9th Circuit approves securities claims in direct listing offerings

In a landmark ruling, a divided 9th U.S. Circuit Court of Appeals gave the green light for securities actions against companies that went public through direct listing on stock exchanges, even though, as historically has been required, the plaintiff could not show that his stock was issued pursuant to the challenged registration statement. The much-anticipated decision in Pirani v. Slack Technologies, Inc., 2021 DJDAR 9809 (9th Cir. Sept. 20, 2021), will force companies and securities lawyers to consider the potential increased liability for companies that choose the direct listing approach to go public.

Companies typically go public by filing a registration statement with the U.S. Securities and Exchange Commission and then having their offering underwritten by investment banks who purchased the securities from the company and sold them to the public. Because the banks want a stable market for the newly issued securities, they typically impose a months-long "lockup" that prevents corporate insiders and investors from immediately selling their stock. But in 2018, the New York Stock Exchange issued a new rule, approved by the SEC, that permitted companies to go public by directly listing their shares on the NYSE. Unlike a classic initial public offering, a company does not issue any new shares but files a registration statement to allow existing shareholders to sell their stock. The shares are sold directly to the public rather than through a bank. Further, because there is no underwriters' lockup, insiders and shareholders can also sell their unregistered shares immediately so long as they comply with SEC Rule 144. In Slack's offering in June 2019, the company simultaneously released 118 million registered shares and 165 million unregistered shares into the public market.

According to the 9th Circuit's opinion, plaintiff Fiyyaz Pirani purchased 30,000 Slack shares on the day of the direct listing and another 220,000 shares during the following months. When the stock price dropped from $38.50 to $25 after reported service disruptions, Pirani filed a lawsuit against Slack, its officers, directors and venture capital investors alleging violations of Section 11, 12(a)(2) and 15 of the Securities Act of 1933. Pirani asserted that Slack's registration statement was materially false and misleading because it failed to disclose purportedly generous compensation to customers for service disruptions and downplayed the competition from Microsoft.

But the defendants contended that Pirani lacked the statutory standing to pursue his action. Section 11 permits a person purchasing "such security" to allege that a registration contained an untrue statement of a material fact or a material omission. Section 12(a)(2) permits an action by a person who purchases "such security" from any person who offers or sells a security by means of a materially false or misleading prospectus. Plaintiffs bringing Section 11 claims historically had to show that the shares they purchased could be "traced" to the allegedly false registration statement, which is impossible where the plaintiff bought in a market containing both registered and unregistered shares, or when there had been multiple registered offerings. See In re Century Aluminum Co. Sec. Litig., 729 F. 3d 1104 (9th Cir. 2013) (plaintiff must be able to trace shares to registration statement to bring Section 11 claim). But these cases did not address a situation in which registered and unregistered entered the market simultaneously.

Judge Susan Illston of the U.S. District Court for the Northern District of California held that dismissing the claims because of the tracing requirement would defeat the congressional intent to permit remedial measures under Sections 11 and 12 for defective registration statements. Thus, the district court held that the phrase "such security" in Section 11 had to be given a broader reading: "acquiring a security of the same nature as that issued pursuant to the registration statement," 445 F. Supp. 3d 367 (N.D. Cal. 2020), alluding to an analysis discussed but ultimately rejected in Barnes v. Osofsky, 373 F.2d 269 (2d Cir. 1967). Judge Illston, however, certified the court's Order for interlocutory appeal because the matter was one of first impression "on which fair-minded jurists might disagree." First addressing standing under Section 11, Judge Jane A. Restani (a senior judge on the Court of International Trade sitting on the 9th Circuit panel by designation), supported by 9th Circuit Chief Judge Sidney R. Thomas, rejected Judge Illston's broad definition of the statute and instead focused on the textual meaning of "such security." The court held that Slack's unregistered securities sold in the direct listing are "such securities" within the meaning of Section 11 "because their public sale cannot occur without the only operative registration [statement] in existence" and any person who bought Slack securities "through its direct listing could do so only because of the effectiveness of its registration statement." Because there was only one registration statement, there was not the traceability problem presented by multiple offerings.

Section 11's legislative history, the court asserted, supported this result. Congress intended that issuers of securities accept responsibility for false registration statements. But precluding liability in the direct listing context would permit companies to file misleading registration statements knowing that there was no Section 11 liability. Accepting Slack's interpretation of Section 11 "would create a loophole large enough to undermine the purpose of Section 11 as it has been understood since its inception."

The analysis of Section 12(a)(2) standing was identical. Neither the registered nor unregistered shares could be offered without the filing of offering materials. The plaintiff therefore satisfied Section 12(a)(2)'s requirement that the stock was sold pursuant to a prospectus. The court declined to address defendants' arguments that Section 12, unlike Section 11, requires privity because the plaintiff must have purchased the security directly from the issuer of the prospectus. The court held that this issue was not the basis for interlocutory appeal and did not raise a novel or controlling question of law. Thus, this argument should remain open for defendants to pursue. The court also held that because there was standing to bring the Section 11 claim, plaintiff also could bring control person liability under Section 15 of the Securities Act.

In a caustic dissent, Judge Eric D. Miller accused the majority of only pretending to obey the statutory text while disregarding it. That the case involved a direct listing rather than successive offerings was a meaningless distinction, because it did not affect the statutory requirement that the plaintiff demonstrate that the purchased security was issued under the allegedly false registration statement. Judge Miller held that the policy considerations were no basis for ignoring the statutory text.

Judge Miller stated that disgruntled investors could still bring lawsuits under Section 10(b) of the Securities Exchange Act of 1934. But that contention ignores the dissimilar burdens on plaintiffs in the two statutes: unlike Section 11, Section 10(b) requires proof that defendants acted with scienter and that the plaintiff relied upon the alleged misrepresentations. Further, a plaintiff in a Section 10(b) bears the burden of showing loss causation while Section 11 provides an affirmative defense that the stock price drop was not attributable to the misrepresentation.

What next? Slack could seek a rehearing en banc by the 9th Circuit or file a petition for writ of certiorari to the U.S. Supreme Court. The decision's novel interpretation of the 1933 Act and its importance to the securities markets make the case ripe for Supreme Court consideration, particularly if other Circuit Courts take a contrary position. Securities lawyers also will undoubtedly explore ways of modifying the direct listing approach in order to address the holding in Pirani. For example, the court observed that Pirani's shares could have been registered in a different registration statement, presenting the same "traceability conundrum" as in past cases, but that factual scenario was not present. 