by Graham Ellis*
Section 11 of the Securities Act imposes liability on five groups, the fifth of which is underwriters, for damage caused by untrue or misleading information in the Resale Registration Statement of a securities transaction. In a typical initial public offering, underwriters purchase securities from the issuing company and then resell those securities to the investing public at a higher price, pocketing the difference for themselves. Additionally, underwriters usually engage in a roadshow to build a book of investor interest.
Scholars have elaborated a justification for underwriter liability within the Securities Act, explaining that liability is necessary because such actors are gatekeepers. By adding credibility to the issuing company and establishing an important connection between the company and the investing public, the underwriter is responsible for the trustworthiness of the issuing company and the transaction’s representations to the public.1 These banks must be incentivized to exercise care in their role as intermediaries.2
The statutory definition of “underwriter” includes three categories: buyers, sellers and offerors, and participants.3 Debates over the meaning of “participant” within this definition have circulated throughout the courts. However, courts may face increased pressure to unify their approach to this question as a result of the emergence of direct listings.
Direct listings are an alternative public offering approach. In a direct listing, shareholders sell existing shares to the public upon listing on the New York Stock Exchange. There is no issuance of new shares as there is in an initial public offering. Because there are no stocks to purchase and then resell, direct listings do not typically involve a traditional underwriter. Instead, investment banks are typically brought in to act as “financial advisors” for the issuing company. Given the relatively novel nature of these transactions and their rising frequency,4 the role of these “financial advisors” is largely undefined. But in prominent direct listings such as Spotify’s, such financial advisors often assist with the registration and listing of the transaction, the drafting of legal forms, and the creation of public communications and investor presentations.5
As a result of this new form of securities distribution, the debate regarding the scope of statutory underwriter liability has reignited. The courts have not yet addressed whether financial advisors in a direct listing should be liable as statutory underwriters. Several scholars argue courts should hold financial advisors liable under the aforementioned “participant” category, asserting that financial advisors’ role in direct listings implicates Congress’s initial purpose in assigning liability to gatekeepers.6 According to these scholars, financial advisors need a legal incentive to properly weed out untrustworthy companies from going forward with a direct listing, and underwriter liability provides such an incentive.7 Additionally, the gatekeeper justification for liability is perhaps even stronger for direct listings because such transactions are an innovation. The investing public has less knowledge about how these transactions function, and, therefore, relies on the institutional knowledge and assurances of financial advisors to a greater extent.8
However, given the increasing importance of direct listings and their genuine benefits, the courts should avoid assigning blanket liability to financial advisors. Doing so would drive up the costs of these transactions, a fact that even proponents of liability concede, and reduce their usefulness.9 In addition, bringing in such financial advisors as underwriters would require an interpretation of the statutory language that risks including a seemingly endless list of actors that perform none of the traditional gatekeeping duties of an underwriter.10
As such, instead of assigning blanket liability to all financial advisors in a direct listing transaction, the courts should assess whether those actors engaged in gatekeeping activities on a case-by-case basis. This approach provides the necessary incentive for investment banks to act carefully in putting forward companies for public offerings while also cabining liability in a way that is coherent and true to Congress’s initial purpose.
First, it is important to understand the current state of underwriter liability and the existing approaches of the courts. These disagreements provide ample space for the potential assignment of liability to financial advisors. Several circuits have interpreted the statutory definition of an underwriter broadly, assigning liability to a range of actors that do not perform the typical roles of an underwriter. These circuits have determined that actors who meet a certain level of importance to the transaction fit within the “participant” or “sell or offer” categories of the statutory definition.11
The Seventh Circuit case Harden v. Raffensberger provides a useful distillation of this approach. In Harden, the issuing company used its own subsidiary to underwrite its public offering. In such situations, New York Stock Exchange rules require qualified independent underwriters to sign-off on the transaction to assure the investing public that the issuing company was trustworthy.12 The court found that such independent underwriters, who perform none of the traditional functions of an underwriter, are statutory underwriters under the “participant” category because they were necessary for the transaction to move forward.13
Often, these assignments of liability are justified as responsive to Congress’s initial purpose in creating underwriter liability. The Seventh Circuit’s opinion in Harden, for example, focused on the defendant’s role in signaling the trustworthiness of the issuing company to the investing public as an assumption of liability.14 The Second Circuit’s broad definition of “underwriter” in SEC v. Chinese Consol. Benevolent Society appears more focused on ensuring that actors involved in connecting the investing public to the issuer be liable as gatekeepers.15 In both cases, however, there is an attempt to hold actors liable as underwriters if they push companies onto the investing public. As a result, their use of various tests and broad interpretations of the statutory language seem to be mere mechanisms to reach this result.
However, other circuits have interpreted the statutory definition to refer to a narrower set of actors by limiting the scope of the “participant” category. In doing so, these circuits cabin underwriter liability to actors that perform the more traditional roles of an underwriter. They reject the “necessary” test as overinclusive, and, instead, insist that the “participant” category should be interpreted to only include participants in the actual exchange of securities at the core of the transaction.16
In re Lehman Brothers Mortgage-Backed Securities Litigation provides a useful example of this approach. There, the Second Circuit found that credit rating agencies were not statutory underwriters despite the plaintiffs’ arguments that they fit under the “participant” definition because they were necessary to the transaction. In doing so, the Second Circuit held that the statutory definition should be read to bring in actors essential “to the actual distribution of securities” rather than any actor that was important to the transaction.17 The Second Circuit asserted that this reading of the definition was required to avoid expanding liability to actors that merely facilitated the transaction.18
The Second Circuit is right to have concerns. An unrestrained interpretation of “underwriter,” which includes any actor deemed “necessary” by the courts, could lead to liability being assigned to actors far outside Congress’ original intent. For example, law firms are frequently integral actors in a securities distribution, and their role is arguably “necessary” for the transaction to move forward. However, law firms play no gatekeeping role between the investing public and the issuing company that would suggest they should be liable. Though the existing opinions that utilize broad interpretations of “underwriter” do not reach this far, and though they arguably only utilize such interpretations to ensure real gatekeepers are held liable, such opinions still create a slippery slope for the possibility of the complete deconstruction of a workable definition.
However, even the Second Circuit acknowledges that the statutory definition of underwriter includes not just traditional underwriters. Its definition attempts to clarify that other actors can still be liable if they are deemed essential to the “actual distribution” of securities.19 Despite this acknowledgement, in reading the “participant” category so narrowly, the court threatens to extinguish the courts’ ability to hold proper gatekeepers accountable. While it distinguishes Harden by pointing out that the Seventh Circuit relied on the independent underwriter’s assumption of liability by stepping into the gatekeeper role of promoting public trust in the issuing company, it is unclear how such factors could be considered under the Second Circuit’s reading of the statute.20
Instead, the courts should adopt a compromise approach that both assigns liability to participants who act as gatekeepers and prevents the statutory definition of underwriter from being continuously expanded. Courts should read “participant” within the statutory definition to include actors that both serve as conduits between the investing public and the issuing company and publicly vouch for the company’s trustworthiness. Focusing underwriter liability on these two factors, as opposed to the arbitrary test of whether someone is “necessary,” effectively limits the scope of potentially liable actors and centers the analysis on the purpose behind assigning underwriter liability. It also guarantees that actors cannot escape liability merely by avoiding the mostly unhelpful markers of traditional underwriters, such as putting on a road show. Finally, this approach represents the best consolidation of current caselaw, as every circuit could apply it without overturning existing precedent.
Capturing conduits between the investing public and issuing companies within the statutory definition of “underwriter” comports directly with the purpose of assigning Section 11 liability to gatekeepers.21 In searching for signals of conduit status, the courts would evaluate the role the defendant played in relaying important information or funds between the investing public and the issuing company. A focus on conduit status would encapsulate several traditional indicia that courts have looked to in the past: book-building, roadshows,22 and the exchange of funds.23 In addition, it is important that such an inquiry be limited to a “two-way street.” Rather than assigning liability to marketing companies, the press, and others who merely distribute information about the company to investors, the courts should instead assess whether actors also take valuable information from the investing public to the issuing company, such as overall demand and price points. In doing so, courts would expand underwriter liability to include actors responsible for helping untrustworthy companies adapt to the necessities of the market while excluding mere messengers and facilitators.24
Capturing actors who vouch for the credibility of the issuing company, in any form, similarly comports with the purpose of incentivizing gatekeepers to take reasonable care in pushing companies onto the investing public. The Seventh Circuit in Harden implicitly adopted this analysis in its discussion of the defendant’s performance of the “same protective function envisioned by the 1933 Congress.”25 Other courts have similarly pointed to the importance of a public endorsement of the issuing company in assigning liability to gatekeepers.26 Indeed, limiting liability to actors who publicly endorse the issuing company simply makes sense. Without a public declaration of support, there can be no contention that the actor pushed the company onto the investing public at all, which is the chief concern regarding gatekeepers.27
However, courts should avoid needless formalism and should refuse to allow defendants to escape liability through clever disclaimers. Instead, the analysis should center on the public’s perception of the actor’s conduct by asking whether a reasonable person in the investing public would gain confidence in the issuing company as a result of the actor’s behavior. Of course, this test is flexible, and critics will argue it creates too vague of a standard against which involved parties can adapt their behavior or that it will result in fewer protections for the investing public by allowing financial advisors to escape liability under certain circumstances. However, it effectively excludes actors who remain behind the scenes in a transaction while also properly incentivizing actors who may satisfy its test to take care in their promotion and investigation of the issuing company. The fear of potential liability, plus the incentive to exercise due care that the due diligence defense for underwriters creates, provides ample protection without overexpanding the definition of underwriter.28
Utilizing these two standards, as opposed to the infinitely broad “necessary” test of the Seventh Circuit or the severely limited approach of the Second Circuit in Lehman Brothers, also best reconciles the diverging opinions on the scope of underwriter liability. As stated, the courts appear to be adopting broad or narrow readings of the statutory definition in an attempt to best reflect the purpose of assigning liability to gatekeepers.29 Rather than require the courts to first wrestle with their preferred scope, the proposed test of evaluating gatekeeper qualities would implant that purpose-based analysis into the actual interpretation of the statute, providing a clear definition and a textual basis for conducting the same analysis that most courts have already been doing.
Because the role of financial advisors in a direct listing remains largely undefined, it makes sense to apply this gatekeeper liability test to the particular facts of the transaction as opposed to creating a blanket rule of inclusion or exclusion. For example, a financial advisor who both uses its network to assess demand and markets a company to the investing public may satisfy this test as a conduit. However, a financial advisor who merely prepared slides that were shown to investors and helped summarize a company’s financial information would not be held liable. Similarly, an investment bank that signs the registration statement and prospectus of the issuing company may be liable because it lent its credibility to the transaction publicly, yet a financial advisor who played no public role in the transaction would fail to satisfy the test.
These results are in line with the overall purpose of underwriter liability and properly incentivize financial advisors against using direct listings as a work-around of liability.
Instead of squabbling over the correct line to draw in interpreting the statutory definition of “underwriter,” the courts should instead lead with an analysis of the defendant’s gatekeeping functions. This analysis effectively cabins liability to a coherent set of actors, which reflects Congress’s purpose and policy considerations. Financial advisors in a direct listing should be evaluated in the same manner, and their liability as underwriters should depend on whether they acted as conduits in the transaction or publicly expressed confidence in the issuing company.
* Graham Ellis is a J.D. Candidate (2022) at New York University School of Law. This piece is a commentary on the 2021 problem at the Irving R. Kaufman Memorial Securities Law Moot Court Competition in New York, hosted by the Fordham University School of Law. The issue in the problem dealt with the question of whether investment bankers that act as financial advisors in a direct listing transaction are statutory underwriters for purposes of liability under Section 11 of the Securities Act. The views expressed in this article do not necessarily represent the views of the author on this point of law. Rather, this article is a distillation of one side of the arguments made by the team at the Irving R. Kaufman Memorial Securities Law Competition.
1. See, e.g., Reiner H. Kraakman, Corporate Liability Strategies and the Costs of Legal Controls, 93 Yale L.J. 857, 890 (1984).
2. Ronald J. Gilson & Reinier H. Kraakman, The Mechanisms of Market Efficiency, 70 Va. L. Rev. 549, 613–21 (1984) (discussing the role of investment banks as reputational intermediaries between issuers and investors).
3. 15 U.S.C. § 77b(a)(11).
4. See Yunpegn (Patrick) Xiong: J.D. Candidate 2021, SPACs and Direct Listings: The Death Knell for Traditional IPOs?, Berekley Law School; Vol. 109 Executive Editor, Calif. L.Rev. (explaining the rise of direct listings and their benefits).
5. See, e.g., Benjamin J. Nickerson, The Underlying Underwriter: An Analysis of the Spotify Direct Listing, 86 U. Chi. L. Rev. 985, 1014 (2019).
6. Id. at 1014–24.
7. See, e.g., Anat Beck, Robert Rapp, & John Livingstone, Investment Bankers as Underwriters–Barbarians or Gatekeepers? A Response to Brent Horton on Direct Listings, 73 S.M.U. L. Rev. F. 251, 256–58 (2020).
8. See Gilson, supra note 3, at 618 (“Our analysis suggests that investment bankers play a third role, that of an information and reputational intermediary, which is particularly important in the context of new issues and other innovations.” (emphasis added)).
9. Nickerson, supra note 6, at 1014.
10. See In re Lehman Brothers Mortg. Backed Sec. Litig., 650 F.3d. 167, 177–80 (2d Cir. 2011).
 See, e.g., SEC v. Platforms Wireless Int’l Corp., 617 F.3d 1072, 1086 (9th Cir. 2010) (requiring undewriters to be an “essential cog in the machine”); SEC v. Int’l Chem. Dev. Corp., 469 F.2d 20, 32 (10th Cir. 1972) (defining participators as performing a “vital aspect in the steps necessary to the distribution”); Harden v. Raffensberger, Hughes & Co., 65 F.3d 1392, 1403 (7th Cir. 1995) (utilizing the Seventh Circuit’s necessary test).
12. See NYSE Guide Rule 5121(a)(2) (CCH).
13. Harden, 65 F.3d at 1403 (assigning underwriter liability to an independent underwriter that took no actual role in the transaction).
14. Id. (noting that issuers could mislead investors in explaining why assigning liability is important).
15. See SEC v. Chinese Consol. Benevolent Soc’y, 120 F.2d 738, 740–41 (2d Cir. 1941) (“But the aim of the Securities Act is to have information available for investors. This objective will be defeated if buying orders can be solicited which result in uninformed and improvident purchases.”).
16. See, e.g., In re Lehman Brothers, 650 F.3d 167, 182 (adopting, generally, a narrower definition).
17. Id. at 176–80.
18. Id. at 181 (noting the risk of bringing in every actor that had any role in the transaction under the definition).
19. Id. at 176.
20. Id. at 179 (“Moreover, Harden is easily distinguished from the instant case . . . .”).
21. See SEC v. Lybrand, 200 F. Supp. 2d 384, 393 (S.D.N.Y. 2002) (quoting Thomas Lee Hazen, The Law of Securities Regulation 431 (4th ed. 2002)).
22. See N.J. Carpenters Vacation Fund v. Royal Bank of Scot. Grp., PLC, 720 F. Supp. 2d 254, 263 (S.D.N.Y. 2010) (stating that marketing securities to investors and assisting in investor road shows would be factual evidence of underwriter status).
23. See generally, SEC v. Chinese Consol. Benevolent Soc’y, 120 F.2d 738 (2d Cir. 1941).
24. See In re Lehman Brothers Mortg.-Backed Sec. Litig., 650 F.3d 167, 181 (2d Cir. 2011) (explaining the need to avoid assigning liability to all actors that merely facilitate the transaction).
25. See Harden v. Raffensberger, Hughes & Co., 65 F.3d 1392, 1403 (7th Cir. 1995).
26. See, e.g., McFarland v. Memorex Corp., 493 F. Supp. 631, 646 (N.D. Cal. 1980) (“Underwriters are subjected to liability because they hold themselves out as professionals who are able to evaluate the financial condition of the issuer.“); In re Refco, Inc. Sec. Litig. 503 F. Supp. 2d 611, 629 (S.D.N.Y 2007) (“Plaintiffs have alleged no facts suggesting the Bond Underwriter Defendants held themselves out in any respect as to the public offering; on the contrary, any role they may have played in that offering was never publicly acknowledged.”).
27. Brent J. Horton, Spotify’s Direct Listing: Is It a Recipe for Gatekeeper Failure?, 72 S.M.U. L. Rev. 177, 188–91 (2019) (expressing concern that companies are “thrusting a troubled company on potential investors”).
28. See 15 USC § 77k(b)(3), (c). For the leading case on the “due diligence” defense, see Escott v BarChris Construction Corp, 283 F. Supp. 643, 682–703 (S.D.N.Y. 1968) (establishing standards of “reasonable” diligence for lawyers, accountants, and underwriters as a defense to § 11 claims). See also Ernest L. Folk III, Civil Liabilities under the Federal Securities Acts: The BarChris Case Part I—Section 11 of the Securities Act, 55 Va. L. Rev. 1, 19–49 (1969) (summarizing due diligence defenses under the Securities Act).
29. See Harden, 65 F.3d at 1403 (justifying liability on the grounds that it is necessary to protect the public); see also In re Lehman Brothers Mortg. Backed Sec. Litig., 650 F.3d 167, 183 (2d Cir. 2011) (justifying exemption from liability because the credit rating agency did not assume liability by merely boosting confidence in the transaction).