When the SEC was considering the NYSE's proposal to permit direct listings of primary offerings, one of the frequently raised problems related to the potential "vulnerability" of "shareholder legal rights under Section 11 of the Securities Act." Section 11 provides standing to sue for misstatements in a registration statement to any person acquiring "such security," typically interpreted to mean a security registered under the specific registration statement. The "vulnerability" was thought to arise as a result of the difficulty plaintiffs may have-in a direct listing where both registered and unregistered shares may be sold at the same time-in "tracing" the shares purchased back to the registration statement in question. In approving adoption of the NYSE rule, the SEC said that it did not "expect any such tracing challenges in this context to be of such magnitude as to render the proposal inconsistent with the Act. We expect judicial precedent on traceability in the direct listing context to continue to evolve," pointing to Pirani v. Slack Technologies. As the NYSE had observed, only the district court in Slack had addressed the issue, and had concluded that, at the pleading stage, plaintiffs could still pursue their claims even if they could not definitively trace the securities they acquired to the registration statement. However, the NYSE noted, the case was on appeal. (See this PubCo post.) That appeal, Pirani v. Slack Technologies, has just been decided by a three-judge panel of the 9th Circuit. The Court affirmed, with one dissent, the district court's order, ruling that the plaintiff had standing to sue under Section 11.
Essentially, a "direct listing" involves a registered sale directly into the public market through an exchange with no intermediary underwriter, no underwriting commissions (just advisory fees) and no roadshow or similar expenses. In contrast to an underwritten IPO, there is no initial sale to an underwriter or pre-opening sale by the underwriter to the initial purchasers. Instead, initial sales are conducted through the exchange, with initial pricing set during the opening auction, not by agreement among the company and underwriters, as in a traditional IPO. Initially, the NYSE had permitted only selling shareholder direct listings, in which the company does not issue or register any new shares; instead, the company files a registration statement only for secondary sales by existing shareholders, allowing them to sell their shares to the public on the relevant exchange. In December 2020, the SEC approved the NYSE rule proposal to allow primary direct listings, in which the company issues and registers new shares for direct sale on the exchange. (See this PubCo post.)
A number of commenters on the NYSE proposal to allow direct primary listings raised concerns about Section 11. For example, the Council of Institutional Investors contended that the "proposal compounds the problems shareholders face in tracing their share purchases to a registration statement." In response, the NYSE argued that "the Section 11 and traceability concerns are due to the potential lack of lockup agreements, which are neither prohibited nor required by the proposal or any other law or regulation, rather than to anything inherent in direct listings themselves or the Exchange rules permitting them to be listed." In addition, the NYSE contended, the traceability requirement may create difficulties under Section 11 in many situations that do not involve direct listings, and the SEC agreed that the issue of traceability can arise "anytime securities that are not the subject of a recently effective registration statement trade in the same market as those that are so subject." Concerns regarding tracing are not unique to primary direct listings, the SEC contended, and courts have denied standing on the basis of lack of traceability in contexts outside of direct listings. In addition, the SEC said, tracing is not set forth in Section 11, and tracing standards are judicially developed and may vary "depending on the particular facts of the distribution and judicial district."
Background. Slack went public in 2019, before the SEC had approved the NYSE's proposal to allow primary direct listings, through a selling shareholder direct listing. As the Court explained, because, in a direct listing, the shares are not sold in an underwritten offering through an intermediary bank, there are typically no lock-up agreements with a bank that restrict the sale of unregistered shares-as there would be in a typical IPO-allowing both registered and unregistered shares (that are exempt from registration) to be sold to the public. When Slack went public, it registered 118 million shares for sale by selling shareholders, and 165 million unregistered shares were also available at the same time for sale to the public on the NYSE.
The plaintiff purchased 30,000 shares on day one at $38.50 and 220,000 over the next several months. After several Slack service disruptions, the share price fell below $25, and the plaintiff brought a class action for violations of Section 11, Section 12(a)(2) and Section 15(a) of the Securities Act. According to the opinion, the plaintiff alleged, among other problems, that "Slack's registration statement was inaccurate and misleading because it did not alert prospective shareholders to the generous terms of Slack's service agreements, which obligated Slack to pay out a significant amount of service credits to customers whenever the service was disrupted, even if the customers did not experience the disruption." Slack moved to dismiss, contending that the plaintiff did not have standing under Section 11 and Section 12(a)(2) "because he cannot prove that his shares were registered under the allegedly misleading registration statement."
As described by the Court, the district court "adopted a broad reading of 'such security' within Section 11, holding that the plaintiff had standing under Section 11-even though he did not know whether the shares he purchased were registered or not-"because he could show that the securities he purchased, even if unregistered, were 'of the same nature' as those issued pursuant to the registration statement." Likewise, the district court also held that the plaintiff had standing under Section 12(a)(2), reading "such security" to include registered or unregistered securities offered in the direct listing. The district court also found standing under Section 15 to sue the individual and venture capital defendants for secondary liability.
The case, one of first impression according to both the district court and the 9th Circuit, was appealed to the 9th Circuit, where the lower court's decision was reviewed de novo, assuming as true the facts alleged in the complaint.
Opinion of the 9th Circuit
Standing under Section 11. Section 11 provides that, in the event "the registration statement.contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, any person acquiring such security . . . " may sue. (Emphasis added.) According to the Court, the "meaning that has been applied in this circuit is that 'such security' in Section 11 means a security issued under a specific registration statement, not some later or earlier statement." That interpretation, the Court said, has prevailed even where there have been successive registrations and other tracing challenges.
The key issue, as framed by the Court, was: "what does 'such security' mean under Section 11 in the context of a direct listing, where only one registration statement exists, and where registered and unregistered securities are offered to the public at the same time, based on the existence of that one registration statement?"
However, instead of adopting the district court's "broad meaning" of "such security"-the "words of a statute do not morph because of the facts to which they are applied"-the Court looked "directly to the text of Section 11 and the words 'such security.'" Under the NYSE rule, the Court reasoned, "a company must file a registration statement in order to engage in a direct listing," citing a note to the NYSE rule explaining that some companies may wish to list their "'common equity securities on the Exchange at the time of effectiveness of a registration statement filed solely for the purpose of allowing existing shareholders to sell their shares..'(emphasis added)." Because there are no lock-ups with underwriters,
"at the time of the effectiveness of the registration statement, both registered and unregistered shares are immediately sold to the public on the exchange..Thus, in a direct listing, the same registration statement makes it possible to sell both registered and unregistered shares to the public. Slack's unregistered shares sold in a direct listing are 'such securities' within the meaning of Section 11 because their public sale cannot occur without the only operative registration in existence. Any person who acquired shares through its direct listing could do so only because of the effectiveness of its registration statement."
In other words, but for the registration statement, none of the listed shares would be saleable on the exchange, whether they were registered or unregistered.
Because there is only one registration statement involved, the Court said, the case does not involve the type of tracing problems typically associated with successive registration statements. To Slack's contention that, under past precedent, the meaning of "such security" in Section 11 applied only to registered shares and that the Court should apply "Section 11 to direct listings in the same way it has in cases with successive registration statements," the Court countered with a largely public policy rationale, asserting that Slack's interpretation "would undermine this section of the securities law" by "essentially eliminat[ing] Section 11 liability" in this context:
"[F]rom a liability standpoint it is unclear why any company, even one acting in good faith, would choose to go public through a traditional IPO if it could avoid any risk of Section 11 liability by choosing a direct listing. Moreover, companies would be incentivized to file overly optimistic registration statements accompanying their direct listings in order to increase their share price, knowing that they would face no shareholder liability under Section 11 for any arguably false or misleading statements. This 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 Court observed that the point was especially true given that the NYSE now permitted primary direct listings. Affirming the district court's denial of the motion to dismiss the Section 11 claim, the Court asserted that to hold otherwise would "contravene the text of the statute."
Standing under Section 12. The Court employed a similar analysis with respect to standing under Section 12. According to the opinion, it "follows from the analysis of 'such security' in Section 11, that the shares at issue in Slack's direct listing, registered and unregistered, were sold 'by means of a prospectus' because the prospectus was a part of the offering materials (i.e. the registration statement and prospectus) that permitted the shares to be sold to the public. As previously determined, neither the registered nor unregistered shares would be available on the exchange without the filing of the offering materials." However, Section 12 also includes an "express privity requirement between the seller and the purchaser that is not present in Section 11." The plaintiff did not challenge the district court's dismissal of his Section 12(a)(2) claim and the Court declined to address it at this point.
Section 15 claims. The Court held that, because the plaintiff had standing under Section 11, "standing exists for the dependent Section 15 claim against controlling persons."
In conclusion, in affirming the partial denial of Slack's motion to dismiss, the Court held that "[s]tatutory standing exists under Sections 11 and 15, and under Section 12(a)(2) to the extent it parallels Section 11."
The dissenting judge viewed the interpretation of sections 11 and 12 as "settled for decades," notwithstanding the new context. He would have reversed and granted the motion to dismiss in full. The plaintiff "cannot prove that his shares were issued under the registration statement that he says was inaccurate." That "failure of proof," he asserted, was "outcome-determinative."
According to the dissent, because Sections 11 and 12 impose strict liability, the statute "tempers it by limiting the class of plaintiffs who can sue." The dissent acknowledged that the term "such security" has "no antecedent in section 11," making the statute "ambiguous as to what sort of security a plaintiff must acquire to have standing." However, that ambiguity was resolved in 1967, "in a landmark decision," Barnes v. Osofsky. In that case, the dissent observed, the court noted that "the phrase 'any person acquiring such security' lent itself to both a 'narrower reading-acquiring a security issued pursuant to the registration statement' and 'a broader one-acquiring a security of the same nature as that issued pursuant to the registration statement,' and it adopted the narrower reading, which it described as a 'more natural' interpretation of the text. Until today, every court of appeals to consider the issue, including ours, has done the same.. That principle ought to resolve this case."
The dissent took issue with the contention that the case was really one of first impression: while it was true that the case arose in the context of a direct listing, in contrast to past cases that involved successive registration statements,
"nothing in the reasoning of the cases suggests that the distinction should matter. In cases involving successive registrations, we did not invent a requirement that a plaintiff's shares must have been issued under the registration statement because we thought it seemed like a good idea; we interpreted the statutory text to impose that requirement..If 'such security' means that plaintiffs must have purchased shares 'issued under the allegedly false or misleading registration statement' in successive-registration cases,.then that is also what it means in direct-listing cases."
"What appears to be driving today's decision," the dissent asserted, "is not the text or history of section 11 but instead the court's concern that it would be bad policy for a section 11 action to be unavailable when a company goes public through a direct listing." But, the dissent contended, that issue has been raised as a concern in other contexts. And even so, the company will remain subject to potential liability under Rule 10b-5 for misstatements made with scienter. "More importantly," the dissent reasoned, "whatever the merit of the policy considerations, they are no basis for changing the settled interpretation of the statutory text." Rather, the place to make changes is in the legislature.
With regard to Section 12, the dissent took a similar position. However, in that instance, the "text of the statute resolves that question. Section 12 differs from section 11 because 'such security' in section 12 has a clear antecedent.. The unambiguous meaning of a security offered or sold 'by means of a prospectus' is therefore a registered security sold in a public offering."
The dissent concluded that both "sections 11 and 12 require a plaintiff to show that he purchased a security issued under the registration statement he is challenging. Whether or not that is good policy in the context of a direct listing, our role is to interpret statutes as they are-not to shape them into what we wish they could be.. Because Pirani cannot show that he purchased a registered security, I would hold that he lacks standing to bring claims under sections 11, 12, or 15 of the Securities Act."
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