Recently, Spotify, the streaming music service, made trade press headlines. The company announced it would offer its shares in a "Direct Public Offering".1; Immediately, a flood of articles emerged in which commentators described, decried and delighted in Spotify's move.
A few things became clear: Spotify, unlike most companies seeking a market for their shares, did not want to raise capital, at least, not through a public offering. The company had numerous options to raise money, and decided against an initial public offering (IPO). It did, however, have a wish list of sorts.
According to its press release, Spotify wanted to:
- Offer greater liquidity for its existing shareholders, without raising capital itself and without the restrictions imposed by standard lockup agreements
- Provide unfettered access to all buyers and sellers of its shares, allowing Spotify’s existing shareholders the ability to sell their shares immediately after listing at market prices
- Conduct its listing process with maximum transparency and enable marketdriven price discovery2;
Why did Spotify not engage in an IPO? In an IPO, the company hires underwriters (usually a group of banks) who buy shares at a particular price, which they sell to clients and investors. This is not always a straightforward matter. The price underwriters pay is often subject to intense negotiation. The company—"issuer"—must pay hefty fees out of the underwriters' price, while the underwriter can resell the stock at a profit. While the company can sell new stock and pitch its stock to prospective buyers, existing shareholders, like employees and pre-IPO investors, are typically subject to a 180-day lockup period that prevents them from selling their shares.
In a direct offering, the company sells no new stock and there's no lockup period. Existing shareholders can sell their holdings immediately after the company lists on a public exchange.
While not unheard of, reports of direct public offerings were enough of an oddity to send many people to the law books to see exactly what one entailed.
In the federal securities law, they found nothing, at least not anything described as a "direct public offering." The term is not defined or even used in the federal statutes. One of the simplest explanations was offered by Recode.net:
"With a 'direct listing,' Spotify essentially posted available shares on the New York Stock Exchange and let the market figure out a fair price, rather than selling a certain number of shares to Wall Street kingpins before the rest of us could buy them."3
As tempting as it is to accept this definition at face value, it omits some important factors. First, federal law sets strict limitations on the sale of securities. In order to avoid the expense of registration under Section 5 of The Securities Act of 1933,4 companies must fit within one of the exemptions of the statute. Next, every state has requirements for the sale of stock to the public, known as "Blue Sky Laws."5 Compliance with these laws is required as well.
Moreover, once undertaking a direct public offering, companies must operate within the restrictions of the specific offering requirements of the law. For example, the New York Stock Exchange has issued a set of guidelines and expectations for those issuers who seek to offer their shares on the Exchange.6
Once having declared a direct public offering, the company must follow the rules associated with the route chosen. Simply declaring an offering to be a "direct public offering" is insufficient. In SEC v. Bronson,7 the court found that failure to comply with federal and state laws rendered the seller susceptible to actions under both federal and state law. In SEC v. Longfin Corp,8 the court carefully discussed a public offering under the "Jumpstarting Our Business Startups Act of 2012" (JOBS Act) and the related Regulation A+. Declaring that the burden was upon defendants to prove the exemption from Section 5, the court minutely examined the transactions among the defendants. It froze the proceeds of the share sales finding that the SEC had demonstrated the likelihood of success in proving that the defendants had failed to comply with the relevant federal law.
The specific mechanics of a direct public offering, and the related requirements, are beyond the scope of this memorandum. Rather, we focus on the liability of the corporation, its officers and directors, and how directors and officers’ liability insurance (D&O) fits into the corporate risk management profile.
- Is a company "public" after undergoing a direct public offering? As is obvious from the nomenclature, the answer is "yes" both under the law and according to common D&O policy definitions. If a company has undergone a direct public offering, it will be deemed to be a public company, and its coverage under relevant D&O forms will be limited to loss arising from "Securities Claims." D&O policies offer private companies a broader range of coverage.
- How is the liability of the corporation affected by a direct public offering? A direct public offering may be exempt from some federal registration requirements, but it is still subject to many federal and state laws. Those making a direct public offering must prepare an S-1 registration statement and financial records, which, of course, must be truthful.
Sellers of stock under a direct public offering face potential liability under Sections 11 and 12 of the 1933 Act9, as well as Section 10(b) of the 1934 Act10. These laws govern sales of registered and unregistered securities that involve the use of interstate commerce. In addition, state securities law may also be triggered.
As for officers and directors who participate in a direct public offering, their liability is governed not only by federal and state securities law, but also state corporate laws. Such individuals owe a fiduciary duty which is found in both statutory and case law, and that duty is independent of any found in the federal securities law.
- How will D&O insurance respond to claims arising out of direct public placements? D&O policies vary, and all claims are unique. Still, there are some general concepts that can be of some value.
First, many private company D&O policies have exclusions for claims arising out of any public stock offering. While there may be some negotiated coverage available, it is important to understand that private company D&O policies are not intended to cover the risk of a public offering.
Second, under a public company policy, including one negotiated with coverage for a specific public offering, coverage for the corporate entity is limited to that arising from securities claims, as defined by the policy. Coverage for individual insureds is broader under public company forms, but is limited to claims arising from actions undertaken in an insured capacity— that is, as an officer or director.11
With the cost of a traditional initial public offering (IPOs) rising, direct public offerings provide companies with a lower cost path to public trading. Changes in federal law have made this path even more enticing. Yet any form of public offering requires careful preparation and thoughtful risk management. D&O insurance can be part of that risk management.
As always, Gallagher professionals are ready to assist.
About the Author:
Donna Ferrara, Esq. is a Senior Vice President in Gallagher’s Management Liability Practice. This group focuses on risk management services, including insurance placement related to executive and management liability issues. During Ms. Ferrara’s three decades in the industry, her vast experience includes litigating and analyzing insurance issues, drafting policies and aiding the settlement process. Ms. Ferrara is a frequent participant in industry forums as well as a respected contributor of articles on insurance, law and technology, having been published in both legal and trade press. She has also been recognized as a “Power Thought Leader” by Risk & Insurance magazine.
1 McCarthy, Barry, IPOs Are Too Expensive and Cumbersome, August 18, 2018. https://newsroom.spotify.com/2018-08-08/ipos-are-tooexpensive-and-cumbersome/
2 Spotify Case Study: Structuring and Executing a Direct Listing, Harvard Law School Forum on Corporate Governances and Financial Regulation, July 5, 2018, https://corpgov.law.harvard.edu/2018/07/05/spotify-case-study-structuring-and-executing-a-direct-listing/
3 Spotify tried to reinvent the IPO. But two quarters later, things look ... normal? July 26 2018, https://www.recode.net/2018/7/26/17615094/spotify-ipo-earnings-direct-listing.
4 15 U.S.C. § 77a et seq.
⁷ 14 F. Supp 3d 402 (SDNY 2014)
⁸ 15 U.S. Code § 77k, 15 U.S. Code § 77l, . See also, 316 F.Supp 3d 743 (SDNY 2018).
⁹ 15 U.S.C. § 78j. 15 U.S. Code § 77k, 15 U.S. Code § 77k, See also, Sjostro, Going Public Through an Internet Direct Public Offering: A Sensible Alternative for Small Companies, 53 Florida Law Review 529,578 (2005Sjostrom, William K., Going Public Through an Internet Direct Public Offering: A Sensible Alternative for Small Companies? Florida Law Review, Vol. 53, p. 529,at 578, 2001. Available at SSRN: https://ssrn.com/abstract=831906).
¹⁰ 9. 15 U.S.C. § 78j. Section 10b, and its related Rule 10b-5 have been found to apply even private placements that involve interstate commerce. See, e.g. Faye L. Roth Revocable Trust v. UBS Painewebber, Inc. 323 F.Supp. 2d 1279 (S.D. FL 2004)
11 Langdale Company v. National Union, No., 14-12723 (11th Cir. 2015). See, also, Security National Insurance Co. v. H.O.M.E., Inc, 312 F. Supp. Ed 777 (Dist. N.D. 2018)