Risk and Reputation
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.
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).1Elliot Bentley, The SPAC Boom, Visualized, Wall St. J. (Feb. 10, 2021, 4:12 PM), https://www.wsj.com/articles/the-spac-boom-visualized-in-one-chart-11612962000 [perma.cc/RPP5-BQXK]. But with innovation comes unforeseen challenges, and the regulatory apparatus constantly works to balance the interests of investors with those of honest businesses.2See, e.g., Katanga Johnson, Analysis: Will the Games Stop? SEC Mulls Crackdown on Trading Apps, Reuters (Jan. 26, 2022, 6:35 AM), https://www.reuters.com/business/finance/will-games-stop-sec-mulls-crackdown-trading-apps-2022-01-26 [perma.cc/PD48-35TV].
The stock market has seen an increase in the popularity of alternatives to the traditional initial public offering (IPO).3The Readback, Don’t Call It an IPO, Barron’s (May 20, 2021, 6:03 PM), https://www.barrons.com/podcasts/the-readback/dont-call-it-an-ipo/D65EBE64-DFA4-4C3E-BB51-1F94A6596315 [perma.cc/B2GK-Q3QF]. The “SPAC boom” that overtook the market in 2020 reflects the growing popularity of one alternative.4See Bentley, supra note 1. The lesser-known direct listing is another innovative way to take a company public.5See John C. Coffee, Jr., The Spotify Listing: Can an “Underwriter-less” IPO Attract Other Unicorns?, The CLS Blue Sky Blog (Jan. 16, 2018), https://clsbluesky.law.columbia.edu/2018/01/16/the-spotify-listing-can-an-underwriter-less-ipo-attract-other-unicorns [perma.cc/T88L-982M]. 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.6See Alan Jones, Demystifying Direct Listings, PWC (June 9, 2017), https://www.pwc.com/us/en/services/deals/blog/understanding-direct-listings.html [perma.cc/R3MJ-CMYY]. Although there were hundreds of SPAC IPOs in 2020 alone,7Bentley, supra note 1. there have been only a dozen direct listings since the method was revived in 2018.8See infra note 50 and accompanying text. 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.9See Taylor Tepper, Warby Parker IPO: What You Need to Know, Forbes Advisor (May 19, 2022, 1:27 PM), https://www.forbes.com/advisor/investing/warby-parker-ipo [perma.cc/38KS-7YLE].
One of the key differences between a direct listing and an IPO is the absence of an underwriter.10See Coffee, Jr., supra note 5. 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.11See id. 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.12See id.
Underwriters traditionally serve a gatekeeping role because they are a third party that can be held liable for the wrongdoing of the issuer.13 . Stephen J. Choi & A.C. Pritchard, Securities Regulation 938 (5th ed. 2019). 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.14Securities Act of 1933 § 11, 15 U.S.C. § 77k. 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.15See Coffee, Jr., supra note 5.
Financial advisors could be liable under section 11 if they qualify as “statutory underwriters,” but the scope of that term is unclear.16See infra note 88 and accompanying text. 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.17Brent J. Horton, Spotify’s Direct Listing: Is It a Recipe for Gatekeeper Failure?, 72 SMU L. Rev. 177, 210–12 (2019). 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.18See generally Cody L. Lipke, Note, Direct Listing: How Spotify Is Streaming on the NYSE and Why the SEC Should Press Play, 12 J. Bus., Entrepreneurship & L. 149 (2019). 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.
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 . Choi & Pritchard, supra note 13, at 490. Investment banks bring expertise to the IPO process, which assists firms in navigating decisions about corporate structure, securities structure, offering amount, and price.20Id. Typically, a company engages a syndicate of underwriters, with a managing underwriter taking the lead in due diligence, marketing, and price discovery.21Id. at 493–94. For an in-depth discussion on underwriter syndicates, see Sébastien Dereeper & Armin Schwienbacher, The Structure and Role of the Underwriting Syndicate, in The Oxford Handbook of IPOs (Douglas Cumming ed., 2019).
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 . Choi & Pritchard, supra note 13, at 494. 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.2317 C.F.R. § 230.433(h)(4) (2021) (defining roadshow as “an offer . . . that contains a presentation regarding an offering by one or more members of the issuer’s management”); Ross Geddes, IPOs and Equity Offerings 154 (2003). Often, however, the underwriter will be in touch with potential investors before the roadshow begins.24 . Geddes, supra note 23, at 56–57. Throughout this time, the underwriter is also engaged in the book building process.25In the book building process, “a price range is established and salesmen solicit expressions of interest from investors. There is complete flexibility over the price of the shares and number to be issued right up until the last moment. Bookbuilding takes place in almost all domestic American and Canadian new issues and the majority of large international offerings.” Id. at 57. 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.26Id. at 58. Shares are ultimately allocated to the investors by the managing underwriter.27 . Choi & Pritchard, supra note 13, at 494.
The two most common arrangements by which underwriters facilitate the sale of securities to the public are firm-commitment underwriting and best-efforts underwriting.28Id. at 491. 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.29Id. Most IPOs are conducted as firm-commitment offerings. Id. at 493. In addition, the underwriter also frequently agrees to provide price stabilization,30 . Geddes, supra note 23, at 58. meaning that if the share price drops below the issue price, the underwriter will purchase securities on the open market to stabilize that decline.31Id. 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 . Louis Loss, Joel Seligman & Troy Paredes, 1 Fundamentals of Securities Regulation 126 (7th ed. 2018). Although the issuer bears more risk in a best-efforts arrangement, it still benefits from the legitimacy that the underwriter’s reputation provides.33See Geddes, supra note 23, at 35 (explaining that the most reputable investment banks tend to underwrite only less risky IPOs).
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.34A Current Guide to Direct Listings, Gibson Dunn (Jan. 8, 2021), https://www.gibsondunn.com/a-current-guide-to-direct-listings [perma.cc/XEK6-CSE8] (explaining that, unlike in IPOs, there is no lock-up period in direct listings).
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 . See Order Granting Approval of Proposed Rule Change to Amend Section 102.01B of the NYSE Listed Company Manual, 83 Fed. Reg. 5650 (Feb. 2, 2018). 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,36A private placement is an unregistered offering of securities, which is typically limited to accredited investors. Investor Bulletin: Private Placements Under Regulation D, U.S. Sec. & Exch. Comm’n (Sept. 24, 2014), https://www.sec.gov/oiea/investor-alerts-bulletins/ib_privateplacements.html [perma.cc/359V-3P3S]. A company might not partake in private placements to avoid public company disclosure requirements. Even if a company has never done a public offering, public company status can be triggered when a company’s investor base reaches a certain threshold. See Exchange Act of 1934, 15 U.S.C. § 78l(g)(1)(A). which was used to determine the market value of the shares.37Proposed Amendment to NYSE Listed Company Manual Section 102.01B, 82 Fed. Reg. 28200, 28201 (June 15, 2017). Although direct listing was possible prior to 2018, it was rarely used.38Robert Pozen, Shiva Rajgopal & Robert Stoumbos, Opinion: Here’s How a Hot Company Can Go Public Without an IPO, MarketWatch (Dec. 7, 2017, 3:27 PM), https://www.marketwatch.com/story/heres-how-a-hot-company-can-go-public-without-an-ipo-2017-12-07 [perma.cc/J8YV-D5RX]; see also Jones, supra note 6.
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 . N.Y. Stock Exch., N.Y.S.E. Listed Company Manual, § 102.01B(E) (2021) [hereinafter NYSE Listed Company Manual], https://nyse.wolterskluwer.cloud/listed-company-manual [perma.cc/3X6Z-U6AQ]. Instead, a company can conduct a direct listing if it provides a valuation evidencing a market value of publicly held shares of at least 0 million. NYSE based this change on its belief that if a company could meet the 0 million valuation, it would not likely fail to meet the 0 million requirement upon listing. Proposed Amendment to NYSE Listed Company Manual Section 102.01B, 82 Fed. Reg. at 28201. Nasdaq also implemented substantially similar rule changes in 2019.40Notice of Filing and Immediate Effectiveness of Proposed Nasdaq Rule Change for Direct Listings, 84 Fed. Reg. 5787, 5787–91 (Feb. 15, 2019); Catherine M. Clarkin, Robert W. Downes & James M. Shea Jr., Updated Nasdaq Requirements for Direct Listings, Harv. L. Sch. F. on Corp. Governance (Mar. 18, 2019), https://corpgov.law.harvard.edu/2019/03/18/updated-nasdaq-requirements-for-direct-listings [perma.cc/KRK9-DTEC]. 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.”41Order Approving NYSE Proposed Rule Change to Modify Provisions Relating to Direct Listings, 85 Fed. Reg. 54454, 54454–61 (Aug. 26, 2020). Under this new rule allowing primary direct listings, a company can directly list both the shares of its existing shareholders and its own securities if it will sell at least 0 million in market value of shares in the exchange’s opening auction on the first day of trading. NYSE Listed Company Manual, supra note 39. If the company will sell less than 0 million in shares on the opening day, it can still conduct a primary direct listing if the shares that it lists and the shares that are publicly held immediately prior to listing have a valuation of 0 million. Id.
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.”42Id. This refers to investment banks.43Horton, supra note 17, at 195. Enter the financial advisors.
Companies going public through a direct listing retain investment banks as financial advisors rather than underwriters.44Id. at 180; Marc D. Jaffe, Greg Rodgers & Horacio Gutierrez, Spotify Case Study: Structuring and Executing a Direct Listing, Harv. L. Sch. F. on Corp. Governance (July 5, 2018), https://corpgov.law.harvard.edu/2018/07/05/spotify-case-study-structuring-and-executing-a-direct-listing [perma.cc/U7FE-DNQ7]. The same investment banks that regularly serve as underwriters in traditional IPOs have served as financial advisors in direct listings. In Spotify’s direct listing, for example, the financial advisors were Goldman Sachs & Co., Morgan Stanley & Co., and Allen & Company. Jaffe et al., supra. 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 . Id.; e.g., Spotify Tech. S.A., Registration Statement (Form F-1/A) at 45 (Mar. 23, 2018); Slack Techs., Inc., Registration Statement (Form S-1/A) at 46 (May 31, 2019); Coinbase Glob., Inc., Registration Statement (Form S-1/A) at 65 (Mar. 23, 2021). See infra Section III.D for a more detailed explanation of direct listing price discovery.
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.46Jaffe et al., supra note 44. Instead, these companies have conducted a single “Investor Day” presentation.47Id. 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.48See id. Additionally, financial advisors do not provide any price stabilization services to the issuer following the offering.49E.g., Spotify Tech. S.A., Registration Statement (Form F-1/A) at 45 (Mar. 23, 2018); Slack Techs., Inc., Registration Statement (Form S-1/A) at 46 (May 31, 2019); Coinbase Glob., Inc., Registration Statement (Form S-1/A) at 65 (Mar. 23, 2021).
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 . Jay R. Ritter, Initial Public Offerings: Direct Listings Through May 19, 2022, (2022), https://site.warrington.ufl.edu/ritter/files/Direct-Listings.pdf [perma.cc/H34Z-NU7M]; Spotify Tech. S.A., Registration Statement (Form F-1) (Mar. 23, 2018); Watford Holdings Ltd., Registration Statement (Form S-1/A) (Mar. 25, 2019); Slack Techs., Inc., Registration Statement (Form S-1/A) (May 31, 2019); Thryv Holdings, Inc., Registration Statement (Form S-1/A) (Sept. 17, 2020); Asana, Inc., Registration Statement (Form S-1/A) (Sept. 18, 2020); Palantir Techs. Inc., Registration Statement (Form S-1/A) (Sept. 21, 2020); Roblox Corp., Registration Statement (Form S-1/A) (Feb. 22, 2021); Coinbase Glob., Inc., Registration Statement (Form S-1) (Mar. 23, 2021); ZipRecruiter, Inc., Registration Statement (Form S-1) (Apr. 23, 2021); Squarespace, Inc., Registration Statement (Form S-1/A) (May 3, 2021); Amplitude, Inc., Registration Statement (Form S-1) (Aug. 30, 2021); Warby Parker Inc., Registration Statement (Form S-1/A) (Sept. 14, 2021); Bright Green Corp., Registration Statement (Form S-1/A) (May 11, 2022). For comparison, there were about 1,800 IPOs in the U.S. from 2018 to 2021, 966 of which were SPAC IPOs.51See SPAC and US IPO Activity, SPAC Analytics, https://www.spacanalytics.com [perma.cc/4F7G-RU55].
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.52A Current Guide to Direct Listings, supra note 34. It also has the potential to provide better returns to selling shareholders, as the price discovery process could decrease underpricing.53See id.; see also Jaffe et al., supra note 44. 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.54A Current Guide to Direct Listings, supra note 34; Jaffe et al., supra note 44. 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.55A company that has already registered an offering with the SEC has the option to register another offering at a later date using Form S-3. See Adam Hayes, SEC Form S-3, Investopedia (Jan. 2, 2021), https://www.investopedia.com/terms/s/sec-form-s-3.asp [perma.cc/K3X4-94ZC]. At least one company, Palantir, has taken advantage of the opportunity to conduct a subsequent offering using Form S-3. See Palantir Techs., Inc., Registration Statement (Form S-3) (Oct. 1, 2021). Most importantly, direct listings are cheap. Spotify paid around $45 million for its direct listing.56See Horton, supra note 17, at 199–200, 200 chart 4. If it had done an IPO, it likely would have paid around $130 million but potentially could have paid up to $300 million.57Id. at 200. Many of the savings come from the absence of an underwriter that usually demands a fee of tens of millions of dollars.58Id. at 199–200. 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 . NYSE Listed Company Manual, supra note 39, at 102.01B; Nasdaq, The Nasdaq Stockmarket Rulebook, r. IM-5315-1(b), https://listingcenter.nasdaq.com/rulebook/nasdaq/rules/Nasdaq%205300%20Series [perma.cc/S35Y-Q7YC]. thus far, these have been companies with a strong public presence.60See, e.g., Spotify Tech. S.A., Registration Statement (Form F-1/A), at 45 (Mar. 23, 2018); Slack Techs., Inc., Registration Statement (Form S-1/A), at 46 (May 31, 2019); Coinbase Glob., Inc., Registration Statement (Form S-1/A), at 65 (Mar. 23, 2021). 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.61See The Readback, supra note 3. 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.62Roblox Corp., Registration Statement (Form S-1) (Nov. 19, 2020); James Chen, Roblox Chooses Direct Listing over IPO Madness, Investopedia (Feb. 1, 2021), https://www.investopedia.com/roblox-chooses-direct-listing-over-ipo-madness-5101253 [perma.cc/L79M-NG6P]. It soon abandoned that plan, conducted a private fundraising, and—within a few months—went public through a direct listing instead.63Roblox Corp., Registration Statement (Form S-1/A) (Feb. 22, 2021); Chen, supra note 62.
C. Section 11 Underwriter Liability
Underwriters are liable for material misstatements and omissions in registration statements filed under the Securities Act.64Securities Act of 1933 § 11(a)(5), 15 U.S.C. § 77k(a)(5). Section 11 of the Securities Act enumerates the parties that are liable for misstatements and omissions and specifically assigns liability to every underwriter.65See id. § 77k(a). Section 11 imposes strict liability on issuers,66See id. § 77k(b). There is an additional, judicially imposed element of these claims called “traceability.” Essentially, the plaintiff must prove that the specific security that they own was part of the offering associated with the registration statement containing the misstatement or omission. Recently, the Ninth Circuit relaxed this requirement for complaints arising from direct listings. See Pirani v. Slack Techs., Inc., 13 F.4th 940 (9th Cir. 2021); Neal Kapoor, Direct Listings and the Tracing Doctrine: Pirani v. Slack, Colum. Bus. L. Rev. Blog (Mar. 14, 2022), https://journals.library.columbia.edu/index.php/CBLR/announcement/view/511 [perma.cc/TV9A-JNYQ]. but for underwriters, section 11 operates more like a heightened negligence standard.67 . In Escott v. BarChris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968), it was not sufficient, for the purpose of claiming the due diligence defense, for the underwriter to elicit data from the company; they must also verify that data to a reasonable degree. Id. at 697. In In re WorldCom, Inc. Securities Litigation, 346 F. Supp. 2d 628 (S.D.N.Y. 2004), the court articulated that the investigation should be a “ ‘thorough’ or ‘searching inquiry,’ ” id. at 678, and should “ ‘look deeper and question more’ where confronted with red flags” in expertized portions of the registration statement. Id. at 677 (quoting In re Enron Corp. Sec., Derivative & ERISA Litig., 235 F. Supp. 2d 549, 707 (S.D. Tex. 2002)). At the very least, it should be noted that what the court considers to be “reasonable” is a very high degree of attention and effort on the part of the underwriter. 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.68See In re WorldCom, 346 F. Supp. 2d at 662. 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.69See 17 C.F.R. § 230.144 (2021).
D. Underwriter in Disguise?
Since the first direct listing in 2018, there has been confusion over the applicability of section 11 to financial advisors.70See Coffee, Jr., supra note 5 (raising the question of underwriter liability for financial advisors in connection to the Spotify direct listing). 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.71See Spotify Tech. S.A., SEC Staff No-Action Letter, 2018 WL 1531993, at *1–3 (Mar. 23, 2018) (accepting Spotify’s representation that financial advisors were not engaged to provide any “underwriting, solicitation, or distribution services”). 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.72See Horton, supra note 17, at 209–12 (concluding that financial advisors lack the incentives to serve as effective gatekeepers and that statutory liability may be necessary to incentivize them). Benjamin Nickerson takes the opposite position, concluding that financial advisors in the Spotify direct listing can almost certainly be considered underwriters.73See Benjamin J. Nickerson, Comment, The Underlying Underwriter: An Analysis of the Spotify Direct Listing, 86 U. Chi. L. Rev. 985, 1019 (2019). 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.74See Anat Alon-Beck, Robert Rapp & John Livingstone, Investment Bankers as Underwriters—Barbarians or Gatekeepers? A Response to Brent Horton on Direct Listings, 73 SMU L. Rev. F. 251, 257–58, 263 (2020) (“[D]epending on facts and circumstances, the financial adviser in a direct listed public offering could clearly be identified as a ‘statutory underwriter.’ ”). 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.75Allison Herren Lee & Caroline A. Crenshaw, Statement on Primary Direct Listings, U.S. Sec. & Exch. Comm’n (Dec. 23, 2020), https://www.sec.gov/news/public-statement/lee-crenshaw-listings-2020-12-23 [perma.cc/7UWN-QVSS]. 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.”76Id. 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.77See Pirani v. Slack Techs., Inc., 445 F. Supp. 3d 367, 372 (N.D. Cal. 2020), aff’d, 13 F.4th 940 (9th Cir. 2021); Class Action Complaint at ¶¶ 15–33, Ramsey v. Coinbase Glob., Inc., No. 21-cv-05634 (N.D. Cal. July 22, 2021); see also Slack’s Direct Listing—Court Allows Securities Act Claims Without Requiring Tracing, Cleary Gottlieb (Apr. 30, 2020), https://www.clearygottlieb.com/news-and-insights/publication-listing/slacks-direct-listing-court-allows-securities-act-claims-without-requiring-tracing [perma.cc/BL66-BXXA]. Given the importance of section 11 liability to investor protection, this uncertainty needs to be clarified.
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 . Loss et al., supra note 32, at 113–14. These underwriters agreed to purchase “whatever portion of the issue was not purchased by the public.”79Id. at 114. The classic underwriter would necessarily undertake a careful examination of an issuer to protect themselves but would not necessarily market the offering.80See infra note 96 and accompanying text. 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.81See infra note 96 and accompanying text. These two functions—risk assumption and reputation lending—are also essential to modern underwriting arrangements.82Ronald J. Gilson & Reinier H. Kraakman, The Mechanisms of Market Efficiency, 70 Va. L. Rev. 549, 616–20 (1984).
Firm-commitment underwriters take on the risk of financial loss when they take title to securities and provide price stabilization services.83See Loss et al., supra note 32, at 116; see also supra text accompanying notes 29–31. 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.84See Thomas J. Chemmanur & Karthik Krishnan, Heterogeneous Beliefs, IPO Valuation, and the Economic Role of the Underwriter in IPOs, 41 Fin. Mgmt. 769, 770 (2012). This is known as the “market power” hypothesis and can be contrasted with the “certification” hypothesis, which states that underwriters reduce information asymmetry by “certifying” that the issue price is consistent with the intrinsic value of the firm. Id. at 771; see also James R. Booth & Richard L. Smith, II, Capital Raising, Underwriting and the Certification Hypothesis, 15 J. Fin. Econ. 261 (1986). Additionally, an underwriter with an exceptional reputation may increase retail investor optimism in the issuer’s future success.85Chemmanur & Krishnan, supra note 84, at 770. 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.86See In re Refco, Inc. Sec. Litig., 503 F. Supp. 2d 611, 629 (S.D.N.Y. 2007) (holding that defendants were not liable under section 11 because they did not purchase securities with intent to distribute, offer securities on issuer’s behalf, “hold themselves out as professionals,” or “b[ear] any risk with respect to th[e] transaction.”) (quoting McFarland v. Memorex Corp., 493 F. Supp. 631, 646 (N.D. Cal. 1980)); see also N.J. Carpenters Vacation Fund v. Royal Bank of Scot. Grp., PLC, 720 F. Supp. 2d 254, 264 (S.D.N.Y. 2010). 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.87See infra Section II.B. It also echoes the House of Representatives’ assertion that the test is one of “participation in the underwriting undertaking.”88H.R. Rep. No. 73-152, at 24 (1933) (Conf. Rep.). 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 1929.89Elisabeth Keller & Gregory A. Gehlmann, Introductory Comment: A Historical Introduction to the Securities Act of 1933 and the Securities Exchange Act of 1934, 49 Ohio St. L.J. 329, 337–42 (1988). 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.9077 Cong. Rec. 947, 954 (1933) (statement of President Franklin D. Roosevelt). 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.”91Id. 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,”92H.R. Rep. No. 73-152, at 24 (explaining that a person is not an underwriter simply because they furnish the underwriter with money with which they conduct a purchase of securities). 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.93The Securities Act originally made underwriters potentially liable for an entire issue; the 1934 amendment to the Act limited damages against underwriters to the “ ‘total price at which the securities underwritten by him and distributed to the public were offered to the public.’ ” Laylin K. James, Comment, Amendments to the Securities Act of 1933, 32 Mich. L. Rev. 1130, 1136 (1934); Keller & Gehlmann, supra note 89, at 346. 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.”9478 Cong. Rec. 8714 (1934) (letter from James M. Landis, Commissioner of the Federal Trade Commission); see also Keller & Gehlmann, supra note 89, at 341. 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.9578 Cong. Rec. 8715 (1934). 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.”96Id. Landis drafted this amendment. For an analysis contemporaneous with the amendment’s passage, see James, supra note 93.
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 . . . .97Securities Act of 1933 § 2(11), 15 U.S.C. § 77b(a)(11).
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.98See In re Lehman Bros. Mortgage-Backed Sec. Litig., 650 F.3d 167, 176 (2d Cir. 2011). 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.99Id. A distribution is defined as a public offering. See Gilligan, Will & Co. v. SEC, 267 F.2d 461, 463 (2d Cir. 1959) (applying the standard for determining if an offering is public to decide whether actions were taken in connection with a distribution); see also SEC v. Ralston Purina Co., 346 U.S. 119, 125–26 (1953) (defining a public offering by whether the offerees had meaningful access to the kind of information found in a registration statement).
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.100Pinter v. Dahl, 486 U.S. 622, 650 n.26 (1988). 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.”10165 F.3d 1392, 1400 (7th Cir. 1995) (quoting SEC v. Holschuh, 694 F.2d 130, 139 n.13 (7th Cir. 1982)). 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,”102Raffensperger, 65 F.3d at 1395. 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).103Id. at 1397. The NASD was a self-regulatory organization that has since been absorbed into the Financial Industry Regulatory Authority (FINRA). National Association of Securities Dealers, Nasdaq, https://www.nasdaq.com/glossary/n/national-association-of-securities-dealers [perma.cc/47UL-SY55]. 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.104Raffensperger, 65 F.3d at 1397; see Self-Underwriting by Nonmember Brokers or Dealers, 46 Fed. Reg. 43457 (Aug. 20, 1981). 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.105Raffensperger, 65 F.3d at 1397–98.
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.106Id. at 1400. 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 underwriter107Id. at 1403. by “carr[ying] out the responsibilities of a usual underwriter in evaluating the terms of the offering.”108Id. at 1402 (quoting Offerings to Public of Own Securities by Brokers and Dealers, 37 Fed. Reg. 26294, 26295 (Dec. 4, 1972)). The decision was bolstered by the fact that qualified independent underwriters voluntarily and explicitly assume the liability usually assumed by an underwriter.109Id. at 1403.
The preeminent case on the interpretation of the definition of “underwriter” is Lehman Brothers.110In re Lehman Bros. Mortgage-Backed Sec. Litig., 650 F.3d 167 (2d Cir. 2011). In that case, the Second Circuit held that credit rating agencies were not liable as statutory underwriters.111Id. at 175. The court drew a line between participation in the distribution of securities and services that make a distribution possible.112The distribution, as defined by the Second Circuit in this case, is “the entire process by which . . . the block of securities is dispersed and ultimately comes to rest in the hands of the investing public.” Id. at 177 (quoting SEC v. Kern, 425 F.3d 143, 153 (2d Cir. 2005). However, the court also uses the word “distribution” to connote the specific act of putting securities in the hands of the public. See, e.g., id. at 183. 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.”113Id. at 175–76. The court also distinguished acts that constitute participation in those activities from acts merely necessary to the completion of the distribution.114Id. 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,115Id. at 171. 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.”116Id. at 183 (quoting In re Lehman Bros. Sec. & ERISA Litig., 681 F. Supp. 2d 495, 499 (S.D.N.Y. 2010)). 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.”117Id. 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.”118Id. at 179 (discussing Harden v. Raffensperger, Hughes & Co., 65 F.3d 1392, 1400 (7th Cir. 1995)). 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. Harden v. Raffensperger, Hughes & Co., 65 F.3d 1392, 1400 (quoting SEC v. Van Horn, 371 F.2d 181, 188 (7th Cir. 1966)). 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.120Securities Act of 1933 § 11(a)(4), 15 U.S.C. § 77k(a)(4). 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.121See Jaffe et al., supra note 44. Nor do they engage in any price stabilization following the distribution.122See id. 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.”123Warby Parker Inc., Registration Statement (Form S-1/A), at 200 (Sept. 14, 2021); see also Slack Techs., Inc., Registration Statement (Form S-1/A), at 171 (May 31, 2019); Coinbase Glob., Inc., Registration Statement (Form S-1/A), at 208 (Mar. 23, 2021). The language is exactly the same in each prospectus. 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.124But see Nickerson, supra note 73.
The primary vehicle for investor education in direct listings has been an “Investor Day” presentation, which takes the place of a traditional IPO roadshow.125See supra notes 46–47 and accompanying text. 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.126See supra notes 46–47 and accompanying text. Regardless, Investor Days are closely analogous to a traditional roadshow, and roadshows are explicitly defined by the SEC as “offers.”12717 C.F.R. § 230.433(h)(4) (2021). The book building process is performed to both market the securities and determine the issue price. It is discussed in more detail in Section I.A. Therefore, Investor Day is almost certainly an “offer.”128See, e.g., SEC v. Chinese Consol. Benevolent Ass’n, 120 F.2d 738, 739–40 (2d Cir. 1941) (holding that an advertisement in a newspaper made by persons unaffiliated with the issuer was an offer).
However, we know that financial advisors do not participate directly in investor meetings; therefore, they do not participate directly in that offer.129Spotify Tech. S.A., Registration Statement (Form F-1/A), at 186 (Mar. 23, 2018). 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.130564 U.S. 135 (2011). 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.131Janus, 564 U.S. at 137. 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.”132Id. at 142, 146. 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.”133Id. at 142–43 (“Even when a speechwriter drafts a speech, the content is entirely within the control of the person who delivers it. And it is the speaker who takes credit—or blame—for what is ultimately said.”). 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.134See supra notes 129–133 and accompanying text; infra notes 135–150 and accompanying text. Underwriters’ traditional involvement in roadshows clearly implicates their reputation, primarily through the book building process.135See Chemmanur & Krishnan, supra note 84, at 770. 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.136See Jaffe et al., supra note 44.
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.137Anything that conditions the market or arouses interest in a public offering could be an offer. Interpretative Releases Relating to Securities Act of 1933 and General Rules and Regulations Thereunder, 22 Fed. Reg. 8359, 8359 (Oct. 4, 1957). 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.138Jaffe et al., supra note 44. The registration process itself is distinct from any sale, purchase, or offer of securities.139See In re Lehman Bros. Mortgage-Backed Sec. Litig., 650 F.3d 167, 175 (2d Cir. 2011); In re Refco, Inc. Sec. Litig., 503 F. Supp. 2d 611, 629 (S.D.N.Y. 2007). 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.140See supra notes 123–126 and accompanying discussion. The financial advisor does not have ultimate control over what goes in the registration statement,141See Jaffe et al., supra note 44. and so they are not the maker of the statement.142See supra notes 130–133 and accompanying discussion. 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.14315 U.S.C. § 77k(a)(4). 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.144See Herman & MacLean v. Huddleston, 459 U.S. 375, 386 n.22 (1983) (explaining that there are participants in the registration process that cannot be held liable under section 11). 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.145In re Refco, Inc. Sec. Litig., 503 F. Supp. 2d 611, 629 (S.D.N.Y. 2007); In re Refco, Inc. Sec. Litig., No. 05 Civ. 8626, 2008 WL 3843343, at *1, *3–5 (S.D.N.Y. Aug. 14, 2008). Participation in the registration process is probably insufficient on its own to create section 11 liability for financial advisors.
The financial advisor also assists with the valuation of the company, a prerequisite for listing on an exchange.146Horton, supra note 17, at 195; NYSE Listed Company Manual, supra note 39, at § 102.01B. To qualify for a direct listing, the company must submit a valuation in excess of $250 million to the exchange.147 . NYSE Listed Company Manual, supra note 39, at § 102.01B. This step is obviously necessary, but as the Second Circuit held, the necessity of an activity is not sufficient to create section 11 liability.148In re Lehman Bros. Mortgage-Backed Sec. Litig., 650 F.3d 167, 175 (2d Cir. 2011). The activity must constitute participation, directly or indirectly, in purchasing, selling, offering, or distributing.149Id. at 177.
At the valuation stage, the financial advisor does not make any offers or sales, nor does the issuer.150See Jaffe et al., supra note 44. 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.151See supra Section II.C.
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.152See Jaffe et al., supra note 44. Financial advisors in direct listings have significantly less control over the price of the listing than do either firm-commitment or best-efforts underwriters.153Firm-commitment underwriters set the price of an issue through the process of book building. Geddes, supra note 24, at 70. In best-efforts arrangements, the price is negotiated by the issuer and the underwriter. Id. at 69. 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.154Jaffe et al., supra note 44. The financial advisor is responsible for consulting with the DMM on the price without input from the issuer.155Id. However, the DMM is free to disregard their advice, and the price is based significantly on orders received by the DMM.156See id.
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.157See Securities Act of 1933 § 2(3), 15 U.S.C. § 77b(a)(3) (defining “sale” as the exchange of the security for value). When the financial advisor provides advice to the DMM, no securities have yet changed hands.158See Jaffe et al., supra note 44. 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.159See In re Refco, Inc. Sec. Litig., 503 F. Supp. 2d, 611, 629–30 (S.D.N.Y. 2007). 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”160See supra note 88. 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-5.161See 17 C.F.R. § 240.10b-5 (2021); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976). 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 . Choi & Pritchard, supra note 13, at 22. Accordingly, the civil liability provisions of the Securities Act punish actors who intentionally or unintentionally shirk their duty to disclose complete and reliable information.163See id. at 570. Section 11 liability provides investors with a remedy for misinformation and omissions in an issuer’s registration statement.164Securities Act of 1933 § 11(a), 15 U.S.C. § 77k(a). That liability extends to other parties that participated in the offering—officers of the issuer, underwriters, and experts.165Id. 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.166John R. Allison, Comment, Section 11 of the Securities Act—A Proposal for Allocating Liability, 45 Wash. L. Rev. 95, 105 (1970).
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.167Securities Act of 1933 § 11(a)(1)–(5), 15 U.S.C. § 77k(a)(1)–(5). 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.168Securities Act of 1933 § 11(f)(1), 15 U.S.C. § 77k(f)(1). 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.169Choi & Pritchard, supra note 13, at 938. Gatekeepers are incentivized—either through liability or regulatory mandates—to use their expertise and access to information to prevent fraud.170For a clear overview of the concept of gatekeeper liability, see Reinier H. Kraakman, Gatekeepers: The Anatomy of a Third-Party Enforcement Strategy, 2 J. L., Econ. & Org. 53 (1986). For a critical examination of the efficacy of gatekeeper liability regimes and suggested alternatives, see Peter J. Henning, The New Corporate Gatekeeper, 62 Wayne L. Rev. 29 (2016) and Stephen Choi, Market Lessons for Gatekeepers, 92 Nw. U. L. Rev. 916 (1998). 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.171Horton, supra note 17, at 210–12.
One proposed solution is to alter stock exchange requirements to require financial advisors to consent to the legal duties and liabilities of an underwriter.172Id. at 212. 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.173See supra Section II.C. 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.174See 17 C.F.R. § 240.10b-5 (2021). While section 11 affords a negligence-based “due diligence” defense to underwriters,175See supra notes 67–68 and accompanying text. Rule 10b-5 requires a showing of scienter on the part of the defendant.17617 C.F.R. § 240.10b-5 (2021); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976). Scienter is defined as an intent to deceive, but it has also been interpreted to include severe recklessness.177E.g., Aaron v. SEC, 446 U.S. 680, 686 n.5 (1980); Edward J. Goodman Life Income Tr. v. Jabil Cir., Inc., 594 F.3d 783, 790 (11th Cir. 2010). 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.178Assaf Hamdani, Gatekeeper Liability, 77 S. Cal. L. Rev. 53, 103–04 (2003). Under negligence-based liability, gatekeepers will compensate for the risk by increasing fees.179Id. Professor Hamdani concludes that as liability regimes move from negligence to strict liability, there is an increase in cost resulting from the distortion of market-entry decisions caused by information asymmetry. Id. at 72–74, 103. Professor Hamdani suggests three potential adverse consequences when strict liability is applied to gatekeepers: market unraveling, the departure of law-abiding clients from the market, and the possibility of no deterrent effect. Id. at 74. 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.180Id. at 73. 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.”181Id. Increased fees can discourage law-abiding clients from entering the market unless the latent benefits of entering the market are sufficiently enticing.182See id.
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.183See supra notes 52–63 and accompanying text. And it creates liquidity for selling shareholders, which potentially increases selling-shareholder returns.184See supra notes 52–53 and accompanying text.
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 . NYSE Listed Company Manual, supra note 39, at § 102.01B n.E. This mechanism could filter out low-performing companies.186Lipke, supra note 18, at 175. 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.187See id.
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.188Hamdani, supra note 178, at 104. 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.”189Id. 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.190Id. at 115–16. The SEC has the capacity to set specific standards for market participants, as they have with attorneys and auditors.191See id. at 116–17 n.182. 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.192See id. 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.
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.