• The New York Stock Exchange’s plan for a new form of direct listings, which would allow companies to go public more easily by bypassing the underwriting process, hit a snag on Tuesday.
  • A group of influential investors who oppose the proposal filed a last-minute attempt to thwart the NYSE's plan.
  • They argued that new form of direct listings would allow companies to circumvent shareholder protections built into the IPO process and thus put investors at risk.
  • Business Insider spoke with three securities experts on whether this argument holds up, and how they see this situation unfolding.
  • Visit Business Insider's homepage for more stories.

Companies looking to go public are watching closely as the New York Stock Exchange's proposal to allow companies to raise capital through a direct listing is under consideration — again.

In late August, the Securities and Exchange Commission greenlighted the NYSE's plan to allow primary direct listings, in which companies can issue new shares while also leapfrogging the costly underwriting process. It was set to be a new twist on the direct-listing process used by Spotify and Slack, which previously hadn't allowed companies to raise new money. 

That development, however, was put on hold on Tuesday after the Council of Institutional Investors (CII), an industry group that represents big-money investors like pension funds, filed a notice that it would petition for a review of the proposal as a last-ditch effort to buy more time, as first reported in the Wall Street Journal. The council argued that the direct listings would allow companies to sidestep shareholder protections built into the traditional IPO process, thus putting investors at greater risk.

Direct listings are creating a buzz, especially among tech companies that are looking to go public and raise capital. Top tech bankers who spoke with Business Insider at the end of 2019 had said they were looking forward to innovation and new paths to public markets that combined elements of a traditional IPO and a direct listing. 

Business Insider spoke with three securities experts to parse out the legal nuances behind primary direct listings and dig into the concerns that critics are raising. 

Read more: Direct listings are a hot new trend for startups that are replacing IPOs. Here's how they work and what top tech bankers think they will mean for Wall Street

Cutting out the middleman can cause 'unclear and clunky' rules and a lack of verification 

A major difference from IPOs is that direct listings cut out the underwriters, typically banks, who review and verify the financial information in the offering documents. This information is crucial because it informs price discovery — the company's valuation and price of shares — explained Cynthia Krus, partner at Eversheds Sutherland who specializes in capital markets and securities governance.

The American Securities Association, which represents Main Street investors like banks and wealth managers, echoed the arguments made by the CII, adding in a letter to the SEC in December 2019 that the problem with this is that there's no third party conducting the necessary due diligence, which could lead to false claims and inflated prices. 

Krus thinks the council has a point. "The current SEC rules are somewhat unclear and clunky at this point," she said, adding that "the rules of the road are not well set" with regard to verifying statements made by the company.

In response to critics' arguments, the NYSE said in a letter to the regulator in March 2020 that there are other "gatekeepers," including senior managers, directors, and accountants, who would have "the same economic incentive as underwriters to participate in the diligence process in order to avoid securities law liability."

Krus says that this would only really work with certain, more established companies with a proven track record who would have the "wherewithal" to substantiate their statements. She pointed to Spotify, which went public via a direct listing in 2018 but did not raise capital. 

"Whereas if you're a fledgling company and you're a startup, and you've just got one idea and it hasn't been marketed, those are the kinds of companies I don't know whether they should be able to access a direct listing. I think it's questionable," she said of direct listings as a whole.

Some argue that direct listings could lead to untraceable shares and fuzzy liability

Another factor underlying primary direct listings is that it creates what Trace Schmeltz, partner and co-chair of Barnes & Thornburg's financial and regulatory group, calls an "ambiguous market."

Unlike in an IPO — where companies directly sell stocks at a single, set price to investors — in direct listings, private shareholders also put their stock along with the company's stock on the market, Schmeltz explained. These stocks are then bundled into a big block of shares held by a depository company, which assigns one identifying number to the whole block.

This means that it's essentially impossible to trace shares back to a single seller, creating a situation where it's difficult to hold anyone liable for any false statements down the road.

"So if the company made a mistake, and you buy your stock effectively from Bob Jones, you can't sue the company for false statements, because you didn't buy stock from the company — you bought it from Bob Jones. Of course, Bob Jones didn't make any statements. He just put his shares out there," explained Schmeltz.

The SEC also noted in its order approving the NYSE's plan that, because all company shares will be sold in the opening auction, it would make it "potentially easier to trace those shares back to the registration statement than in other contexts."

Despite that arguement, there's an ongoing legal case that the CII's argument relates to, said Rob Peters, a senior director at Intelligize, a research platform for securities and compliance professionals. The case was brought by a group of investors against Slack, the instant-messaging company that made a splashy market debut through a direct listing in 2019.

Like Spotify, Slack did not raise any cash initially. Once its shares were publicly traded, the company and shareholders were able to offer stock to investors. 

Because investors bought a mix of shares from Slack's shareholders — some of which were covered by the company's registration statements filed with the SEC, and some of which weren't — Slack argued that the suit should be dismissed since they can't trace the shares directly back to the company.

In April, the judge disagreed with Slack, ruling that the plaintiffs actually do have legal standing to sue Slack under Section 11 of the Securities Act, which gives investors the ability to hold others liable for damages caused by false statements or omissions of fact — even though they couldn't trace their shares directly to the company. 

The Slack case, which is currently under appeal and is cited in the CII's most recent letter to the SEC, grapples with the issue of who can be held liable for damages when you have untraceable shares via direct listings, said Peters. Its outcome could shape the way the direct-listings process is regulated, and offer more clout to the CII's arguments — even though the NYSE claimed in its March letter, without mentioning the Slack case, that the ongoing litigation should have "no bearing" on the SEC's decision over their proposal.

Less sophisticated investors may not fully understand the nuances of the direct listings process, added Peters. "The job of the SEC is to protect investors, so they have to balance to reach between protecting investors and making capital markets efficient and available," he said. 

Read more: Big investors have been slashing valuations on stakes in private companies like Palantir and Sweetgreen. But bankers say there could be a quick fix.

Pushes for a clearer regulatory process and technological reform

Ultimately, the SEC should set out clear rules when it comes to direct listings, these experts said. Both Krus and Peters said that companies should have an independent, third-party reviewer to ensure that the information going out to public investors is true.

Schmeltz adds that there needs to be structural changes to the way the SEC runs its capital markets: "The SEC needs to find a way to separate the primary market of the companies and the secondary market of the individuals reselling their shares."

One way to do this is by dovetailing existing technology with new regulations. "We just happen to have a securities market that has 21st-century technology and early-20th-century laws," Schmeltz said.

"There would have to be potential reform at the depository level to tag the block at a granular level," he added about the blocks of stocks formed during a primary listing, which are comprised of company and individual shareholder stocks.

These reforms in the capital markets structure are crucial, especially since all three securities experts say that, ultimately, the markets are headed in the direction of direct listings.

"We need the innovation. We need markets that are as direct-to-consumers without middlemen as possible," said Schmeltz. "The whole wave of innovation in the financial markets is to disintermediate middleman, investment bankers. So I think this effort will succeed and you'll see a new market."

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