On December 2, 2022, the SEC, acting through its Division of Trading and Markets, approved changes that Nasdaq had proposed to its regime for primary direct listings (which Nasdaq refers to as direct listings with a capital raise). These are direct listings in which the company raises capital by selling shares in the opening auction when the shares start trading on the exchange. We believe that these changes have the potential to make primary direct listings more attractive by enabling the transaction to proceed, subject to certain conditions, even when the price determined by the opening auction ends up outside the price range that appears in the company’s registration statement for the direct listing. Below is a summary of certain key aspects of the changes. The SEC approved the changes on an accelerated basis, and they remain open to public comment.
In perhaps the most significant change from the previous regime, the sale of the company’s shares in the opening auction can now be completed at a price that is outside the price range in the registration statement. One of the constraints that made primary direct listings unattractive was the forced cancellation of the transaction if the matching of buy and sell orders in the opening auction would have led to a clearing price outside that price range. The SEC limits the permitted width of price ranges in registration statements. In traditional IPOs, the price range must not be greater than $2 if the high end of the range is up to $10 and not greater than 20% of the high end otherwise. For auction-based pricing mechanisms, which primary direct listings arguably are, the SEC has permitted ranges of up to $4 for a high end of up to $20 and 20% of the high end otherwise. Nasdaq’s opening auction, commonly referred to as the “cross,” sets a clearing price by using an algorithm that maximizes the number of shares executed.
The previous regime made choosing the price range for the registration statement difficult. Weaker than expected demand could result in a failed transaction due to a clearing price below the low end of the range, but an overly conservative price range risked triggering cancellation if robust demand for the shares yielded a clearing price above the high end of the range. So far, all direct listings have been purely secondary—they registered only the resale of shares by existing shareholders over time and not any capital raise by the company itself in the opening auction, thus avoiding the need for a price range.
The changes the SEC approved significantly reduce the risk of cancellation of a primary direct listing due to an unexpectedly low or high clearing price. While the registration statement will still need to contain a price range that is not wider than the SEC permits, the amended rules allow the transaction to go forward so long as the final clearing price is within a band that runs from the point that is 20% below the low end of the price range in the registration statement all the way to the point that is 80% above the high end of the range. This is wider on the upside than the band often relied on for pricing outside the range in IPOs, which spans 20% below the low end to 20% above the high end of the range. Like in IPOs, however, the amount 20% below the low end of the range can be calculated based on the high end of the range. For example, if the price range is $8 to $10, the primary direct listing will be able to proceed so long as the cross yields a clearing price of at least $6 and not greater than $18.
In addition to the -20%/+80% band, the ability to price outside the range will be subject to certain other conditions, but we believe that with appropriate preparation these other conditions should generally not be difficult to satisfy. Among other things, the company must have certified to Nasdaq and publicly disclosed that it does not expect that a price within the permitted band would materially change the disclosure in the registration statement, and the registration statement must contain a sensitivity analysis explaining how the company’s plans would change if the actual proceeds from the offering are less than or exceed the amount assumed in the price range. After the actual clearing price has been determined in the cross, the company must confirm to Nasdaq that no additional disclosures are required under federal securities laws based on that price.
While the ability to use a wider band for pricing the sale significantly increases flexibility in primary direct listings, some execution uncertainty remains, including because the company must register a fixed number of shares that it wants to sell, and all of those shares must be sold in the cross (together with any better-priced sell orders). It is therefore theoretically possible that there are buy orders at the right price level but not for a sufficient quantity of shares. Marketing efforts similar to those in a traditional IPO may be needed to ensure adequate demand.
A company seeking to raise capital in a direct listing on Nasdaq will need to retain an underwriter and identify that underwriter in the registration statement. There will be no actual underwriting commitment as in a traditional IPO, however. Instead, Nasdaq intends for the underwriter to assume underwriter liability and therefore conduct due diligence. This is consistent with current practice for direct listings insofar as financial advisers on direct listings already voluntarily conduct due diligence on the company. Forcing banks to be named as underwriters, however, represents a major shift due to the liability implications. Many details of how underwriter liability would apply in direct listings remain open, including the apportionment of liability among several banks.
It remains to be seen exactly what role the underwriter(s) named in the primary direct listing registration statement will be allowed to play beyond due diligence and financial advice. When proposing the changes, Nasdaq expressed the view that an underwriter retained in connection with a direct listing with a capital raise will perform substantially similar functions to those performed by an underwriter in a traditional IPO. According to Nasdaq, this will include the functions related to establishing and adjusting the price range. In normal IPO practice, this would mean assisting with testing-the-waters meetings and roadshow meetings and collecting valuation and pricing feedback from investors.
The Spotify no-action letter from 2018, however, sets parameters for Regulation M-compliant activities by issuers and their financial advisers in connection with secondary direct listings that contemplate a more limited role for banks. In that more limited role, the banks are not retained to provide underwriting, solicitation, or distribution services and will not assist in the preparation of, or actively participate in, meetings that the company may hold with investors. In subsequent direct listings, the SEC has repeatedly challenged companies to describe their Regulation M analysis and the compliance by their financial advisers with the terms of the Spotify no-action letter.
We expect that the first company to avail itself of the new primary direct listing process may obtain an SEC no-action letter that will more clearly define the range of activities in which banks named as underwriters for the direct listing will be allowed engage. We also believe, however, that many of the Regulation M issues that the Spotify no-action letter addresses can potentially be avoided if the transaction is a pure primary direct listing and does not also register the resale of shares held by existing shareholders.
Compared to the procedures that Nasdaq applies to traditional IPOs and secondary direct listings, the new amendments (among other changes they contain) impose additional conditions before the cross can execute in a primary direct listing and the shares can open for trading. The period before the shares are released for trading is referred to as the “pre-launch period.” These additional conditions for primary direct listings are designed to further enhance the robustness and transparency of the price discovery process, but they have the potential to delay execution and the commencement of trading.
The NYSE has made a similar proposal to amend its rules for primary direct listings to permit pricing outside the range in the company’s registration statement within the -20%/+80% band. Like the Nasdaq proposal approved on Friday, NYSE’s proposal contemplates the mandatory retention of an underwriter. The SEC has set December 15, 2022 as the date by which it must either approve or disapprove NYSE’s proposal, and we expect the SEC to act on it soon.