In the past several years, the number of claims filed against newly public companies under the Securities Act of 1933 has increased significantly.1 At the same time, the development of direct listings has given companies seeking to list their shares on exchanges an alternative to the traditional initial public offering. These trends converged with the litigation filed against Slack Technologies, challenging its direct listing under the Securities Act.2 Earlier this week, the U.S. Court of Appeals for the Ninth Circuit, in a 2-1 decision, affirmed a district court decision finding that shareholders had standing under the Securities Act to challenge statements made in Slack's direct listing registration statement. The result, if it remains undisturbed, raises some troubling questions for defendants.
Unlike fraud claims under the securities laws which require proof of reckless or intentional misconduct, Section 11 imposes strict liability against the issuer for innocent or merely negligent misstatements in a registration statement. Section 11 also flips the burden of proving loss causation, imposing on defendants the burden of showing non-culpable reasons for the decline below the stock's offering price. If the court finds a misrepresentation or material omission, individual defendants can escape liability only by proving the affirmative defense of due diligence—an inquiry rarely resolved at the pleading stage.
The one factor counterbalancing Section 11's low liability standards and harsh penalties is that standing to bring such claims is strictly limited: Because "strict liability is strong medicine … the statute tempers it by limiting the class of plaintiffs who can sue."3 Under the statute, only those who purchased stock issued in and directly traceable to the IPO can assert a Section 11 claim. However, the Ninth Circuit's decision in Slack Technologies could dramatically alter this balance, exposing public companies to expanded Section 11 liability, overturning decades of decisional law and issuers' recent efforts to limit liability in direct offerings.
For the last half-century, every Circuit court to address the issue (including the Ninth Circuit), recognizing the statutory balance struck by the Securities Act's drafters, has strictly construed Section 11's standing requirements, insisting that plaintiffs demonstrate that their shares are directly traceable to the challenged registration statement.4 Thus, once any non-IPO-registered shares come into the market, whether by means of a secondary offering or through sales of shares exempt from registration under the securities laws, courts routinely rejected Section 11 claims asserted by subsequent purchasers. These courts rejected arguments that it was statistically likely that at least some of the shares purchased in the aftermarket were issued in the offering as well as arguments concerning perceived inequities in denying some after-market purchasers a Section 11 remedy.5
For various reasons, including the desire to provide liquidity to existing shareholders and avoid investment banking fees, some newly public companies have structured their IPOs in ways that permit unregistered shares to be sold sooner rather than later. Two such strategies include 1) direct listings (which permit immediate sales of both registered and unregistered stock by existing private shareholders) and 2) exceptions or carve-outs to the strictures of traditional underwritten IPO lock-ups, which otherwise typically limit the sale of non-registered securities for a 180 day-period after the offering.6 Various legal observers had postulated that tracing and liability would be limited if not impossible in these circumstances.
However, the Ninth Circuit, like several California district courts before it, now appears to balk at the idea of denying shareholders a Section 11 remedy where unregistered shares are sold simultaneously with or after the offering through any channel other than a secondary offering; circumstances where strict application of tracing requirements would have significantly limited or eliminated Section 11 claims. In connection with one of the first direct offerings and the first to be tested in the courts, the Ninth Circuit affirmed the district court's holding that unregistered Slack shares were somehow traceable to the registration statement even though they were not issued or registered in connection with the direct listing.7 Focused on the registration statement being a necessary condition or "but for" cause of the sale of Slack's stock on a public stock exchange, the majority held that registered and unregistered shares "could not be purchased without the issuance of Slack's registration statement, thus demarking these shares … as 'such security' under Sections 11 and 12 of the Securities Act."8
By reducing the tracing requirement to one of "but for" causation, the majority opinion appears to significantly lower the standard for plaintiffs to plead and prove standing. This holding opens troubling questions for defendants in the traditional IPO context, including whether there will be a need for actual tracing after a lock-up expires and/or if unregistered shares enter the market prior to that time under Rule 144. Plaintiffs will likely argue that such shares would not be publicly tradable "but for" the IPO registration statement regardless of whether they were registered or when they were sold.9 But as the dissent in Slack states: "What appears to be driving [the court] 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[,]" but that "policy concern is neither new nor particularly concerning" because it was addressed in Barnes.10 This policy-driven interpretation is "'inconsistent with the over-all statutory scheme'" and ignores the fact that a plaintiff could still plead a Section 10(b) claim under the Securities Exchange Act of 1934, a claim that requires pleading and proving scienter.11
The split-panel decision in Slack calls into question the carefully balanced statutory scheme and decades of consistent, reasoned judicial authority requiring tracing to demonstrate that shares were both issued and registered in the offering. If not overturned by a near-certain en banc appeal, the Ninth Circuit's decision could be used by plaintiffs to rewrite the statute to expand strict liability beyond what the Securities Act's drafters intended.
[1] https://www.cornerstone.com/Publications/Reports/Securities-Class-Action-Filings-2019-Year-in-Review at 24-28. Some of the increase may have been due to the Supreme Court holding in Cyan that state courts retain concurrent jurisdiction over Securities Act claim. Cyan, Inc. v. Beaver County Employees Retirement Fund, 138 S. Ct. 1061 (2018). While plaintiffs often prefer to file such claims in state courts, which typically apply more liberal pleading standards, either alone or in parallel with near-identical cases in federal courts, the Delaware Supreme Court vindicated the right of Delaware companies to require shareholders to bring such claims solely in federal courts. Salzberg et al. v. Sciabacucchi, 227 A.3d 102 (Del. 2020). See https://www.wsgr.com/en/insights/delaware-supreme-court-rules-federal-forum-selection-charter-provisions-are-valid.html. As a result, the focus of Securities Act filings has shifted back to federal court. See https://www.cornerstone.com/Publications/Reports/Securities-Class-Action-Filings-2020-Year-in-Review at 2-3 (noting overall decline in Section 11 filings in 2020 due to the pandemic and decline in state court filings due to Sciabacucchi).
[2] https://corpgov.law.harvard.edu/2020/05/17/courts-cut-shareholders-slack-on-section-11-claims/.
[3] Pirani v. Slack Technologies, Inc., et al., No. 20-16419, slip op. at 22 (9th Cir. Sept. 20, 2021) (Miller, J., dissenting).
[4] See, e.g., In re Century Aluminum Co. Sec. Litig., 729 F.3d 1104 (9th Cir. 2013) (citing Barnes v. Osofsky, 373 F.2d 269 (2d Cir. 1967).)
[5] Slack, slip op. at 22 (Miller, J., dissenting).
[6] https://corpgov.law.harvard.edu/2020/02/25/carving-out-ipo-protections/.
[7] The majority in Slack cited but deviated from the Ninth Circuit’s decision in Century Aluminum and the seminal Second Circuit decision in Barnes v. Osofsky. In the decision below in Slack, the district court relied on dicta in Barnes musing that relaxing the requirement of tracing “would not be such a violent departure from the words [of the statute] that a court could not properly adopt it if there would be good reason for doing so.” However, as the dissent in Slack points out, the majority ignores Judge Friendly’s fundamental analysis in Barnes, backed by citation to the legislative history and the opinions of the SEC and preeminent SEC scholars Louis Loss and Judge Jerome Frank, who chaired the SEC shortly after it came into existence that such “a broader reading [of standing] would be inconsistent with the over-all statutory scheme.” Slack, slip op. at 26.
[8] Slack, slip op. at 5.
[9] If the Ninth Circuit’s decision remains undisturbed, later courts could limit its application to direct listings in which “on the first day . . . registered and unregistered shares are released to the public at once,” id. at 7, 15, distinguishing it from traditional IPOs followed by unregistered shares entering the market later through Rule 144 exempt sales or expiration of a lock-up.
[10] Slack, slip op. at 26 (Miller, J. dissenting).
[11] Id. (Miller, J., dissenting) (quoting Barnes, 373 F.2d at 272).
