The Council of Institutional Investors (CII), a group that represents a large group of institutional investors, has taken steps to block the SEC’s approval of a new NYSE rule that would allow companies to sell newly issued shares in a direct listing. CII will need to submit a petition to the SEC in the coming days. This move caused the SEC to stay the approval of the new rule. For a summary of the new rule, see our post here.
CII objects to the rule out of concern that companies may attempt to limit their liability to investors for damages caused by false statements of fact or material omissions of fact within registration statements associated with direct listings. This concern arises in part because of the potential inability of investors who buy in a direct listing to “trace” their shares to those offered in the registration statement.
Tracing is a pre-requisite to bringing a securities class action against the company. Historically, because companies face strict liability in securities class actions brought in connection with their public offerings, plaintiffs have been required to demonstrate that they actually purchased stock in the challenged offering. For example, a shareholder who purchased shares in the open market would need to show that their shares were sold pursuant to the registration statement, rather than by a pre-IPO equity holder who had freely tradeable shares and was able to sell them outside of the registration statement; if such shares were purchased outside of the registration statement, the shareholder would not qualify to bring the lawsuit.
CII wants the SEC to establish a system for tracing shares before approving an expansion of the direct listing regime. Without the ability to trace shares to the registration statement, plaintiffs may face a greater burden when bringing putative class actions against the company in connection with its offering. Notably, abusive lawsuits by shareholders seeking to circumvent federal reforms of the securities laws have plagued companies for decades.
Interestingly, the same traceability concern CII cites in connection with direct listings can arise in a traditional IPO where not all of the pre-IPO equity holders are locked up. Lockups are contractual agreements between pre-IPO holders and the underwriters of the IPO. These agreements generally preclude pre-IPO equity holders from selling shares or derivative securities into the market during a limited period (often 180 days) post-IPO. Underwriters typically seek to have all or close to all of the pre-IPO equity locked up in an effort to avoid the stock pressure that can arise when a large group of holders are selling into the market at the same time.
When less than all of the pre-IPO stock is locked up, at least some of the pre-IPO holders can sell shares into the market, outside of the registration statement, from day one. When this happens, plaintiffs seeking to sue the company in connection with its offering may have to make an additional showing to maintain their lawsuit.
Lockups are not required in either a traditional IPO or a direct listing. While lockups are common practice in traditional IPOs, even that practice is changing as we discussed in our post comparing traditional IPOs and direct listings. Avoiding a 100% locked-up IPO can turn out to be beneficial in the context of abusive post-IPO litigation, even though lockups can have other benefits.
The SEC rules are not clear about timing for resolving a stay. Until then companies can continue to conduct direct listings that do not have a primary capital raising component.