What's behind the fight over direct listings?
Shakeel Hashim
Protocol
September 25, 2020
Amid the furor around Snowflake's gigantic IPO pop last week, Bill Gurley started to tweet. (What else is new?) Gurley's long argued the IPO process is broken. But this time he pointed out that though the NYSE is trying to create a new alternative to IPOs — Primary Direct Floor Listings, a version of the direct listing that allows companies to raise capital at the same time — the Council of Institutional Investors was pushing back against it.
Gurley's not wrong. At the end of August, the SEC stayed the NYSE's proposal, despite having approved it a week earlier. That was down to a petition from the CII, which said that the proposal does not contain "adequate investor protections."
So what's the problem? Well, first a bit of background on securities fraud.
"The bigger problem comes back to this issue called proxy plumbing," CII general counsel Jeff Mahoney told me. "Typically, in order to prove that you've been defrauded, you have to trace your share back to the offering statement, which included the fraud," he said. "In a typical IPO, if I end up getting some shares from an IPO and there's a fraud in the document … I can claim that my shares relate to the fraud in that document." In other words, investors in an IPO can trace their shares back to their registration, making fraud relatively easy to prove."But in a direct listing, you have a situation where there's typically no lockup," Mahoney said. In a Primary Direct Floor Listing, shares sold by the company would become available at the same time as shares sold by insiders. That means "you can't trace those shares back to that registration statement, because you don't know whether you got shares as part of that registration statement, or if you got shares from an insider whose shares are unregistered and not covered by that registration statement." That makes it much harder to prove you've been defrauded.
Direct listing supporters might say that this isn't a big problem. In its initial approval of the NYSE's proposal, the SEC pointed out tracing shares back is "a recurring issue, particularly in the context of aftermarket securities purchases," something that Mahoney concedes, too.
But this isn't an abstract worry. After Slack's direct listing, some investors sued the company, saying it didn't fully disclose certain risks. Slack pushed back, saying it shouldn't be held liable because the investors couldn't trace their shares back to the registration statement. The court involved ruled against Slack, but referred the case to the Ninth Circuit court, which could rule differently, Mahoney wrote in his petition.
He points to a memo from Latham & Watkins, a law firm that worked on Slack and Spotify's direct listings. In it, the firm cites the traceability problem as "another important advantage of the direct listing," saying that it could "deter litigation." That makes it hard to dismiss the CII's claims as scaremongering.Mahoney also dismissed the idea that the CII opposes direct listings because it wants its members to benefit from first-day pops. "That doesn't make any sense at all," he said, because "our members generally are not involved in IPOs ... [they] are largely passively invested."For Mahoney, the solution to all this involves fixing the proxy plumbing system. That's something the SEC has begun work on, but it's going to take a while because of the complexity of the financial system.
But if it is fixed, he'd be happy. "If they fixed proxy plumbing and we had a system of traceable shares, would we have filed that petition? The answer's no, we would not have."Another solution might be to add a lockup period to direct listings so insiders can't sell all their shares straight away — something Palantir has done ahead of its listing next week. "I don't know if [that] has something to do with my petition or not, but I thought it was interesting," Mahoney said.
Mahoney's larger point, though, is that this issue is too important to go without further discussion. "Given how significant this change is to the U.S. capital market system, shouldn't this issue be discussed by the full commission?" he asked.
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