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[CS&M Draft—01/28/2020]
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SIFMA Compliance & Legal 2020 Annual Seminar
March 16, 2020
Compliance Issues in Investment Banking
Gary Distell Guggenheim Securities, LLC
Darian Futrell Goldman Sachs & Co. LLC
Jodi Huckabee Barclays Capital Inc.
Andrew Pitts Cravath, Swaine & Moore LLP
C.B. Richardson Citigroup Global Markets Inc.
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Direct Listings
I. What Is a Direct Listing?
A. A direct listing is a type of SEC-registered offering
completed under the Securities Act of 1933 (the “Securities Act”).
While there are many similarities between a traditional
underwritten initial public offering (“IPO”) and a direct listing,
there are also significant differences in the key processes,
structure and registration statement disclosure of the two types of
offerings.
B. A direct listing takes place when a company’s outstanding
stock is listed on a stock exchange without the occurrence of an
underwritten offering. A notable difference between a traditional
IPO and a direct listing is that in the former, a company issues
new shares for sale to the public, whereas direct listings are
structured as the resale of securities held by existing
shareholders rather than as primary offerings.
1. As the securities are not being underwritten, the involvement
of underwriters (and by extension, features intended to stabilize
stock price such as overallotment options and syndicate short
positions) is eliminated; instead, investment banks are included as
financial advisors in the offering process.
2. Lock-up agreements are also excluded from direct listings;
all shareholders are eligible to sell their shares on the first day
of trading.
C. In a direct listing, a company’s existing shareholders are
able to sell their shares immediately after listing through the
normal auction mechanisms of the stock exchanges, and prospective
purchasers are able to purchase shares from any willing seller.
Unlike with a traditional IPO, in a direct listing there is no
fixed, pre-determined number of shares available for sale and there
is no IPO price. The placing of orders through broker-dealers
drives share demand and price-setting.
II. Why Go Public at All?
A. A private company may decide to “go public” for several
reasons. Chief among them are to:
1. generate equity capital through the sale of stock to the
public. To achieve this goal, a company must engage in a
traditional IPO. Currently, direct listings do not result in
influxes of cash for the
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company, as the U.S. Securities and Exchange Commission (the
“SEC”) disallows the generation of new capital via direct
listings;1
2. respond to liquidity demands of existing investors. Going
public allows shareholders (such as early investors and employees)
to “cash out” by selling shares into a liquid market with certainty
around pricing and quick execution of trades;
3. gain the ability to use publicly traded stock as currency for
acquisitions and for employee compensation; and
4. increase public awareness about the company. Market exposure,
branding and credibility afforded to companies listed on a stock
exchange can provide a form of advertising, attract institutional
investors and funds and aid in raising debt financing, and in
fulfilling other business objectives.
1 A December 2019 New York Stock Exchange proposal (amended
after the rejection of a similar
proposal) to allow companies to sell shares, and thereby raise
capital, in the opening auction on the first day of trading on the
Exchange is currently under review by the SEC. The proposal is
discussed in further detail below.
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Key Considerations When Choosing a Direct Listing
Why pursue a traditional IPO? Why pursue a direct listing?
Capital Requirements
Company needs to raise money Company has no need to raise money,
but wants to provide liquidity to existing shareholders and
employees
Control Over Process
Opportunity for Company and underwriters to drive the
valuation/pricing dynamic and more tightly control messaging to
investors and who is allocated stock (i.e., pension funds, hedge
funds, retail, etc.)
Comfortable with buyers/sellers setting valuation without a
traditional roadshow and limited ability of investment banks to
help market
Marketing Potential to benefit from actively marketing the
Company’s story to top investors in a highly coordinated and
directed manner
Company has a highly visible, well known and easily understood
business model that requires less investor/equity research analyst
education
Size of Company Company is not large enough to attract
sufficient investor attention
Company has a meaningful equity value, has seen several rounds
of financing and is big enough to attract investor attention
without targeted and lengthy marketing efforts
Shareholder Considerations
Opportunity to transition concentrated private ownership
structure to broadly dispersed public shareholder base
Company has well-diversified private shareholder base and
history of multiple financing rounds
Company expects existing shareholders will be willing to sell
enough shares to create a liquid trading market
Research Ability for company to actively drive the equity
research analyst selection and education process
Company has high profile that will naturally attract broad
equity research coverage without extensive analyst education
process
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Pros and Cons of a Direct Listing
Pros Cons
Provides for immediate shareholder liquidity
• No lock-ups for significant shareholders, which would be
required in traditional IPO
• Lock-up period for a traditional IPO is typically 180 days for
directors, officers and shareholders that hold a meaningful amount
of stock
• All existing shareholders can sell without any legal
restrictions on first day of trading
Gives shareholders and potential buyers equal access to the
market
Market-driven price discovery process • Rather than rely on
investment bank’s pricing
recommendation, initial trading price is entirely dependent upon
market forces
• Because selling shareholders sell directly into the market, in
theory no risk of losing out on potential “pop” from an
“underpriced” IPO
May result in lower transaction fees than a traditional IPO
Company cannot raise money May be subject to a more
unpredictable market open
• No offering by which stabilization can take place (e.g., no
overallotment mechanism)
• Dependent on existing shareholders to provide liquidity • May
not attract traditional IPO investors, who are often
institutional investors who buy large initial blocks
• Requires willing buyers and sellers to create an orderly and
liquid trading market
• Can’t terminate the IPO/listing if Company and shareholders
don’t like opening price
• No ability to direct shares to friendly holders
Non-traditional marketing
• Substantial limitations on role of investment bank advisors to
assist with marketing process and price discovery
• The Company has less time with potential significant investors
than in a traditional roadshow process
• Target buyers may be less sophisticated and not well-versed in
Company
Less engagement with equity research analysts as compared to
traditional IPO
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III. Practical Considerations of SEC Filings
A. Prior to Spotify and Slack, generally, a company engaging in
a direct listing filed a registration statement on Form 10 to
become a reporting company under the Securities Exchange Act of
1934 (the “Exchange Act”) and simultaneously listed its shares on a
stock exchange.
1. Form 10 does not carry Securities Act liability and there are
no “gun-jumping” issues, but there is still liability for material
misstatements or omissions.
B. Why use the Securities Act Form S-1?
1. As with the traditional IPO, the SEC requires Form S-1 or, in
cases of foreign issuers, Form F-1, for use of the new NYSE direct
listings rule used by Spotify and Slack. A direct listing’s Form
S-1 receives the same SEC staff review as that of a traditional
IPO. Form S-1 was required in connection with Watford Holdings’
March 2019 direct listing on NASDAQ.
2. Because the issuer is participating in the facilitation and
development of a trading market, even though issuer itself is not
offering shares for sale, the SEC requires a Securities Act
registration statement because the SEC considers these activities
as a “distribution”.
3. In addition, an active registration statement ensures that
all shareholders are able to sell shares on the first day of
trading.
a) Form S-1/Form F-1 registers the resale of all shares that are
not otherwise already freely tradeable under Rule 144.
o Without Form S-1/Form F-1 registration, under Rule 144,
affiliates and other holders of restricted stock could be subject
to delay before they may sell.
o A Form S-1/Form F-1 is deregistered after 90 days (the
relevant length of time for a company to be deemed a reporting
company under Rule 144).
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IV. Disclosure Specific to a Direct Listing
Direct listing resale registration statement is substantially
similar to that of an underwritten IPO, with a few key differences.
They are as follows:
A. Shares registered
1. In a direct listing, there is no pre-determined committed
number of shares to be sold and specified to be registered.
2. Generally, a direct listing registers existing shares that
are not otherwise already freely tradeable under Rule 144, whereas
in an IPO, an issuer creates new shares for sale to the public.
B. Pricing
1. In a direct listing, pricing is not pre-determined and there
is no price range on the cover of the “red herring” preliminary
prospectus. The cover page of the preliminary prospectus instead
outlines how the opening public price will be determined. The cover
page pricing explanations include:
a) disclosure that the opening price will be determined by
buy-and-sell orders collected by the stock exchange from
broker-dealers;
b) how the market for the sales will open;
c) recent high and low private transaction sales prices of
individual stock units; and
d) risk factor disclosure stating that the opening price may
have little correlation to the historical sales prices.
2. The stock exchange reference price and opening price are not
determined until after the S-1/F-1 is declared effective.
a) NYSE declared a reference price for each of Spotify and Slack
the day before trading; the reference prices were not presented in
the registration statement. The reference prices were tied to
recent private secondary trades and served only as a guidepost to
the public.
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C. Plan of distribution
1. The registration for a traditional IPO includes an
underwriting section. Because a direct offering is not
underwritten, the underwriting section is generally replaced with a
plan of distribution, as characteristically seen in resale
registration statements.
2. The plan of distribution states that shareholders may sell
their shares, rather than listing bank syndicates and the number of
shares to be sold.
3. The SEC has commented that the procedures that apply to
determining the opening trading price on the stock exchange and how
buy-and-sell orders are assessed without a traditional pricing
range should be detailed in the plan of distribution section.
D. Registered holders
1. A section of the prospectus must list either the registered
holders or categories of registered holders of existing stock.
E. Financial advisors
1. Financial advisor names, arrangements with the company and
compensation are generally required to be disclosed in the
prospectus.
2. In the event that financial advisors are involved in advising
existing shareholders, such relationships must be disclosed.
F. Fee for financial advisors
1. In a traditional IPO, underwriting compensation must be
disclosed. Underwriting discounts and commissions are listed on the
cover of the prospectus, and additional underwriting compensation
is listed in the “Underwriting” section.
2. In a direct listing, a financial advisory fee may be listed
in a separate section covering other expenses of the listing. For
example, the Spotify F-1 included an “Expenses of the Registration”
section that, aside from various administrative fees, listed legal,
auditors, transfer agent, registrar and “other advisers” fees. It
did not specify the exact financial advisory fees.
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G. Risk factors
1. Risk factors cover the various unique features of a direct
listing. For example, in a January 17, 2018 comment letter to
Spotify, the SEC required that Spotify highlight, among other
things, the differences between a traditional IPO and a direct
listing, as well adequately discuss topics such as the potential
impact of the absence of safeguards, such as book-building and
lock-up agreements, on trade price and volume, risk of fluctuations
in trading prices following initial listing and uncertainties with
the listing process.
V. Gone Are the Gatekeepers?
A. In addition to providing important services such as
marketing, book-building and market stabilization activities,
underwriters have also traditionally been viewed as “gatekeepers”
of companies seeking to go public.
1. Sections 11 and 12(a)(2) of the Securities Act subject
underwriters to liability for material misstatements or omissions
contained in a registration statement or prospectus.
2. In addition to legal liability under the U.S. securities
laws, underwriters take on reputational risk when selling IPO
shares to clients and the market as a whole.
B. Banks serve as financial advisors in a direct listing, since
there is no underwritten offering.
1. It remains to be seen whether the lack of underwriters will
limit the universe of companies pursuing direct listings. Analysis
on the outcome is split—while some industry players believe that
direct listings may weaken investor protections, thereby eventually
resulting in adverse effects on the overall market, according to
Reuters, on January 14, 2020, SEC Commissioner Rob Jackson backed
direct listing, stating that underwriting fees act as an impediment
to listing for middle-market companies.
2. Because financial advisors are not selling shares into the
market, the reputational risk associated with a direct listing may
be less than in a traditional IPO.
a) However, the market may associate financial advisors,
especially the lead financial advisors, with a particular
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direct listing and as a result there may be meaningful
reputational risk by association.
b) As there is no obligation to provide market stabilization,
financial advisors do not face the same risk of losing money from
initial listings that face immediate downward pressure.
VI. Underwriter vs. Financial Advisor
A. Banks play an important role in assisting and advising on
direct listings, and therefore are still key actors in the
process.
B. The disclosure in the registration statement highlights the
role of financial advisors. The disclosure clearly delineates the
banks’ role as not underwriting the offering, and the plan of
distribution section contrasts the role of financial advisors in a
direct listing against the role investment banks play in a
traditional underwritten IPO.
C. Whether an investment bank is acting as a statutory
underwriter is based on the applicable facts and circumstances and
has not been tested in the context of direct listings.
1. The Securities Act defines “underwriter” to mean “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...”.
2. The direct listing process is designed so that the banks are
not construed as underwriters.
D. Banks generally seek to conduct a due diligence process in a
direct listing that is similar to that in a traditional IPO. They
also commission “10b-5” letters from legal counsel, as well as
auditor comfort letters.
VII. Pre-Listing Period Public Financial Guidance in a Direct
Listing
A. The direct listing company issues public guidance and
financial outlook information to potential investors during the
period between the effectiveness of registration statement and
pricing/trading.
1. Such guidance was issued in both Spotify’s and Slack’s direct
listings. Each of the companies filed a press release covering
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quarterly earnings and outlook after the registration statement
went effective but prior to opening for trading.
2. In both cases, outlook was not filed on a free writing
prospectus and was not incorporated into Form S-1/Form F-1.
3. Resale registration statement became effective 10 days prior
to trading in Slack’s direct listing and eight days prior to
trading in Spotify’s direct listing.
4. Similar guidance is unusual in traditional IPOs due to
liability concerns.
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First Day of Trading
Pre-Trading Day Before Trading
Marketing to investors directly (e.g., “Investor Day”) at least
15 days after first public SEC filing
Resale registration statement declared effective Existing
shareholders and prospective investors
assess forward-looking financial guidance during this period to
zero in on price for sale/purchase
Shareholders deposit shares to be sold through DTC
Stock exchange (in consultation with the Company’s financial
advisor) declares a reference price
• Serves as a guidepost only, and disclosure in preliminary
prospectus cautions that trading price may have no correlation to
pricing range indications or reference price
• Calculated based on recent high and low sales prices in recent
transactions in private placement market
Morning of Trading Opening of Trading
Auction commences Demand size and price start to emerge Buyers
and sellers adjust orders for several hours
throughout morning as the market begins to reach an
equilibrium
Once an equilibrium is reached, the market maker (either the
company’s financial advisor or the NYSE designated market maker in
consultation with the company’s financial advisor) will open the
stock for trading
Price discovery may be aided by private secondary trading
activity prior to direct listing
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VIII. Stock Exchange Listing Rules
A. Listing of Private Companies
1. Prior to the February 2018, the ability to list private
companies not previously registered with the SEC was limited. A
prospective company had to demonstrate $100 million aggregate
market value of publicly held shares based on both:
a) an independent third-party valuation; and
b) the most recent trading price for its shares in a private
placement market.
o Such trading price requires continued trading history over
multiple-month period.
B. New NYSE Rule - February 2018
1. In March 2017, the NYSE began the formal rule filing process
with the SEC to permit the direct listing of Spotify, which lacked
sustained trading activity in a private placement market.
2. The SEC approved the new NYSE rule in February 2018.
3. The rule provides an exception to the trading requirement for
companies looking to list on the NYSE that:
a) have an independent third-party valuation of at least $250
million aggregate market value of publicly held shares; and
b) use a financial advisor for consultation with the NYSE’s
designated market maker in determining the opening trading
price.
4. Amended Section 102.01B of the Listed Company Manual and NYSE
Rules 15, 104 and 123D.2
2Section 102 of the Listed Company Manual sets forth the minimum
numerical standards for issuers
to list equity securities on NYSE.
NYSE Rule 15 sets forth the requirements for a pre-opening
indication.
NYSE Rule 104 sets forth the responsibilities and duties of a
designated market maker.
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5. The requirement that a company must have at least 400 round
lot shareholders (i.e., holders of at least 100 shares of company
stock) in order to be listed on NYSE remained unchanged.
C. New NASDAQ Rule - February 2018
1. The new NASDAQ rule mimics the NYSE rule incorporating the
$250 million valuation threshold, and amended NASDAQ Rule 5315
(Initial Listing Requirements for Primary Equity Securities).
2. NASDAQ requires that a company has 300 round lot holders in
order to initially list.3
3. On December 3, 2019, the SEC approved NASDAQ rule changes to
allow direct listings on the NASDAQ Global and Capital Markets
exchange. Previously, direct listings were permitted only on the
NASDAQ Global Select Market.
IX. New NYSE Proposal Rejected by SEC
A. On November 26, 2019, the NYSE proposed a rule that would
allow companies conducting a direct listing to also raise capital
through the public markets. Currently, the direct listing process
only permits the resale of existing shares, not the offering of new
shares. The SEC rejected this proposal on December 6, 2019.
B. The SEC did not provide details on rejecting the proposal,
but there are a few potential reasons, including:
1. Investors may be unaware of price and dilutive effect of
offerings as described in the NYSE proposal.
a) In a traditional IPO, the price and amount of shares for sale
are fixed and there is limited ability to price above/below range
or upsize/downsize.
b) In the NYSE proposal-style open auction, the company can
opportunistically increase or decrease shares at the
NYSE Rule 123D addresses openings and halts in trading. NYSE
Rule 15, 104, and 123D Rule Changes
Relating to NYSE Direct Listings. NYSE Information Memo (March
28, 2018).
3 Effective August 2019, NASDAQ revised its listing criteria to
exclude securities subject to any resale restrictions from the
calculation of round lot shareholders, publicly held shares and
market value of publicly held shares. In addition, at least half of
the minimum required number of round lot holders must each hold
unrestricted securities with a minimum value of $2,500.
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opening price with limited disclosure or advance warning to
investors.
2. Limiting the types of companies to which direct listing is
available.
a) The SEC may want to limit availability of direct listings to
mature, larger companies seeking to provide shareholders’
liquidity, rather than companies that need to raise capital, which
may use a traditional public offering to achieve that goal.
C. Amended NYSE Proposal
1. The NYSE amended its proposal on December 11, 2019.
2. Under the proposed change, companies which meet the
requirements for a direct listing would have to sell at least $100
million worth of stock instead of $250 million presented in the
initial proposal.
3. The amended proposal also suggests delaying the 400 round lot
shareholder requirement until 90 days after the listing date.
X. Equity Awards and Other Considerations
A. Restricted stock may vest upon public listing. This is an
increasingly common market practice for technology companies.
B. Settlement is a taxable event. To cover withholding taxes
incurred, it is advisable that holders trade on day one to cover
the tax liability. In addition, withholding tax liability is based
on opening price, and payments may be made by the company on
holders’ behalf.
C. Unlike in a traditional IPO, there is no offer price to which
to refer in order to determine the value of the equity award
settlement, the resulting tax liability and the number of shares to
be traded to cover the liability.
1. One focus of the disclosure in the Slack Form S-1 was how the
acceleration of equity awards and desire to cover the withholding
tax by selling shares into the market would impact trading on the
first day.
a) In the Slack Form S-1, the estimated number of shares to be
sold at the opening of trading was based on an estimated opening
price using a recent independent
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common stock valuation report. Additional disclosure detailed
that the estimate would be revised the day prior to the opening of
trading (after the Form S-1 went effective).
D. Definition of “initial public offering” in fund or other
documents.
1. A direct listing may not be considered an “underwritten
initial public offering”.
2. Shareholder agreements, registration rights agreements and
the terms of preferred stock may use the term “initial public
offering”.
3. It is necessary to consider implications of a direct listing
versus underwritten IPO in this context.
XI. Regulation M
A. Regulation M under the Exchange Act is designed to regulate
market manipulation by underwriters, issuers, selling shareholders
and other participants in an offering.
B. Its rules regulate bids and purchases by distribution
participants (which include underwriters), issuers, selling
shareholders and certain of their respective affiliates in
connection with a securities distribution during the “restricted
period”.
1. The “restricted period” generally begins five business days
before the pricing date, but may begin one business day prior to
pricing if the security being distributed has an average daily
trading volume of $100,000 and the issuing company’s equity
securities have a public float of $25 million.
2. The “restricted period” ends when a participant’s
participation in the offering is complete (when the offered
securities have been distributed or a participant has sold its
allotment).
C. Regulation M rules also regulate passive market making,
stabilization activities and short sales.
D. Regulation M prohibits trading that could artificially
inflate the price of a security or generate a false impression of
active trading.
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E. The new type of direct listing used by Spotify and Slack
generated questions about applicability of Regulation M under the
Exchange Act to this type of direct listing. Key questions
included:
1. whether the registration of shares for resale under Form
S-1/F-1 constitutes an offering, and if so, in combination with
investor outreach and education, whether such activity constitutes
a “distribution” for purposes of Regulation M; and
2. since unlike in a traditional IPO, there is no underwriting
process to set the offering price or the number of shares to be
sold and no clear-cut pre- and post-pricing times, whether or how
participants should observe the restricted period under Regulation
M.
F. In advance of its direct listing, Spotify submitted a
no-action request letter to the SEC, requesting clarification of
the applicability of Regulation M to the listing.
1. Spotify represented to the SEC that the company, financial
advisors, registered shareholders and their respective affiliates
would observe a restricted period commencing on the fifth business
day prior to the designated market maker’s determination of the
opening trading price and that such period would end with the
commencement of secondary market trading in the shares on the
NYSE.
2. Based on the fact pattern set forth in the no-action
request:
a) Spotify would not offer any new shares under the registration
statement for at least 90 days after declared effective;
b) Spotify would not receive any proceeds from sale of shares by
shareholders;
c) resales during the effective period would be made solely
through ordinary brokerage transactions into an independent market
not controlled by the company, financial advisors, registered
shareholders or their respective affiliates;
d) financial advisors would only be engaged to provide advice
and assistance with respect to the filing of the registration
statement and the listing of shares;
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e) financial advisors would not further assist Spotify in the
planning of, or participate in, investor meetings;
f) financial advisors would not engage in any special selling
efforts or stabilization/price support activities;
g) timing of resales would be at the sole discretion of the
registered shareholders; and
h) financial advisors would have no discretionary authority to
transact in the shares held in brokerage accounts and no fees or
expenses could be paid by the company or any financial advisors in
connection with the brokerage accounts.
G. The SEC responded that they would not recommend
enforcement.
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Conflict of Interests and Regulation Best Interest
A. Conflict of Interest
1. Overview
a) Given the potential negative repercussions of unrestrained
conflicts of interest on the financial market and the dynamic ways
in which conflicts of interest may arise, lawmakers continually
enact new laws designed to mitigate or eliminate instances of it.
One such recent law is Regulation Best Interest (“Reg. BI”).
2. Definition
a) In the context of Reg. BI, a conflict of interest is defined
as “an interest that might incline a broker, dealer, or a natural
person who is an associated person of a broker or
dealer—consciously or unconsciously—to make a recommendation that
is not disinterested”. Exchange Act, Rule 15l-1(b)(3).
B. Regulation Best Interest
1. Overview of Reg. BI
a) On June 5, 2019, the SEC adopted rule 15 l-1, Regulation Best
Interest (“Reg. BI”) under the Exchange Act. Reg. BI establishes a
new standard of conduct for broker-dealers and associated persons
of a broker-dealer4 (together, “broker-dealers”) for the
recommendation5 of any securities transaction or investment
strategy involving
4 An “associated person of a broker or dealer” is “any partner,
officer, director, or branch manager of
such broker or dealer (or any person occupying a similar status
or performing similar functions), any person directly or indirectly
controlling, controlled by, or under common control with such
broker or dealer, or any employee of such broker or dealer”,
generally excluding, for the purpose of certain registration
processes, persons whose functions are solely clerical or
ministerial. Exchange Act, § 3(a)(18).
5 The SEC takes a principles-based approach based on existing
SEC precedent and guidance on what constitutes a recommendation.
Whether a broker-dealer has made a recommendation depends is a
factual inquiry, considering factors such as “whether the
communication reasonably could be viewed as a call to action and
reasonably would influence an investor to trade a particular
security or group of securities”. Regulation Best Interest: The
Broker‐Dealer Standard of Conduct, 84 Fed. Reg. 33336 (July 12,
2019).
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securities6 to retail customers.7 Regulation Best Interest: The
Broker‐Dealer Standard of Conduct, 84 Fed. Reg. 33318 (July 12,
2019), available at
https://www.federalregister.gov/documents/2019/07/12/2019-12164/regulation-best-interest-the-broker-dealer-standard-of-conduct.
b) Prior to the adoption of Reg. BI, broker-dealers abided by
the “suitability” standard of conduct under which brokers, in
advising their customers, needed only to recommend investments
suitable for their customers; such investments were not required to
be in the best interest of their customers, and could ultimately
offer greater financial or other benefits to the broker-dealer than
the customer. Reg. BI enhances the broker-dealer suitability
standard to emphasize that a retail customer’s financial interests
should be the primary driver to a broker-dealer making
recommendations. SEC Adopts Rules and Interpretations to Enhance
Protections and Preserve Choice for Retail Investors in Their
Relationships With Financial Professionals, SEC Press Release (June
5, 2019), available at
https://www.sec.gov/news/press-release/2019-89.
2. Broker-Dealer General Obligation to Act in Customers’ Best
Interest
a) Reg. BI Rule 15l-1(a)(1) (hereinafter, the “General
Obligation”) states that “[a] broker, dealer, or a natural person
who is an associated person of a broker or dealer, when making a
recommendation of any securities transaction or investment strategy
involving securities (including account recommendations)8 to a
retail
6 Under Reg. BI, the term “any securities transactions” includes
the purchase, sale or exchange of
securities, and “investment strategy involving securities”
includes account type recommendations, explicit recommendations to
hold a security, implicit hold recommendations resulting from
agreed-upon account monitoring by a broker-dealer, and instructions
regarding selling or purchasing a security. Id. at 33336.
7 A retail customer is a natural person, or the legal
representative of such natural person, who: (i) receives a
recommendation of any securities transaction or investment strategy
involving securities from a broker, dealer, or a natural person who
is an associated person of a broker or dealer; and (ii) uses the
recommendation primarily for personal, family, or household
purposes. Exchange Act, Rule 15l-1(b)(1).
8 The SEC defines “account recommendations” under Reg. BI as
including “recommendations of securities account types generally
(e.g., to open an IRA or other brokerage account), as well as
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customer, shall act in the best interest of the retail customer
at the time the recommendation is made, without placing the
financial or other interest of the broker, dealer, or natural
person who is an associated person of a broker or dealer making the
recommendation ahead of the interest of the retail customer.”
b) The General Obligation is fulfilled through broker-dealer
compliance with four component obligations, namely (1) Disclosure
Obligation, (2) Care Obligation, (3) Conflict of Interest
Obligation and (4) Compliance Obligation. Regulation Best Interest:
The Broker‐Dealer Standard of Conduct, 84 Fed. Reg. 33320 (July 12,
2019). See also Exchange Act, Rule 15l-1(a)(2).
c) Reg. BI became effective on September 10, 2019, and has a
compliance date of June 30, 2020.
3. Further Discussion of the Four Component Obligations of the
General Obligation
a) Disclosure obligation. The broker-dealer, prior to or at the
time of the recommendation, must provide the retail customer full
and fair written disclosure of:
o Any material facts relating to the scope and terms of the
broker-dealer/retail customer relationship with the retail
customer, including:
i. that the broker-dealer is acting within a broker-dealer
capacity in making the recommendation;
ii. any material fees and costs applicable to the transaction;
and
iii. The type and scope of services the broker-dealer will
provide to the retail customer, including any material limitations
on the securities or investment strategies involving
recommendations to roll over or transfer assets from one type of
account to another (e.g., a workplace retirement plan account to an
IRA)”. Id. at 33336.
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securities that the broker-dealer may recommend.
o All material facts relating to conflicts of interest
associated with the recommendation, such as conflicts stemming from
third-party payments, proprietary products and compensation
arrangements.
b) Care obligation. In making a recommendation or series of
recommendations to a retail customer, a broker-dealer must ensure
that the recommendation does not place the financial or other
interest of broker-dealer ahead of the interest of the retail
customer. In addition, the broker-dealer must employ reasonable
diligence, skill and care to:
o understand the recommendation’s potential risks, rewards and
costs, and have a reasonable basis to believe that the
recommendation could be in the best interest of at least some
retail customers;
o have a reasonable basis to believe that the recommendation is
in the best interest of a particular retail customer based on that
retail customer’s investment profile and the potential risks,
rewards and costs associated with the recommendation; and
o have a reasonable basis to believe that a series of
recommended transactions, even if in the retail customer’s best
interest when viewed in isolation, is not excessive and is in the
retail customer’s best interest when assessed with the retail
customer’s investment profile. Exchange Act, Rule
15l-1(a)(2)(ii).
c) Conflict of Interest Obligation. The broker-dealer must
establish, maintain and enforce written policies and procedures
reasonably designed to:
o identify and at a minimum disclose in accordance with the
Disclosure Obligation, or eliminate, all
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conflicts of interest associated with recommendations to retail
customers;9
o identify and mitigate conflicts of interests that create an
incentive for a broker-dealer to place the interest of the
broker-dealer ahead of the interest of the retail customer in
making recommendations;10
o in accordance with the Disclosure Obligation, identify and
disclose material limitations11 placed on recommendations that may
be made to a retail customer and any associated conflicts of
interest, and prevent such limitations and associated conflicts of
interest from causing the broker-dealer to make recommendations
that place the broker-dealer’s interest ahead of the interest of
the retail customer; and
o identify and eliminate sales contests, sales quotas, bonuses
and non-cash compensation12 that are based on the sales of specific
securities or specific types of securities within a limited period
of time.
d) Compliance Obligation. A broker-dealer must establish,
maintain and enforce written policies and procedures
9 The SEC notes that it would be sufficient for broker-dealers
to use a risk-based compliance and supervisory system rather than
require a detailed review of each recommendation. Regulation Best
Interest: The Broker‐Dealer Standard of Conduct, 84 Fed. Reg. 33385
(July 12, 2019).
10 The applicability of this requirement to associated persons
extends only to incentives provided to the associated person by the
firm or a third-party within the control of or associated with the
broker-dealer’s business. It does not include the associated
person’s external interests not within the control of or associated
with the broker-dealer’s business. Id. at 33391.
11 While recognizing that for purposes of practicality all
broker-dealers limit offerings, the SEC states that in this
context, “a material limitation placed on the securities or
investment strategies involving securities could include, for
example, recommending only proprietary products (e.g., any product
that is managed, issued, or sponsored by the broker-dealer or any
of its affiliates), a specific asset class, or products with
third-party arrangements (e.g., revenue sharing, mutual fund
service fees).” Id. at 33393.
12 The SEC cautions that in specifying these incentives, it does
not give implicit approval of other types incentives not mentioned
here. It lists these incentives to exemplify those that create
high-pressure environments to sell specific securities or types of
securities within a limited period of time, creating conflict of
interest situations which the SEC does not believe can be
reasonably mitigated. The SEC explains that instances in which
incentives do not create high-pressure situations to sell a
specifically identified type of security do not generally fall
afoul of this requirement. Id. at 33396.
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reasonably designed to achieve compliance with Reg. BI in its
entirety. Exchange Act, Rule 15l-1(a)(2)(iv).
The Compliance Obligation is designed to ensure that
broker-dealers have internal controls in place to prevent Reg. BI
violations. The required policies and procedures heighten the
chances of early SEC recognition of insufficiencies or failures in
compliance, thereby decreasing the chance of harm to retail
customers.13
Given the variety in broker-dealer operations, the Compliance
Obligation does not outline specific elements to be included in a
broker-dealer’s policies and procedures. Whether policies and
procedures are reasonably designed to be Reg. BI-compliant will be
a fact-based inquiry.14
13 Id. at 33455.
14 Id. at 33397.
I. What Is a Direct Listing?A. A direct listing is a type of
SEC-registered offering completed under the Securities Act of 1933
(the “Securities Act”). While there are many similarities between a
traditional underwritten initial public offering (“IPO”) and a
direct listing, the...B. A direct listing takes place when a
company’s outstanding stock is listed on a stock exchange without
the occurrence of an underwritten offering. A notable difference
between a traditional IPO and a direct listing is that in the
former, a company ...1. As the securities are not being
underwritten, the involvement of underwriters (and by extension,
features intended to stabilize stock price such as overallotment
options and syndicate short positions) is eliminated; instead,
investment banks are in...2. Lock-up agreements are also excluded
from direct listings; all shareholders are eligible to sell their
shares on the first day of trading.
C. In a direct listing, a company’s existing shareholders are
able to sell their shares immediately after listing through the
normal auction mechanisms of the stock exchanges, and prospective
purchasers are able to purchase shares from any willing sel...
II. Why Go Public at All?A. A private company may decide to “go
public” for several reasons. Chief among them are to:1. generate
equity capital through the sale of stock to the public. To achieve
this goal, a company must engage in a traditional IPO. Currently,
direct listings do not result in influxes of cash for the company,
as the U.S. Securities and Exchange C...2. respond to liquidity
demands of existing investors. Going public allows shareholders
(such as early investors and employees) to “cash out” by selling
shares into a liquid market with certainty around pricing and quick
execution of trades;3. gain the ability to use publicly traded
stock as currency for acquisitions and for employee compensation;
and4. increase public awareness about the company. Market exposure,
branding and credibility afforded to companies listed on a stock
exchange can provide a form of advertising, attract institutional
investors and funds and aid in raising debt financing,...
III. Practical Considerations of SEC FilingsA. Prior to Spotify
and Slack, generally, a company engaging in a direct listing filed
a registration statement on Form 10 to become a reporting company
under the Securities Exchange Act of 1934 (the “Exchange Act”) and
simultaneously listed its share...1. Form 10 does not carry
Securities Act liability and there are no “gun-jumping” issues, but
there is still liability for material misstatements or
omissions.
B. Why use the Securities Act Form S-1?1. As with the
traditional IPO, the SEC requires Form S-1 or, in cases of foreign
issuers, Form F-1, for use of the new NYSE direct listings rule
used by Spotify and Slack. A direct listing’s Form S-1 receives the
same SEC staff review as that of a t...2. Because the issuer is
participating in the facilitation and development of a trading
market, even though issuer itself is not offering shares for sale,
the SEC requires a Securities Act registration statement because
the SEC considers these activit...3. In addition, an active
registration statement ensures that all shareholders are able to
sell shares on the first day of trading.a) Form S-1/Form F-1
registers the resale of all shares that are not otherwise already
freely tradeable under Rule 144.
IV. Disclosure Specific to a Direct ListingA. Shares
registered1. In a direct listing, there is no pre-determined
committed number of shares to be sold and specified to be
registered.2. Generally, a direct listing registers existing shares
that are not otherwise already freely tradeable under Rule 144,
whereas in an IPO, an issuer creates new shares for sale to the
public.
B. Pricing1. In a direct listing, pricing is not pre-determined
and there is no price range on the cover of the “red herring”
preliminary prospectus. The cover page of the preliminary
prospectus instead outlines how the opening public price will be
determined....a) disclosure that the opening price will be
determined by buy-and-sell orders collected by the stock exchange
from broker-dealers;b) how the market for the sales will open;c)
recent high and low private transaction sales prices of individual
stock units; andd) risk factor disclosure stating that the opening
price may have little correlation to the historical sales
prices.
2. The stock exchange reference price and opening price are not
determined until after the S-1/F-1 is declared effective.a) NYSE
declared a reference price for each of Spotify and Slack the day
before trading; the reference prices were not presented in the
registration statement. The reference prices were tied to recent
private secondary trades and served only as a gui...
C. Plan of distribution1. The registration for a traditional IPO
includes an underwriting section. Because a direct offering is not
underwritten, the underwriting section is generally replaced with a
plan of distribution, as characteristically seen in resale
registration s...2. The plan of distribution states that
shareholders may sell their shares, rather than listing bank
syndicates and the number of shares to be sold.3. The SEC has
commented that the procedures that apply to determining the opening
trading price on the stock exchange and how buy-and-sell orders are
assessed without a traditional pricing range should be detailed in
the plan of distribution section.
D. Registered holders1. A section of the prospectus must list
either the registered holders or categories of registered holders
of existing stock.
E. Financial advisors1. Financial advisor names, arrangements
with the company and compensation are generally required to be
disclosed in the prospectus.2. In the event that financial advisors
are involved in advising existing shareholders, such relationships
must be disclosed.
F. Fee for financial advisors1. In a traditional IPO,
underwriting compensation must be disclosed. Underwriting discounts
and commissions are listed on the cover of the prospectus, and
additional underwriting compensation is listed in the
“Underwriting” section.2. In a direct listing, a financial advisory
fee may be listed in a separate section covering other expenses of
the listing. For example, the Spotify F-1 included an “Expenses of
the Registration” section that, aside from various administrative
fees,...
G. Risk factors1. Risk factors cover the various unique features
of a direct listing. For example, in a January 17, 2018 comment
letter to Spotify, the SEC required that Spotify highlight, among
other things, the differences between a traditional IPO and a
direct l...
V. Gone Are the Gatekeepers?A. In addition to providing
important services such as marketing, book-building and market
stabilization activities, underwriters have also traditionally been
viewed as “gatekeepers” of companies seeking to go public.1.
Sections 11 and 12(a)(2) of the Securities Act subject underwriters
to liability for material misstatements or omissions contained in a
registration statement or prospectus.2. In addition to legal
liability under the U.S. securities laws, underwriters take on
reputational risk when selling IPO shares to clients and the market
as a whole.
B. Banks serve as financial advisors in a direct listing, since
there is no underwritten offering.1. It remains to be seen whether
the lack of underwriters will limit the universe of companies
pursuing direct listings. Analysis on the outcome is split—while
some industry players believe that direct listings may weaken
investor protections, thereb...2. Because financial advisors are
not selling shares into the market, the reputational risk
associated with a direct listing may be less than in a traditional
IPO.a) However, the market may associate financial advisors,
especially the lead financial advisors, with a particular direct
listing and as a result there may be meaningful reputational risk
by association.b) As there is no obligation to provide market
stabilization, financial advisors do not face the same risk of
losing money from initial listings that face immediate downward
pressure.
VI. Underwriter vs. Financial AdvisorA. Banks play an important
role in assisting and advising on direct listings, and therefore
are still key actors in the process.B. The disclosure in the
registration statement highlights the role of financial advisors.
The disclosure clearly delineates the banks’ role as not
underwriting the offering, and the plan of distribution section
contrasts the role of financial adviso...C. Whether an investment
bank is acting as a statutory underwriter is based on the
applicable facts and circumstances and has not been tested in the
context of direct listings.1. The Securities Act defines
“underwriter” to mean “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 partici...2. The direct listing process is
designed so that the banks are not construed as underwriters.
D. Banks generally seek to conduct a due diligence process in a
direct listing that is similar to that in a traditional IPO. They
also commission “10b-5” letters from legal counsel, as well as
auditor comfort letters.
VII. Pre-Listing Period Public Financial Guidance in a Direct
ListingA. The direct listing company issues public guidance and
financial outlook information to potential investors during the
period between the effectiveness of registration statement and
pricing/trading.1. Such guidance was issued in both Spotify’s and
Slack’s direct listings. Each of the companies filed a press
release covering quarterly earnings and outlook after the
registration statement went effective but prior to opening for
trading.2. In both cases, outlook was not filed on a free writing
prospectus and was not incorporated into Form S-1/Form F-1.3.
Resale registration statement became effective 10 days prior to
trading in Slack’s direct listing and eight days prior to trading
in Spotify’s direct listing.4. Similar guidance is unusual in
traditional IPOs due to liability concerns.
VIII. Stock Exchange Listing RulesA. Listing of Private
Companies1. Prior to the February 2018, the ability to list private
companies not previously registered with the SEC was limited. A
prospective company had to demonstrate $100 million aggregate
market value of publicly held shares based on both:a) an
independent third-party valuation; andb) the most recent trading
price for its shares in a private placement market.
B. New NYSE Rule - February 20181. In March 2017, the NYSE began
the formal rule filing process with the SEC to permit the direct
listing of Spotify, which lacked sustained trading activity in a
private placement market.2. The SEC approved the new NYSE rule in
February 2018.3. The rule provides an exception to the trading
requirement for companies looking to list on the NYSE that:a) have
an independent third-party valuation of at least $250 million
aggregate market value of publicly held shares; andb) use a
financial advisor for consultation with the NYSE’s designated
market maker in determining the opening trading price.
4. Amended Section 102.01B of the Listed Company Manual and NYSE
Rules 15, 104 and 123D.1F5. The requirement that a company must
have at least 400 round lot shareholders (i.e., holders of at least
100 shares of company stock) in order to be listed on NYSE remained
unchanged.
C. New NASDAQ Rule - February 20181. The new NASDAQ rule mimics
the NYSE rule incorporating the $250 million valuation threshold,
and amended NASDAQ Rule 5315 (Initial Listing Requirements for
Primary Equity Securities).2. NASDAQ requires that a company has
300 round lot holders in order to initially list.2F3. On December
3, 2019, the SEC approved NASDAQ rule changes to allow direct
listings on the NASDAQ Global and Capital Markets exchange.
Previously, direct listings were permitted only on the NASDAQ
Global Select Market.
IX. New NYSE Proposal Rejected by SECA. On November 26, 2019,
the NYSE proposed a rule that would allow companies conducting a
direct listing to also raise capital through the public markets.
Currently, the direct listing process only permits the resale of
existing shares, not the offer...B. The SEC did not provide details
on rejecting the proposal, but there are a few potential reasons,
including:1. Investors may be unaware of price and dilutive effect
of offerings as described in the NYSE proposal.a) In a traditional
IPO, the price and amount of shares for sale are fixed and there is
limited ability to price above/below range or upsize/downsize.b) In
the NYSE proposal-style open auction, the company can
opportunistically increase or decrease shares at the opening price
with limited disclosure or advance warning to investors.
2. Limiting the types of companies to which direct listing is
available.a) The SEC may want to limit availability of direct
listings to mature, larger companies seeking to provide
shareholders’ liquidity, rather than companies that need to raise
capital, which may use a traditional public offering to achieve
that goal.
C. Amended NYSE Proposal1. The NYSE amended its proposal on
December 11, 2019.2. Under the proposed change, companies which
meet the requirements for a direct listing would have to sell at
least $100 million worth of stock instead of $250 million presented
in the initial proposal.3. The amended proposal also suggests
delaying the 400 round lot shareholder requirement until 90 days
after the listing date.
X. Equity Awards and Other ConsiderationsA. Restricted stock may
vest upon public listing. This is an increasingly common market
practice for technology companies.B. Settlement is a taxable event.
To cover withholding taxes incurred, it is advisable that holders
trade on day one to cover the tax liability. In addition,
withholding tax liability is based on opening price, and payments
may be made by the compan...C. Unlike in a traditional IPO, there
is no offer price to which to refer in order to determine the value
of the equity award settlement, the resulting tax liability and the
number of shares to be traded to cover the liability.1. One focus
of the disclosure in the Slack Form S-1 was how the acceleration of
equity awards and desire to cover the withholding tax by selling
shares into the market would impact trading on the first day.a) In
the Slack Form S-1, the estimated number of shares to be sold at
the opening of trading was based on an estimated opening price
using a recent independent common stock valuation report.
Additional disclosure detailed that the estimate would be ...
D. Definition of “initial public offering” in fund or other
documents.1. A direct listing may not be considered an
“underwritten initial public offering”.2. Shareholder agreements,
registration rights agreements and the terms of preferred stock may
use the term “initial public offering”.3. It is necessary to
consider implications of a direct listing versus underwritten IPO
in this context.
XI. Regulation MA. Regulation M under the Exchange Act is
designed to regulate market manipulation by underwriters, issuers,
selling shareholders and other participants in an offering.B. Its
rules regulate bids and purchases by distribution participants
(which include underwriters), issuers, selling shareholders and
certain of their respective affiliates in connection with a
securities distribution during the “restricted period”.1. The
“restricted period” generally begins five business days before the
pricing date, but may begin one business day prior to pricing if
the security being distributed has an average daily trading volume
of $100,000 and the issuing company’s equity ...2. The “restricted
period” ends when a participant’s participation in the offering is
complete (when the offered securities have been distributed or a
participant has sold its allotment).
C. Regulation M rules also regulate passive market making,
stabilization activities and short sales.D. Regulation M prohibits
trading that could artificially inflate the price of a security or
generate a false impression of active trading.E. The new type of
direct listing used by Spotify and Slack generated questions about
applicability of Regulation M under the Exchange Act to this type
of direct listing. Key questions included:1. whether the
registration of shares for resale under Form S-1/F-1 constitutes an
offering, and if so, in combination with investor outreach and
education, whether such activity constitutes a “distribution” for
purposes of Regulation M; and2. since unlike in a traditional IPO,
there is no underwriting process to set the offering price or the
number of shares to be sold and no clear-cut pre- and post-pricing
times, whether or how participants should observe the restricted
period under Re...
F. In advance of its direct listing, Spotify submitted a
no-action request letter to the SEC, requesting clarification of
the applicability of Regulation M to the listing.1. Spotify
represented to the SEC that the company, financial advisors,
registered shareholders and their respective affiliates would
observe a restricted period commencing on the fifth business day
prior to the designated market maker’s determination...2. Based on
the fact pattern set forth in the no-action request:a) Spotify
would not offer any new shares under the registration statement for
at least 90 days after declared effective;b) Spotify would not
receive any proceeds from sale of shares by shareholders;c) resales
during the effective period would be made solely through ordinary
brokerage transactions into an independent market not controlled by
the company, financial advisors, registered shareholders or their
respective affiliates;d) financial advisors would only be engaged
to provide advice and assistance with respect to the filing of the
registration statement and the listing of shares;e) financial
advisors would not further assist Spotify in the planning of, or
participate in, investor meetings;f) financial advisors would not
engage in any special selling efforts or stabilization/price
support activities;g) timing of resales would be at the sole
discretion of the registered shareholders; andh) financial advisors
would have no discretionary authority to transact in the shares
held in brokerage accounts and no fees or expenses could be paid by
the company or any financial advisors in connection with the
brokerage accounts.
G. The SEC responded that they would not recommend
enforcement.A. Conflict of Interest1. Overviewa) Given the
potential negative repercussions of unrestrained conflicts of
interest on the financial market and the dynamic ways in which
conflicts of interest may arise, lawmakers continually enact new
laws designed to mitigate or eliminate instances...
2. Definitiona) In the context of Reg. BI, a conflict of
interest is defined as “an interest that might incline a broker,
dealer, or a natural person who is an associated person of a broker
or dealer—consciously or unconsciously—to make a recommendation
that is no...
B. Regulation Best Interest1. Overview of Reg. BIa) On June 5,
2019, the SEC adopted rule 15 l-1, Regulation Best Interest (“Reg.
BI”) under the Exchange Act. Reg. BI establishes a new standard of
conduct for broker-dealers and associated persons of a
broker-dealer3F (together, “broker-dealers”) f...b) Prior to the
adoption of Reg. BI, broker-dealers abided by the “suitability”
standard of conduct under which brokers, in advising their
customers, needed only to recommend investments suitable for their
customers; such investments were not required...
2. Broker-Dealer General Obligation to Act in Customers’ Best
Interesta) Reg. BI Rule 15l‐1(a)(1) (hereinafter, the “General
Obligation”) states that “[a] broker, dealer, or a natural person
who is an associated person of a broker or dealer, when making a
recommendation of any securities transaction or investment
strate...b) The General Obligation is fulfilled through
broker-dealer compliance with four component obligations, namely
(1) Disclosure Obligation, (2) Care Obligation, (3) Conflict of
Interest Obligation and (4) Compliance Obligation. Regulation Best
Interes...c) Reg. BI became effective on September 10, 2019, and
has a compliance date of June 30, 2020.
3. Further Discussion of the Four Component Obligations of the
General Obligationa) Disclosure obligation. The broker-dealer,
prior to or at the time of the recommendation, must provide the
retail customer full and fair written disclosure of:i. that the
broker-dealer is acting within a broker-dealer capacity in making
the recommendation;ii. any material fees and costs applicable to
the transaction; andiii. The type and scope of services the
broker-dealer will provide to the retail customer, including any
material limitations on the securities or investment strategies
involving securities that the broker-dealer may recommend.
b) Care obligation. In making a recommendation or series of
recommendations to a retail customer, a broker-dealer must ensure
that the recommendation does not place the financial or other
interest of broker-dealer ahead of the interest of the retail ...c)
Conflict of Interest Obligation. The broker-dealer must establish,
maintain and enforce written policies and procedures reasonably
designed to:d) Compliance Obligation. A broker-dealer must
establish, maintain and enforce written policies and procedures
reasonably designed to achieve compliance with Reg. BI in its
entirety. Exchange Act, Rule 15l‐1(a)(2)(iv).