that the alternative process may encourage more companies to consider going public.  Reuters cites an NYSE executive for that proposition: "Will this displace the traditional IPO? No, but is it another pathway we are providing companies to come to the public markets and to have investors participate and (have) growth opportunities? Yes."

Originally published June 29, 2020.

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