Supreme Court to consider relaxing barrier to securities suits

In a case that could significantly relax the barriers to private securities lawsuits against companies going public, the Supreme Court next month will consider whether a direct listing on an exchange eliminates the need for a claim under the Securities Act of 1933 to prove that the plaintiff bought stock issued pursuant to the registration statement that allegedly contained misrepresentations. The Court, in oral argument set for April 17, will hear an appeal from a Ninth Circuit decision holding that a direct listing removes the long-standing requirement that a plaintiff bringing a Securities Act claim “trace” his shares to the challenged registration statement.

The case, Slack Technologies, LLC v. Pirani, No. 22-200, concerns claims brought against Slack, a software company (now owned by Salesforce) that markets a real-time messaging platform, under Sections 11 and 12(a)(2) of the Securities Act after Slack went public in 2019 by means of a direct listing on the New York Stock Exchange (NYSE). In a typical initial public offering (IPO), a company raises capital by selling stock at a predetermined price to an investment banking syndicate, which in turn resells the stock to the public at a higher price. In order to support the stock price, the underwriters typically impose a six-month (or longer) lockup period in which corporate insiders or others cannot sell stock, including unregistered stock sold under SEC Rule 144.

By contrast, several high-tech companies, including Slack, that had no pressing need for additional capital, but wanted to permit public trading of their stock – while also avoiding the significant transaction costs of an IPO – decided to take advantage of a new 2018 NYSE rule, approved by the Securities and Exchange Commission (SEC), allowing companies to directly list their shares for trading on the NYSE when a registration statement filed with the SEC became effective. Because there is no need for a lock-up period to support the stock price, a direct listing enables all shares, registered and unregistered, to be traded immediately.

That situation presents potentially insurmountable hurdles for a plaintiff asserting claims under Section 11 and 12(a)(2) for alleged misstatements in the registration statement and the prospectus that is part of the registration statement. Section 11 provides near-strict liability for misstatements in a registration statement to any person “acquiring such security.” Section 12(a)(2) imposes negligence-based liability on anyone who offers or sells a security “by means of a prospectus” with a material misstatement “to the person purchasing such security from him.” Courts have held for more than half a century that the textual reference to “such security” limited Section 11 and 12(a)(2) claims to plaintiffs who could show that they purchased securities issued under the registration statement and prospectus at issue. Thus, a plaintiff who could not “trace” his shares to a particular registration statement or prospectus was precluded from bringing claims against that specific filing.

In this case, Slack’s common stock began trading on the NYSE on June 20, 2019 after its Form S-1 registration statement and a prospectus were declared effective by the SEC. No new shares were issued, but insiders and corporate investors were able to sell existing shares into the market immediately upon Slack’s listing. Plaintiff Fiyyaz Pirani purchased a total of 250,000 Slack shares after the direct listing. When Slack’s stock price declined sharply following service disruptions, Pirani filed an action against Slack, as well as certain officers, directors, and venture capital investors, alleging violations of Section 11 and 12(a)(2) on the ground that Slack’s registration statement and prospectus contained false and misleading statements concerning the company’s financial condition and business practices.

The defendants’ threshold argument for dismissal was that the plaintiff could not plead or prove that his stock was issued pursuant to the registration statement being attacked, because his stock purchase was in a market comprised of a mix of registered and unregistered stock. Judge Susan Illston of the United States District Court for the Northern District of California, characterizing the case as a “matter of first impression,” held that the phrase “such security” in Section 11 warranted a broader reading in a direct listing to permit an action where the security purchased “was of the same nature” as that issued pursuant to the registration statement. Otherwise, the court held, the policy underlying the Securities Act of providing remedial action for false registration statements would be negated. Similarly, Judge Illston gave the phrase “such security” in Section 12(a)(2) the same broad reading as for Section 11. See 445 F. Supp. 3d 367 (N.D. Cal. 2020). But recognizing the unprecedented nature of the case, Judge Illston granted interlocutory appeal.

The Ninth Circuit rejected Judge Illston’s broad reading of “such security.” But in a 2-1 decision, the court held that under the NYSE’s rules, Slack’s unregistered shares could not begin trading until the registration statement became effective. Thus, Slack’s unregistered shares were also “such securities” under Section 11 because their public sale could not have occurred without the only operative registration statement in existence. Further, a contrary holding “would contravene the text of the statute” and encourage companies to go public through a direct listing because there would be no Section 11 liability for false statements. Such an interpretation “would create a loophole large enough to undermine the purpose of Section 11 as it has been understood since its inception.” The Ninth Circuit noted that prior decisions upholding a tracing requirement did not concern a direct listing. The court applied the identical analysis to permit an action under Section 12(a)(2). See 13 F. 4th 940 (9th Cir. 2021). In a blistering dissent, Judge Eric Miller accused the majority of disregarding well-established precedent, the legislative history and the settled interpretation of the statutory text. Defendants filed a petition for certiorari, which was granted by the Supreme Court on Dec. 13, 2022.

Slack’s brief filed with the Court presents a wide-ranging broadside against the Ninth Circuit decision. First, Slack asserts that the structure of the Securities Act and the legislative history demonstrates conclusively that the phrase “such security” was intended to apply only to registered securities, as courts had held for more than 50 years. Further, Slack argued, adopting the lower court’s analysis would undermine the “delicate balance” between the Securities Act and the Securities Exchange Act of 1934. The Securities Act was intended to apply to alleged misstatements in offerings, and allows private plaintiffs to bring lawsuits with a low threshold for proving liability but only when the claim is tied to a specific registration statement or prospectus. By contrast, Section 10(b) permits a private plaintiff to bring claims with respect to the purchase of any security, registered or unregistered, but only if the plaintiff can plead and prove scienter, i.e., an intent to defraud. Further, private plaintiffs bringing Section 10(b) actions must satisfy the heightened pleading requirements of the Private Securities Litigation Reform Act. The Supreme Court previously has recognized the interrelatedness of the provisions of the Securities Act and the Exchange Act. See Herman & MacLean v. Huddleston, 459 U.S. 375 (1983).

Nor would eliminating the tracing requirement for direct listings provide a license to lie in a registration statement. Private plaintiffs could still bring lawsuits under Section 10(b) of the Exchange Act and the SEC (but not private plaintiffs) may bring actions for false statements in offering materials under Section 17(a) of the Securities Act.

Slack also seeks to turn policy arguments in its favor. Slack noted that in a typical IPO unregistered shares may trade after the lockup period expires, but only because there is an operative registration statement in existence. Thus, under the rationale adopted by the Ninth Circuit, the tracing requirement would be eliminated even for trading in those shares. Further, the Ninth Circuit’s decision would stifle innovation in the securities markets. Finally, any modification of the regulatory framework should be addressed by the SEC or Congress. But the courts should not upend decades of settled precedent based on dubious policy considerations. According to Slack, leaving policy adjustments to the political branches would permit “more tailored ways” to address the concerns of the courts below, while “endorsing the blunt solutions of those courts” would result in a “dramatic overnight expansion of the scope of liability” under the Securities Act and suppress capital formation and innovation.

For his part, plaintiff Pirani argued in his brief that statutory reference to “such security” in Section 11 was ambiguous and given the textual ambiguity, the Ninth Circuit “properly considered the statutory design.” The SEC had approved the direct listing process on the NYSE on condition that the company going public filed a registration statement so that investors could rely on valuing shares as in a typical IPO. Pirani asserted that the statutory scheme would be thwarted if investors could rely on a Section 11 remedy only if they could provide that they purchased registered shares, which they could not know at the time of purchase. Recovery would be denied even to purchasers of registered shares because it would be impossible to determine which shares were registered. Congress, Pirani argued, did not intend such a result. Congress did not “intend for Section 11 to apply to a random, freakish assortment of cases as a way of making up for the high standards that it set for issuers.”

In reality, both Slack and the Ninth Circuit may have exaggerated the risks and benefits of direct listings. Relatively few companies have gone public through direct listings, rather than a typical IPO, given that most companies want to raise capital through a public offering.

As Yogi Berra reportedly stated, it’s tough to make predictions, especially about the future. But the conservative Supreme Court rarely decides to consider appeals from a pro-plaintiff Ninth Circuit decision just to affirm (although it has happened, see Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27 (2011)). If the Court reverses, the most significant aspects will be first, the Court’s analysis and commentary of shareholder rights and the securities laws, and second, any SEC regulatory response.