Risk and Reputation

Taylor J. Wilson* December, 2022

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

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 11’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.

I. 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.

A. 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 arrangement, the underwriter does not purchase the securities from the issuer but rather acts as an agent, selling on the issuer’s behalf. The underwriter receives a commission for each security sold.³² Although the issuer bears more risk in a best-efforts arrangement, it still benefits from the legitimacy that the underwriter’s reputation provides.³³

As this description shows, underwriters are intimately involved in the IPO process. They play an important role in marketing and selling securities by assuming the risk of loss or renting their reputation to the issuer. Despite the importance of investment banks in IPOs, most of the functions just described are absent when investment banks act as financial advisors in direct listings.

B. The Emergence of Direct Listings and Primary Direct Listings

Direct listings are a relatively new way of taking a company public. Unlike an IPO, the company does not itself issue any securities when it goes public through a direct listing. Instead, it simply registers securities that are already held by company insiders (such as employees and early-stage investors) with the SEC, allowing those insiders to sell their securities.³⁴

In 2018, the SEC approved a change to New York Stock Exchange (NYSE) listing rules, making it significantly easier for companies to use a direct listing.³⁵ Prior to this change, exchanges such as NYSE and Nasdaq could allow direct listings at their discretion, but the rules required companies to have a recent trading history in a private placement market,³⁶ which was used to determine the market value of the shares.³⁷ Although direct listing was possible prior to 2018, it was rarely used.³⁸

After NYSE’s 2018 rule change, companies can use a “shareholder direct listing” to go public without a sustained history of trading on a private placement market.³⁹ Nasdaq also implemented substantially similar rule changes in 2019.⁴⁰ In 2020, the SEC approved another change to NYSE listing standards, which allowed companies to go public through a direct listing while also raising fresh capital, creating the “primary direct listing.”⁴¹

Apart from exchange listing requirements, shareholder and primary direct listings differ significantly from traditional IPOs in their structure. Most important for our discussion is that both types of direct listings are undertaken without the services of a traditional underwriter. Because the company is not actually issuing any securities, there are no securities for an underwriter to sell. However, investment banks are not completely absent from the process. NYSE rules governing direct listing transactions mandate valuations conducted by an “entity that has significant experience and demonstrable competence in the provision of such valuations.”⁴² This refers to investment banks.⁴³ Enter the financial advisors.

Companies going public through a direct listing retain investment banks as financial advisors rather than underwriters.⁴⁴ Financial advisors’ involvement in these transactions is more limited than that of traditional underwriters. They advise on the registration statement, assist in the preparation of “investor education materials” and other public communications, and consult with the designated market maker who ultimately sets the price.⁴⁵

Unlike a traditional IPO, direct listings do not have a book building process, and, so far, companies using direct listings have also opted to skip the traditional roadshow.⁴⁶ Instead, these companies have conducted a single “Investor Day” presentation.⁴⁷ Financial advisors do not participate in investor meetings, but the assistance they provide in preparing investor education materials likely contributes to the Investor Day presentation.⁴⁸ Additionally, financial advisors do not provide any price stabilization services to the issuer following the offering.⁴⁹

Since the SEC approved the changes to NYSE rules, shareholder direct listings and primary direct listings have made up a small portion of the total number of public offerings. Professor Jay Ritter has identified only thirteen shareholder direct listings between the 2018 rule change and May 2022: Spotify, Watford Holdings, Slack, Asana, Palantir Technologies, Thryv Holdings, Roblox, Coinbase, ZipRecruiter, Squarespace, Amplitude, Warby Parker, and Bright Green.⁵⁰ For comparison, there were about 1,800 IPOs in the U.S. from 2018 to 2021, 966 of which were SPAC IPOs.⁵¹

Traditional IPOs are a way for a company to get cash. In contrast, in a shareholder direct listing, the company does not itself sell any shares, so it does not raise any capital. The company can raise capital if it chooses to undertake a primary direct listing rather than a shareholder direct listing. But, as of the writing of this Note, no company has made use of a primary direct listing. So, what does a company gain from going public through a shareholder direct listing or a primary direct listing?

First, a direct listing provides liquidity to the issuer’s existing shareholders by offering them an opportunity to sell.⁵² It also has the potential to provide better returns to selling shareholders, as the price discovery process could decrease underpricing.⁵³ Compared to an IPO, the price discovery process in a direct listing is better because a broader range of initial participants are involved. Anyone can place an order through their broker-dealer at whatever price they think is appropriate, and the orders become part of the initial reference price-setting process.⁵⁴ And although there is no initial capital raised in a shareholder direct listing, it gives the company the option to conduct another offering of securities later on.⁵⁵ Most importantly, direct listings are cheap. Spotify paid around $45 million for its direct listing.⁵⁶ If it had done an IPO, it likely would have paid around $130 million but potentially could have paid up to $300 million.⁵⁷ Many of the savings come from the absence of an underwriter that usually demands a fee of tens of millions of dollars.⁵⁸ On the whole, the direct listing can be an attractive option for companies that do not have an immediate need for capital and that have a sufficiently prominent public presence to successfully sell securities without the intensive marketing of the traditional IPO process.

The requirements and benefits of direct listing allow for inferences about which companies are likely to use this method. Companies without private placement trading history can go public using a shareholder direct listing if they achieve a valuation of $250 million;⁵⁹ thus far, these have been companies with a strong public presence.⁶⁰ Additionally, companies using a shareholder direct listing do not have a need for an immediate cash infusion. This profile suggests that such companies do not need the intensive marketing services of an underwriter.⁶¹ Roblox Corporation’s shareholder direct listing serves as an interesting example of this. Roblox, the owner of the popular online gaming platform, had planned to conduct a traditional IPO in December of 2020, going so far as to file a registration statement with the SEC.⁶² It soon abandoned that plan, conducted a private fundraising, and—within a few months—went public through a direct listing instead.⁶³

C. Section 11 Underwriter Liability

Underwriters are liable for material misstatements and omissions in registration statements filed under the Securities Act.⁶⁴ Section 11 of the Securities Act enumerates the parties that are liable for misstatements and omissions and specifically assigns liability to every underwriter.⁶⁵ Section 11 imposes strict liability on issuers,⁶⁶ but for underwriters, section 11 operates more like a heightened negligence standard.⁶⁷ Underwriters are afforded an affirmative defense (called the “due diligence defense”), allowing them to escape liability by showing that they conducted a reasonable investigation and had reasonable grounds to believe that the statements were true.⁶⁸ A party to an offering can be liable under section 11 even if they do not explicitly assume the role of an underwriter, as long as their actions come within the statutory definition of the term.⁶⁹

D. Underwriter in Disguise?

Since the first direct listing in 2018, there has been confusion over the applicability of section 11 to financial advisors.⁷⁰ It was certainly on the mind of Spotify’s legal counsel—the role of financial advisors was a major subject of a no-action letter requested by Spotify.⁷¹ This question has also had some scholarly inquiry, with little in the way of definitive answers. Professor Brent Horton raises the most serious concerns. He is skeptical that financial advisors are liable and concludes that if financial advisors are not liable, they should have liability imposed on them to incentivize due diligence.⁷² Benjamin Nickerson takes the opposite position, concluding that financial advisors in the Spotify direct listing can almost certainly be considered underwriters.⁷³ Professors Anat Alon-Beck, Robert Rapp, and John Livingstone discuss the question briefly, concluding that some financial advisors could be liable without enumerating what types of involvement would trigger liability.⁷⁴ Of those that seem to think section 11 liability is unlikely to apply, there has yet to be a clear demonstration of why. Parts II and III of this Note aim to fill that gap by providing a detailed analysis of financial advisors under section 11’s definition of underwriter.

Two SEC Commissioners dissented from the approval of the 2020 amendment to NYSE rules allowing for primary direct listings.⁷⁵ In their joint statement, they raised the issue of financial advisor liability, saying: “We understand that certain financial advisors involved in a primary direct listing may meet the statutory definition of an underwriter . . . . However, it is currently unclear what types of involvement would result in meeting the statutory definition.”⁷⁶ It is also notable that when Slack and Coinbase were sued under section 11 in connection with their direct listings, the financial advisors were not listed as defendants.⁷⁷ Given the importance of section 11 liability to investor protection, this uncertainty needs to be clarified.

II. Uncertainty around Financial Advisor Liability under Section 11

Part II of this Note examines the precedent interpreting section 2(a)(11) of the Securities Act. Section II.A explains the core functions common to all underwriters and argues that they should be taken into consideration when determining whether a party is a statutory underwriter. Section II.B discusses the legislative history of the Securities Act. Section II.C discusses the different judicial interpretations of section 2(a)(11) and argues in favor of the Lehman Brothers interpretation.

A. Core Underwriter Functions: Risk and Reputation

The section 2(a)(11) definition of underwriter should be read in light of the underwriting function that it is intended to capture. A classic underwriter in the English system of securities distribution functioned much like an insurer.⁷⁸ These underwriters agreed to purchase “whatever portion of the issue was not purchased by the public.”⁷⁹ The classic underwriter would necessarily undertake a careful examination of an issuer to protect themselves but would not necessarily market the offering.⁸⁰ The function of this arrangement was to reallocate financial risk from the issuer to the underwriter, but it had the additional benefit of lending credibility to the issue.⁸¹ These two functions—risk assumption and reputation lending—are also essential to modern underwriting arrangements.⁸²

Firm-commitment underwriters take on the risk of financial loss when they take title to securities and provide price stabilization services.⁸³ Best-efforts underwriters do not take on financial risk, but they do lend their reputation when they market offerings. Specifically, they leverage their long-term relationships with IPO market participants, such as investment banks, to achieve high valuations for issuers.⁸⁴ Additionally, an underwriter with an exceptional reputation may increase retail investor optimism in the issuer’s future success.⁸⁵ All three methods of underwriting implicate the underwriter’s reputation in some way; their presence lends credibility to the issuer’s offering.

The two core functions—risk shifting and credibility lending—are essential to the undertaking of underwriting.⁸⁶ While these functions are not an explicit part of the section 2(a)(11) underwriter definition, they should be considered when applying the definition to participants that are not clearly underwriters. The performance of these functions is consistent with Congress’s concern in drafting the Securities Act to include actors who had something to gain from a fraudulently successful issue.⁸⁷ It also echoes the House of Representatives’ assertion that the test is one of “participation in the underwriting undertaking.”⁸⁸ A reasonable interpretation of the definition of underwriter excludes actors that do not perform these functions.

B. Legislative History

The Securities Act of 1933 was passed in response to the stock market crash of 1929.⁸⁹ Accordingly, its primary purpose is the protection of investors. When President Franklin D. Roosevelt recommended this legislation to Congress, he asserted that Congress has a duty to ensure that every issue of new securities is “accompanied by full publicity and information,” but without creating a government guarantee of any security.⁹⁰ He wanted the legislation to “put[] the burden of telling the whole truth on the seller” and “protect the public with the least possible interference to honest business.”⁹¹ While the statute had a remedial purpose, that purpose was limited. The legislative history of the Securities Act and subsequent amendments reflect a desire to balance legitimate business interests against the Act’s primary purpose to protect investors.

In explaining the definition of an underwriter, the House of Representatives insisted that “[t]he test [was] one of participation in the underwriting undertaking,”⁹² suggesting that there should be some similarity between an actor who is labeled as a statutory underwriter and the classic, firm-commitment or best-efforts underwriter. Namely, they should assume risk or lend reputation in a similar way.

The extent of liability for parties other than the issuer was hotly debated in Congress, and the liability of underwriters was ultimately limited in a 1934 amendment to the Securities Act.⁹³ In a letter to Congress regarding the amendments, James Landis, who drafted the Act, explained that the definition was intended to be broad enough to ensure that an underwriter is liable even when they do not “openly and actively promote the sale of an issue.”⁹⁴ This reflects the idea that even when an actor does not actively promote for an issuer, they still have an interest in the success of the issuer, and the issuer still gains legitimacy in the public’s view by virtue of the investment bank’s involvement.⁹⁵ Despite the lack of promotion, these underwriters “without exception, will undertake a careful examination of the terms and merits of an issue before assuming the underwriting commitment.”⁹⁶

The legislative history of the Act reflects an intention to impose liability on parties that actually participate in the types of activities in which an underwriter typically engages. The legislators were concerned that the presence of a reputable bank would instill confidence in investors whether they market the issue or not. They were also confident that, even when the underwriter’s involvement was minimal, investors would still undertake close enough examination of the issuer to identify and prevent fraud.

C. Interpretations of “Direct or Indirect Participation”

The Securities Act defines an underwriter as:

any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking . . . .⁹⁷

This rather unwieldy definition can be broken down into three activities that give rise to liability: purchasing shares for the purpose of a distribution, offering on behalf of an issuer, or selling on behalf of an issuer.⁹⁸ An actor who engages directly or indirectly in these three activities is an underwriter, and their actions must take place in connection with a distribution.⁹⁹

The Supreme Court has not decided the proper interpretation of the definition of underwriter but has discussed it generally in dicta. In Pinter v. Dahl, the Court justified a narrow interpretation of section 12(a) of the Securities Act by comparing it to section 11. According to the Court, section 11 is the broader provision, providing liability for “collateral participants” who participate directly or indirectly in the activities that lead to a sale.¹⁰⁰ Federal circuit courts have given the definition facially different, but not irreconcilable, treatments. This Note argues that the Second Circuit’s definition in Lehman Brothers is the better interpretation.

The Seventh Circuit provides a relatively broad interpretation of the definition. In Harden v. Raffensperger, Hughes & Co., the court held that a qualified independent underwriter is a statutory underwriter because “the term ‘underwriter’ is broad enough to encompass all persons who engage in steps necessary to the distribution of securities.”¹⁰¹ This interpretation, when taken with the fact that Raffensperger, the qualified independent underwriter, never agreed to “buy, sell, distribute, or solicit orders for the Firstmark notes,”¹⁰² is broad in comparison to Lehman Brothers.

The Seventh Circuit’s holding relied on the unusual role of the qualified independent underwriter. A qualified independent underwriter was an entity whose participation was mandated by the rules of the National Association of Securities Dealers (NASD).¹⁰³ Qualified independent underwriters were required to participate in offerings where the issuer was a securities broker or dealer that was self-underwriting the issue of its own securities.¹⁰⁴ They were required to conduct due diligence, set the upper limit for the price of an offering, and take the full legal responsibility and liability of an underwriter.¹⁰⁵

The parties in Raffensperger agreed that the qualified independent underwriters did not purchase securities for the purpose of distribution, nor did they offer or sell securities on Firstmark’s behalf.¹⁰⁶ The decision to hold them liable as underwriters rested heavily on the fact that the role was created specifically by the NASD and the SEC to approximate the protective function of an underwriter¹⁰⁷ by “carr[ying] out the responsibilities of a usual underwriter in evaluating the terms of the offering.”¹⁰⁸ The decision was bolstered by the fact that qualified independent underwriters voluntarily and explicitly assume the liability usually assumed by an underwriter.¹⁰⁹

The preeminent case on the interpretation of the definition of “underwriter” is Lehman Brothers.¹¹⁰ In that case, the Second Circuit held that credit rating agencies were not liable as statutory underwriters.¹¹¹ The court drew a line between participation in the distribution of securities and services that make a distribution possible.¹¹² It held that “[t]he plain language of the statute limits liability to persons who participate in the purchase, offer, or sale of securities for distribution.”¹¹³ The court also distinguished acts that constitute participation in those activities from acts merely necessary to the completion of the distribution.¹¹⁴ To fully understand this holding, it is helpful to understand the role of credit rating agencies in the case.

The credit rating agencies in Lehman Brothers assigned ratings to the securities at issue based on risk, a crucial step in the distribution of the securities,¹¹⁵ but the rating agencies did not “‘participate[] in the relevant’ undertaking: that of purchasing securities from the issuer with a view towards distribution, or selling or offering securities for the issuer in connection with a distribution.”¹¹⁶ There was also a temporal aspect to the decision: “[t]he Rating Agencies’ efforts in creating and structuring certificates occurred during the initial stages of securitization, not during efforts to disperse certificates to investors.”¹¹⁷ The court clarified that the “process of distribution” is not the entire process of taking securities to market from inception to end, but it is instead limited to the time when the issuer begins trying to put securities into the hands of the public (by making and soliciting offers) and actually succeeds in doing so (by selling and distributing securities). Participation in the process of distribution is not sufficient if it does not constitute either direct or indirect participation in purchasing from the issuer or selling or offering on the issuer’s behalf.

The Second Circuit had occasion to consider the Seventh Circuit’s interpretation in Lehman Brothers and found that it was “not as broad as [the] plaintiffs urge[d] because the court in [Raffensperger] made clear that its inquiry was limited to the statutorily enumerated activities.”¹¹⁸ When the Seventh Circuit said that the definition of underwriter “specifically covers every person who participates in a distribution,” it was referring to participation in the same acts emphasized by the Second Circuit.¹¹⁹ The Second Circuit simply made the further distinction that there are acts essential to a distribution that do not fall within the categories of purchasing, selling, offering, or distributing, such that these acts do not create underwriter liability. The qualified independent underwriter became a participant by virtue of their voluntary assumption of underwriter liability and their explicit purpose of acting like an underwriter rather than by their participation in the statutorily enumerated acts.

The Second Circuit’s definition is also consistent with Congress’s concern about actors who are actually participating in the “underwriting undertaking.” Those who assist with a purchase, sale, offer, or distribution actively take on financial risk or lend their reputation. If anyone performing any act necessary to the ultimate distribution were liable, actors who do not participate in these core elements of the “underwriting undertaking” would also be roped in. Section 11 specifically provides for the liability of lawyers and other experts, like accountants, engineers, and appraisers.¹²⁰ It would be redundant to include these sections if “underwriter” encompassed any person performing an activity necessary to the distribution.

For an actor to be considered a statutory underwriter, their participation must relate directly or indirectly to the sale, purchase, or offer of securities in connection with a distribution. Additionally, they should lend their reputation to the issuer to some degree, and they should bear some amount of risk. Because of its consistency with legislative history and its ability to encompass the core underwriter functions, the Lehman Brothers interpretation should be followed.

III. Financial Advisor’s Liability under Section 11

Part III of this Note applies the definition articulated in Part II to the case of financial advisors. Section III.A argues that financial advisors’ minimal involvement in Investor Day presentations is probably insufficient to be considered indirect participation in an offer. Section III.B contends that participation in the completion of the registration statement is likewise insufficient. Section III.C asserts that the valuation conducted by financial advisors is insufficient because it is analogous to a credit rating. Section III.D explains that the price discovery services of the financial advisor, while necessary to the listing, are not sufficiently connected to selling, offering, or purchasing. Section III.E concludes and raises a normative argument for the application of liability.

Under the Lehman Brothers interpretation, a statutory underwriter must participate directly or indirectly in discrete sales, purchases, offers, or distribution. Normatively, their participation should either put them at financial risk or implicate their reputation. Otherwise, they may fall outside of the intended scope of the statute. But financial advisor arrangements do not include a risk-shifting function. Unlike the classic underwriter or the firm-commitment underwriter, financial advisors have not agreed to assume financial risk by purchasing securities from the issuer.¹²¹ Nor do they engage in any price stabilization following the distribution.¹²² In the absence of shouldering any financial risk, it will be necessary to show that financial advisors meaningfully lend credibility to the issue in a manner similar to that of a best-efforts or classic underwriter. Otherwise, the financial advisor does not perform either of the core underwriter functions.

A. Investor Day Presentations

The activity that has the greatest potential to give rise to section 11 liability is financial advisors’ involvement in the preparation of investor presentation materials. Financial advisors play a role in “the preparation of investor communications and presentations in connection with investor education.”¹²³ Do these educational efforts constitute direct or indirect participation in an offer? This Section will demonstrate that they might be insufficient to render a financial advisor an underwriter.¹²⁴

The primary vehicle for investor education in direct listings has been an “Investor Day” presentation, which takes the place of a traditional IPO roadshow.¹²⁵ It is telling that the Investor Day, and the direct listing as a whole, lacks the book building process that is usually concomitant with a roadshow.¹²⁶ Regardless, Investor Days are closely analogous to a traditional roadshow, and roadshows are explicitly defined by the SEC as “offers.”¹²⁷ Therefore, Investor Day is almost certainly an “offer.”¹²⁸

However, we know that financial advisors do not participate directly in investor meetings; therefore, they do not participate directly in that offer.¹²⁹ Purportedly, involvement is limited to the preparation of presentations. So the question must be whether this is sufficient to constitute indirect participation in the offer. For example, is an outsider who is retained to write and design a newspaper advertisement indirectly participating in the solicitation of an offer?

The Supreme Court addressed a version of this question in the context of Rule 10b-5 in Janus Capital Group, Inc. v. First Derivative Traders.¹³⁰ The issue in that case was whether Janus Capital Management LLC, which served as an investment adviser to a mutual fund, was liable under Rule 10b-5 for material misstatements in the mutual fund’s prospectuses.¹³¹ The Court held that Janus Capital Management did not “make” the statements in the prospectus because “the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”¹³² The Court reasoned that without control over these aspects of the statement, the person helping to prepare the statements “can merely suggest what to say.”¹³³ So too with the preparation of presentations for Investor Day: a financial advisor does not “make” the statements about the issuer’s offering because they lack ultimate control over what the officers of the issuer say at the presentation.

Additionally, the financial advisor is neither lending its reputation nor assuming any risk in helping to prepare these materials.¹³⁴ Underwriters’ traditional involvement in roadshows clearly implicates their reputation, primarily through the book building process.¹³⁵ In a direct listing’s Investor Day, not only is the financial advisor absent from the room where the offer is made and not making any statements itself it is also not building a book.¹³⁶

A caveat to the analysis above is warranted. The question of whether one has participated in an offer is necessarily fact specific. If a financial advisor so much as calls potential investors and tells them about the direct listing, that could be sufficient to render it an underwriter.¹³⁷ However, the analysis in this Part focuses on the actions that financial advisors purport to take, not those that they may take illicitly behind the scenes.

If the financial advisor is not present at the meeting where an offer is made, and the statements that constitute the offer cannot be attributed to the advisor, it is difficult to see how it is a participant in that offer. As is the case with a speechwriter, the public neither attributes the statements to the financial advisor nor believes that it is endorsing those statements. As such, the preparation of materials for an Investor Day presentation is not sufficient to constitute direct or indirect participation.

B. Registration Statements

Relatedly, financial advisors assist the issuer in completing the registration statement that is filed with the SEC.¹³⁸ The registration process itself is distinct from any sale, purchase, or offer of securities.¹³⁹ One might argue that participation in registration should be considered participation in an offer, but this will run into the same problems that were encountered in reference to investor education.¹⁴⁰ The financial advisor does not have ultimate control over what goes in the registration statement,¹⁴¹ and so they are not the maker of the statement.¹⁴² Under section 11, some people who participate in the preparation of a registration statement can be held liable on the basis of that participation—namely, those who consent to be named as experts.¹⁴³ However, the fact that section 11 requires experts to consent to be named for their participation in the registration process to create liability implies that participation is not enough. It must be the kind of participation that lends legitimacy to the registration.¹⁴⁴ This was on display in Refco, where the Second Circuit decided that a defendant that participated only in the registration process was not liable as an underwriter.¹⁴⁵ Participation in the registration process is probably insufficient on its own to create section 11 liability for financial advisors.

C. Valuation

The financial advisor also assists with the valuation of the company, a prerequisite for listing on an exchange.¹⁴⁶ To qualify for a direct listing, the company must submit a valuation in excess of $250 million to the exchange.¹⁴⁷ This step is obviously necessary, but as the Second Circuit held, the necessity of an activity is not sufficient to create section 11 liability.¹⁴⁸ The activity must constitute participation, directly or indirectly, in purchasing, selling, offering, or distributing.¹⁴⁹

At the valuation stage, the financial advisor does not make any offers or sales, nor does the issuer.¹⁵⁰ The issuer simply seeks to prove to the exchange that it meets the requirements for listing. It is an exchange requirement rather than a market expectation. The fact that an issuer has met an exchange’s listing requirements cannot be taken as an endorsement of its securities’ quality; no one assumes that securities are a good investment simply because their issuer has qualified to trade them on an exchange. While this step is essential to the listing, it lacks the necessary connection to purchasing, selling, offering, or distributing. The role of a financial advisor, therefore, is sufficiently analogous to the role of credit rating agencies to conclude that it does not give rise to section 11 liability.¹⁵¹

D. Price Setting in Consultation with the Designated Market Maker

Financial advisors are also required by the exchange to assist the designated market maker (DMM) in setting the price of the listing.¹⁵² Financial advisors in direct listings have significantly less control over the price of the listing than do either firm-commitment or best-efforts underwriters.¹⁵³ The opening price is determined by buy and sell orders collected by NYSE from broker-dealers and the DMM’s determination of where buy orders can be matched with sell orders at a single price.¹⁵⁴ The financial advisor is responsible for consulting with the DMM on the price without input from the issuer.¹⁵⁵ However, the DMM is free to disregard their advice, and the price is based significantly on orders received by the DMM.¹⁵⁶

Like the valuation, this step is necessary for the distribution, but it lacks the requisite connection to purchasing, selling, offering, or distributing. While it is temporally closer to the actual sale than valuation, price setting is simply not a sale.¹⁵⁷ When the financial advisor provides advice to the DMM, no securities have yet changed hands.¹⁵⁸ Additionally, it seems that if this were to create liability, such liability would have to extend to the DMM as well.

Unlike price discovery in a firm-commitment or best-efforts arrangement, the financial advisor’s reputation is not implicated in the price-setting process. Their lack of control makes it very unlikely that their participation in the price-setting process will foster confidence or doubt in the final price determination. Unlike a best-efforts underwriter, the financial advisor does not market the sale of securities at the price, further reducing both the incentive to achieve a correct price and the public’s ability to rely on the financial advisor’s participation for comfort.

E. Should Financial Advisors Be Liable?

The evaluation of these discrete acts displays the absence of core underwriter functions, making it difficult to conclude that they should be statutory underwriters. The services that financial advisors provide are unlikely to qualify them as underwriters because such services typically fall outside of the categories of selling, offering, purchasing, or distributing.¹⁵⁹ Investment banks acting as financial advisors do not conduct a roadshow, build a book of interested investors, or market the issue to the public. Therefore, it is unlikely that investment banks acting as financial advisors in direct listings are liable under section 11 as statutory underwriters.

Their reputations are not put on the line, and they bear no financial risk. Unlike the classic underwriter, it does not appear that any of the services provided by financial advisors display a level of confidence in the issue that would lend credibility. The absence of the core underwriter functions makes it difficult to argue that financial advisors are engaged in the “underwriter undertaking”¹⁶⁰ and implies that they should fall outside of the scope of actors that Congress intended to regulate through the underwriter definition. When taken with the foregoing analysis, this suggests that financial advisors should not be held liable as underwriters.

IV. Pulled in Two Directions

Part IV of this Note examines the implications of the conclusion that financial advisors cannot be held liable as underwriters. Section IV.A discusses the concerns it raises for investor protection and introduces the concept of gatekeeper liability. Section IV.B applies a framework developed by Professor Assaf Hamdani to explain why imposing negligence-based liability on financial advisors could undermine the primary benefit of direct listing and instead suggests a direct regulation approach.

Financial advisors are unlikely to be liable as underwriters under section 11. Their activities lack the requisite connection to purchasing, selling, offering, or distributing securities. Core underwriter functions—risk shifting and reputation lending—are likewise absent. Even though financial advisors do not serve the role of an underwriter, should they be tagged with liability anyway?

A missing underwriter is a missing gatekeeper. Underwriters are in a position to identify fraud, and they are strongly incentivized to stop it because of their exposure to liability. There is a concern that without liability under section 11, the most rigorous antifraud statute, a financial advisor will be unable to perform the gatekeeping role of an underwriter. However, the financial advisor is still subject to scienter-based liability under Rule 10b-5.¹⁶¹ This observation allows us to reframe the discussion of financial advisor liability as a discussion about what level of liability is acceptable. Should we accept scienter-based liability for financial advisors, or should we insist on increasing it to a negligence standard? This Part assumes that there is a need to incentivize financial advisors to be effective gatekeepers but argues that negligence-based liability may be too costly a way to achieve it.

A. Investor Protection Concerns

Securities law is largely concerned with ensuring that the investing public has access to complete and reliable information about companies before investing in them.¹⁶² Accordingly, the civil liability provisions of the Securities Act punish actors who intentionally or unintentionally shirk their duty to disclose complete and reliable information.¹⁶³ Section 11 liability provides investors with a remedy for misinformation and omissions in an issuer’s registration statement.¹⁶⁴ That liability extends to other parties that participated in the offering—officers of the issuer, underwriters, and experts.¹⁶⁵ In doing so, the law recognizes that material misstatements and omissions can cause damage to investors through their impact on the market price of the security.¹⁶⁶

The inapplicability of section 11 to financial advisors means one less defendant in section 11 cases and one less party from which an investor could potentially recover. Although investors may not succeed in their section 11 claims against financial advisors, they will still have the opportunity to bring these claims against the issuer, officers of the issuer that signed the registration statement, the issuer’s directors, and experts that consented to be named on the registration statement.¹⁶⁷ The liability of these parties is joint and several: the plaintiff can recover from any one of the defendants, and the defendants may recover contributions from each other after the fact.¹⁶⁸ It is therefore possible that an investor could fully recover without including the financial advisor in the litigation. The risk of an investor not fully recovering is greatest if an issuer is insolvent. Without the ability to include the investment bank, the investor may be able to recover only a portion of what is owed to them.

A greater concern than finding someone to sue is the absence of a gatekeeper. A gatekeeper is a secondary actor who has been enlisted by Congress and the SEC to provide some degree of oversight.¹⁶⁹ Gatekeepers are incentivized—either through liability or regulatory mandates—to use their expertise and access to information to prevent fraud.¹⁷⁰ Underwriters are incentivized to act as gatekeepers by the threat of section 11 liability. The absence of this liability raises the concern that financial advisors do not have an adequate incentive to act as effective gatekeepers.¹⁷¹

One proposed solution is to alter stock exchange requirements to require financial advisors to consent to the legal duties and liabilities of an underwriter.¹⁷² This solution draws on the qualified independent underwriter. Recall from Harden v. Raffensperger, the qualified independent underwriter was a particular entity created by the NASD and the SEC to approximate the function of an underwriter.¹⁷³ This strategy would have stock exchanges require financial advisors to voluntarily assume section 11 liability.

Section 11 is not the only way to hold a gatekeeper liable. Rule 10b-5 allows plaintiffs to sue anyone committing fraud through an exchange.¹⁷⁴ While section 11 affords a negligence-based “due diligence” defense to underwriters,¹⁷⁵ Rule 10b-5 requires a showing of scienter on the part of the defendant.¹⁷⁶ Scienter is defined as an intent to deceive, but it has also been interpreted to include severe recklessness.¹⁷⁷ Imposing section 11 liability on financial advisors is fairly characterized as a move from scienter-based liability to negligence-based liability. Increasing liability would increase the incentive of financial advisors to be effective gatekeepers but also imposes a cost on the market. Given that cost, is the incentive imposed by Rule 10b-5’s scienter-based liability sufficient?

B. Weighing the Cost of Increased Liability

Increasing liability from scienter to negligence carries a cost.¹⁷⁸ Under negligence-based liability, gatekeepers will compensate for the risk by increasing fees.¹⁷⁹ When a gatekeeper is unable to reliably distinguish between clients with bad intentions and those with lawful intentions, its fees will not reflect the actual probability of wrongdoing for each particular client.¹⁸⁰ The gatekeeper will instead opt to charge a uniform risk premium to all of its clients “based on the average likelihood of wrongdoing that characterizes the relevant population of prospective clients.”¹⁸¹ Increased fees can discourage law-abiding clients from entering the market unless the latent benefits of entering the market are sufficiently enticing.¹⁸²

These assertions about the effect of increased liability are especially salient for direct listings because their primary benefits derive from their low cost. The absence of an underwriter is the primary source of the cost-saving benefit. Professor Hamdani’s framework suggests that increasing liability could increase the cost imposed by financial advisors, diluting the cost-saving benefit. If the cost increases to the degree that it outweighs the latent benefits—namely, the option to conduct a secondary offering later on—then the dilution would be even greater.

If we found direct listings to be abhorrently dangerous, then it would be fine to discourage their use. But that is not the case. Instead, direct listings come with many benefits. Companies benefit because direct listings are quick, efficient, and cost-effective.¹⁸³ And it creates liquidity for selling shareholders, which potentially increases selling-shareholder returns.¹⁸⁴

Investors also stand to gain from direct listings. The bar for entry to the direct listing market is high; a company must show a valuation of $250 million to qualify for an NYSE direct listing.¹⁸⁵ This mechanism could filter out low-performing companies.¹⁸⁶ There is a potential risk-shifting mechanism as well: the company is funded in its earlier and riskier stages by venture capital firms and is only taken public as a mature company.¹⁸⁷

Exactly how much cost increased liability would impose on the direct listing market is an empirical question beyond the scope of this Note. Still, if increasing liability on financial advisors could dilute the benefits of direct listings, should we be content with the scienter-based Rule 10b-5? Professor Hamdani suggests that we should not.¹⁸⁸ Scienter-based liability will only make financial advisors liable when they know about wrongdoing, meaning they have “no incentives to scrutinize client conduct even when detecting misconduct is relatively easy.”¹⁸⁹ However, the fact that the primary benefit of this process is its cost savings should give policymakers a reason to consider other methods for enlisting financial advisors as gatekeepers.

When gatekeeper liability is overly costly, as it may be in the case of financial advisors, government regulation can step in to provide incentives. Professor Hamdani’s research suggests that when negligence-based regimes are overly costly, they can be supplemented with direct regulation—rules requiring or forbidding certain discrete actions—to incentivize gatekeepers while keeping costs low.¹⁹⁰ The SEC has the capacity to set specific standards for market participants, as they have with attorneys and auditors.¹⁹¹ If the primary concern is that financial advisors will not scrutinize client conduct, the SEC could promulgate rules requiring financial advisors or another entity to do so.¹⁹² There should be some attempt made to both protect investors and maintain the benefits of direct listings, and Hamdani’s framework suggests that direct regulation could be the way.

Conclusion

It is tempting to think of the financial advisor’s role as an adaptation of the traditional underwriter’s role, especially because the same actor performs both functions. But that is not enough to attach section 11 liability. Rather than imposing section 11 liability on financial advisors at the expense of the benefits of the innovation, the SEC should create rules that require financial advisors, or some other entity, to closely scrutinize issuer information. In the meantime, the SEC should dispel uncertainty by providing guidance based on the analysis in Part III of this Note. It should instruct investors, issuers, and financial advisors that direct communication with investors as part of Investor Day, attendance of Investor Day events, or promotion of Investor Day events will likely be considered participation in an offer for the purposes of section 2(a)(11) of the Securities Act.

Securities regulation is a balancing act between the protection of investors and the legitimate interests of businesses. Direct listing is no different. It offers new benefits to investors and issuers, and it offers new dangers. In adapting to this development, the SEC should seek to maximize investor protections to the extent that it retains the benefits of the method.

* J.D. Candidate, May 2023, University of Michigan Law School. Thank you to Professor Adam Pritchard for his guidance and feedback throughout the writing process and to Professor Nico Howson for his support and encouragement. I am incredibly grateful for the work of the Michigan Law Review Volume 121 editors, in particular the support of the Notes Office and Annie Schuver. Thanks also to Hye-Jin Kim of Volume 120 for valuable feedback throughout the writing process. Thanks to my son Lewis, for giving me many breaks to play with trains and pretend to be lions. Finally, thank you to my lovely wife, Caryn, for supporting me constantly and making this possible.