Supreme Court limits claims for direct listings

Sometimes the Supreme Court surprises us and sometimes the Court reaffirms what we already thought we knew. In Slack Technologies, LLC v. Pirani, No. 22-200, decided on June 1, the Supreme Court, in a unanimous decision by Justice Gorsuch, reiterated that a plaintiff bringing a claim under Section 11 of the Securities Act of 1933 must be able to plead and prove that his shares were registered under the challenged registration statement. The Court, in reversing a decision by the Ninth Circuit Court of Appeals, held that this long-standing principle – dating to the 1960’s – applies even when a company directly lists shares for trading on the New York Stock Exchange, allowing registered and unregistered shares to enter the trading market simultaneously and thereby making it impossible for a plaintiff to show that he bought registered shares. The Court found that even though direct listings are novel, the tracing requirement under Section 11 remains unchanged. However, in remanding the case to the Ninth Circuit for further consideration, the Court dropped a tantalizing footnote suggesting that the plaintiff might still have a viable claim under another provision of the Securities Act.

The decision concerned 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). As the Court explained, 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 lockup period in which corporate insiders or others cannot sell stock, including unregistered stock sold under SEC Rule 144.

However, several high-tech companies, including Slack, that had no immediate need for additional capital but wanted to permit public trading of their stock, decided to avoid the significant transaction costs of an IPO by taking 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 underwriter and therefore no lock-up period, a direct listing enables all shares, registered and unregistered, to be sold to the public immediately. According to the Court, Slack’s direct listing offered for purchase 118 million registered shares and 165 million unregistered shares.

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 likely 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.

Plaintiff Fiyyaz Pirani purchased 30,000 Slack shares on the day that Slack went public and an additional 220,000 over the next few months. 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. Similarly, Judge Illston gave the phrase “such security” in Section 12(a)(2) the same broad reading. 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. 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 biting dissent, Judge Eric Miller accused the majority of disregarding well-established precedent, the legislative history and the settled interpretation of the statutory text.

Justice Gorsuch’s analysis acknowledged that there was no clear definition of “such security” found in Section 11(a) of the 1933 Act and therefore the meaning must be determined from the “context and circumstances.” But the context supplied “several clues.” First, Section 11 imposes liability for false statements in “the” registration statement, not just any registration statement. Second, the Securities Act repeatedly uses the word “such” to focus on particular things or statements. Thus, the reference to “such security” speaks to a security registered under the registration statement containing the allegedly misleading statement or omission. Further, other provisions in the Securities Act plainly refer to “such security” as securities subject to registration. Finally, Section 11(e) ties the maximum available recovery under Section 11 to the value of registered securities. All these provisions, according to the Court, contradict Pirani’s effort to provide an expanded reading of Section 11.

Pirani argued that if Congress wanted liability under Section 11 to apply only to securities issued pursuant to a specific registration statement, it could have used the language of Section 5 that imposes liability for the offer or sale of any security unless a registration statement has been filed as to such security. But the Court pointed out that Congress also could have written Section 11(a) to have stated expressly that liability is created by the sale of “any” security having some relationship to a registration statement.

The Court also swatted down Pirani’s policy arguments for a broader reading of Section 11 in order to allow liability for a registration statement’s false and misleading statements in a direct listing. The Court noted that Section 11 imposes essentially strict liability for misstatements in a registration statement, while Section 10(b) of the Securities Exchange Act of 1934 permits a 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, deceive or manipulate. Thus, Congress may have “sought a balanced liability regime that allows a narrow class of claims to proceed on lesser proof but requires a higher standard of proof to sustain a broader set of claims.” Only Congress, not the Court, may disturb this balance.

Pirani’s lawsuit, however, may not be extinguished. It is noteworthy that the Court’s decision addressed only the Section 11 claim but not the Section 12(a)(2) claim. In remanding the case to the Ninth Circuit for further consideration, the Court observed in a footnote that it had no need to express its views about the proper interpretation of Section 12 or its application in this case. More significantly, the Court stated: “Nor do we endorse the Ninth Circuit’s apparent belief that §11 and §12 travel together, but instead caution that the two provisions contain distinct language that warrants careful consideration.”

This statement seemingly reflects the statements of several Justices at oral argument that the text of Section 12(a)(2) permits claims for the purchase of unregistered securities. These Justices brushed off objections by Slack’s counsel that a 1995 Supreme Court decision limited Section 12 claims to public offerings of registered securities. It remains to be seen whether the Ninth Circuit will accept the Supreme Court’s implicit invitation to re-examine the scope of Section 12 liability to determine whether it is distinct from Section 11.

The Slack decision has been hailed as a victory for direct listings, but the effect may be overstated. Because most companies go public to raise funds, relatively few companies have taken advantage of the NYSE rule. Further, still looming is the question of the viability of Section 12(a)(2) claims.