Risk and Reputation.

• Author: Wilson, Taylor J.

Direct listing is an innovative alternative to a traditional initial public offering. Since direct listing was revived in 2018, there have been many lingering questions, particularly about the liability of financial advisors involved in the process. In a traditional IPO, a company retains an investment bank as an underwriter; the underwriter takes on a degree of financial risk and lends credibility to the company's offering, often directly marketing the offering to potential investors. In a direct listing, however, investment banks act as financial advisors but do not assume financial risk or market the sale of securities. Section 11 is an important antifraud provision of the Securities Act of 1933, which imposes liability on all offering participants meeting the statutory definition of underwriter. Whether that definition fairly encompasses financial advisors is unsettled, resulting in uncertainty for both investors and offering participants.

After arguing for the application of the Lehman Brothers interpretation of the underwriter definition, this Note then argues that financial advisors are not likely to be statutory underwriters under that interpretation. This Note therefore recommends against the application of section 11 liability to financial advisors. After briefly discussing the risks this conclusion implies for investors, this Note discusses what should be done. One scholar has suggested that section 11 liability should be imposed on financial advisors through exchange rules. But increasing liability is not without costs. Reframing the question as a choice between negligence-based liability and scienter-based liability, this Note points to the possibility that an increase in liability could undermine the primary benefits of direct listing. Drawing on a framework developed by Professor Assaf Hamdani, this Note finally discusses the possibility of using direct regulation in concert with scienter-based liability to incentivize financial advisors to be effective gatekeepers.

INTRODUCTION I. WHAT IS A DIRECT LISTING? A. The Role of Underwriters in the IPO Process B. The Emergence of Direct Listings and Primary Direct Listings C. Section 11 Underwriter Liability D. Underwriter in Disguise? II. UNCERTAINTY AROUND FINANCIAL ADVISOR LIABILITY UNDER SECTION 11 A. Core Underwriter Functions: Risk and Reputation B. Legislative History C. Interpretations of "Direct or Indirect Participation" III. FINANCIAL ADVISOR'S LIABILITY UNDER SECTION 11 A. Investor Day Presentations B. Registration Statements C. Valuation D. Price Setting in Consultation with the Designated Market Maker E. Should Financial Advisors Be Liable? IV. PULLED IN TWO DIRECTIONS A. Investor Protection Concerns B. Weighing the Cost of Increased Liability CONCLUSION INTRODUCTION

In recent years, the securities market has experienced significant innovation. Some of these innovations are geared toward investors, like the development of the trading app Robinhood, which has increased access to the market for retail investors. Others are geared toward companies, like the recent explosion in the use of special purpose acquisition companies (SPACs). (1) But with innovation comes unforeseen challenges, and the regulatory apparatus constantly works to balance the interests of investors with those of honest businesses. (2)

The stock market has seen an increase in the popularity of alternatives to the traditional initial public offering (IPO). (3) The "SPAC boom" that overtook the market in 2020 reflects the growing popularity of one alternative. (4) The lesser-known direct listing is another innovative way to take a company public. (5) In a direct listing, rather than issuing new shares, companies simply list shares that are held by insiders and employees, allowing them to liquidate their holdings while taking the company public. (6) Although there were hundreds of SPAC IPOs in 2020 alone, (7) there have been only a dozen direct listings since the method was revived in 2018. (8) But despite being few in number, many of the companies that chose direct listing were large and recognizable: Spotify, Coinbase, and Warby Parker, to name a few. (9)

One of the key differences between a direct listing and an IPO is the absence of an underwriter. (10) Underwriters are investment banks that play a major role in traditional public offerings, providing several services to the issuer and fraud protection to the public. (11) For all their import, underwriters are notably absent from direct listings, but investment banks are not. Rather than acting as underwriters, these banks now play the part of financial advisors. (12)

Underwriters traditionally serve a gatekeeping role because they are a third party that can be held liable for the wrongdoing of the issuer. (13) If there are material misstatements or omissions in the issuer's registration statement, an investor can bring a claim under section 11 of the Securities Act of 1933 (the "Securities Act") against both the issuer and the underwriter. (14) Since the emergence of the direct listing, however, it has been unclear whether a section 11 claim can be brought against an investment bank acting solely as a financial advisor. (15)

Financial advisors could be liable under section 11 if they qualify as "statutory underwriters," but the scope of that term is unclear. (16) With large tech companies like Spotify and Slack choosing to use direct listings, large amounts of investor capital may be implicated in section 11 suits without investors knowing who to sue. (17) The greater concern is that, in the absence of liability, financial advisors may not have adequate incentive to serve as effective gatekeepers to the capital market.

But imposing liability to incentivize gatekeeper functions has its own problems. The direct listing process significantly reduces expenses for issuers, in turn benefitting investors. (18) These benefits are due in large part to the absence of an underwriter. Increasing liability could undermine these benefits.

This Note claims that financial advisors in direct listings are unlikely to be liable as underwriters under section 11 of the Securities Act and that the Securities and Exchange Commission (SEC) should not act to impose liability. Part I provides an overview of the underwriter's traditional role in an IPO and the financial advisor's role in the direct listing process, drawing particular attention to the distinction between the two activities. Part II examines precedent interpreting section Il's definition of "underwriter" and argues for the use of the Second Circuit's interpretation in Lehman Brothers. Part III applies that interpretation to financial advisors, arguing that they are not liable as underwriters in direct listing transactions. Part IV examines the risk to investors and the costs of imposing liability. It raises concern that the cost accompanying increased liability might undermine the benefits of direct listing and instead suggests that the SEC should explore direct regulation.

1. WHAT IS A DIRECT LISTING?

   To understand the role that financial advisors play in direct listings and their status under section 11, it is necessary to understand the role of underwriters in a traditional IPO. Section I.A of this Note provides an overview of the underwriters' role in a typical IPO. Section I.B explains the emergence of direct listings and contrasts them with the traditional IPO. Section I.C introduces section 11 liability and how it applies to underwriters. Section I.D explains the SEC's response to the question at issue as well as the scholarly attention it has received.

   1. The Role of Underwriters in the IPO Process

      When a company chooses to offer shares to the public, it usually engages one or more investment banks to underwrite the transaction. (19) Investment banks bring expertise to the IPO process, which assists firms in navigating decisions about corporate structure, securities structure, offering amount, and price. (20) Typically, a company engages a syndicate of underwriters, with a managing underwriter taking the lead in due diligence, marketing, and price discovery. (21)

      Underwriters play an important role at every step of the traditional IPO process. After agreeing to participate in the offering, an underwriter conducts due diligence for the registration statement. (22) After the registration statement is filed with the SEC, the underwriter will begin marketing the company. The centerpiece of this is the "roadshow," which is a series of marketing presentations given by the issuer in connection with an offering of securities, usually with the assistance of an underwriter. (23) Often, however, the underwriter will be in touch with potential investors before the roadshow begins. (24) Throughout this time, the underwriter is also engaged in the book building process. (25) Once the book is built, the underwriter establishes the price based on the information it has acquired and confirms offers from investors at that price. (26) Shares are ultimately allocated to the investors by the managing underwriter. (27)

      The two most common arrangements by which underwriters facilitate the sale of securities to the public are firm-commitment underwriting and best-efforts underwriting. (28) In a firm-commitment underwriting arrangement, the underwriter guarantees the sale of the issuer's securities by purchasing the securities from the issuer at a discount and then reselling them to the investing public at a higher price. (29) In addition, the underwriter also frequently agrees to provide price stabilization, (30) meaning that if the share price drops below the issue price, the underwriter will purchase securities on the open market to stabilize that decline. (31) This arrangement benefits the issuer because the underwriter takes on the risk that the securities might not sell.

      In a best-efforts underwriting, on the other hand, the issuer bears most of the financial risk. In this...