Supreme Court Delivers Key Defense Victory by Limiting Section 11 Claims in Direct Listings — and Again Calling for a Rigid Application of the Tracing Requirement
On June 1, 2023, the United States Supreme Court issued a unanimous opinion that makes it more difficult for shareholders to bring Section 11 claims against companies that go public via direct listings. The case involved a class action against Slack Technologies, LLC (Slack) for alleged violations of Sections 11 and 12 of the Securities Act of 1933 (Securities Act). Courts have long held that Section 11 requires that the plaintiff show that the shares the plaintiff purchased were issued pursuant to the registration statement containing the alleged misrepresentations. In a typical IPO, the shares that are immediately available to the public are issued pursuant to the registration statement. However, in a direct listing, holders of previously issued unregistered shares (such as the issuer’s employees and early investors) are free to sell shares to the public alongside registered shares, without any requirement that any new shares be issued, making it essentially impossible for purchasers to know whether the shares they purchased were pursuant to the most recent registration statement or in some earlier offering. For example, Slack’s direct listing included 118 million registered shares and 165 million unregistered shares.
Based on the language of Section 11, the Supreme Court rejected the Ninth Circuit’s view that Section 11 liability extends to securities that are not necessarily issued pursuant to the defective registration statement but that have some relationship to the registration statement. Rather, Section 11 liability requires a plaintiff to plead that it purchased shares traceable to the allegedly misleading registration statement. Though the court did not reach the question of whether the same traceability requirement applies to claims under Section 12(a)(2) of the Securities Act, the court did note that the two sections “contain distinct language that warrants careful consideration.”
In rejecting the Ninth Circuit’s interpretation of the Section 11 traceability requirement, the Supreme Court reinforced the narrow scope of Section 11 liability and created a significant hurdle for investors seeking to assert Section 11 claims following a direct listing. This decision reinvigorates the tracing requirement for Section 11 and makes it plain that the court will construe the provision narrowly according to the statutory text.
Ninth Circuit Delivers Key Defense Win, Upholds Forum Selection Bylaw Precluding Certain Derivative Shareholder Actions in Federal Court
On June 1, 2023, the United States Court of Appeals for the Ninth Circuit, sitting en banc, affirmed dismissal of a derivative shareholder lawsuit against Gap Inc. (Gap) based on a forum selection clause in the company’s bylaws mandating that derivative actions be brought in the Delaware Court of Chancery. The Ninth Circuit held that the bylaw was valid and enforceable despite the fact that it would preclude shareholders from pursuing derivative claims under Section 14(a) of the Exchange Act.
The plaintiff had argued that Gap’s forum selection bylaw was void under the anti-waiver provision of the Securities Exchange Act of 1934 (Exchange Act) because it would prevent her from bringing a derivative Section 14(a) claim in any court, since Section 14(a) claims may be brought in federal court only. The Ninth Circuit disagreed on the grounds that the Exchange Act’s anti-waiver provision applies only to substantive restrictions, not procedural restrictions. The Ninth Circuit concluded that the forum bylaw was not a substantive restriction because the plaintiff could still bring direct (as opposed to derivative) claims in federal court given that the bylaw applied only to derivative claims.
This decision is an obvious win for companies seeking to limit shareholders’ ability to file derivative suits wherever they please. The Ninth Circuit’s holding will make it more difficult for plaintiffs to select a federal forum to gain a perceived strategic advantage. However, the opinion also creates a split with the Seventh Circuit, which struck down a similar forum selection bylaw last year. Given the circuit split, this issue could soon make its way to the US Supreme Court.
Court of Chancery Rules That Private Equity Firm Could Walk Away From Deal Based on Undisclosed Phantom Stock
Following a three-day trial in May, the Delaware Court of Chancery held that French private equity firm Antin Infrastructure Partners S.A.S. and its affiliate OTI Parent LLC (Antin) had the right to walk away from a $230 million deal to acquire a group of privately held Florida broadband companies (collectively, OpticalTel) due to OpticalTel’s failure to disclose “phantom equity.” OpticalTel had agreed that all of its representations concerning its capitalization would be true and correct at closing, including a representation that there was no outstanding phantom equity. The representation did not contain a de minimus qualifier, a point the parties had heavily negotiated.
After the merger agreement was signed, a former OpticalTel employee Rafael Marquez “came out of the woodwork” claiming an interest in an OpticalTel subsidiary and began a “campaign of disruption” to shake down the parties for the money that he believed he was entitled to. Antin found that Marquez’s claim, though largely overstated, had some factual basis and therefore presented serious post-closing litigation risk. Antin noticed a breach of the capitalization representations and terminated the merger agreement for this breach, in addition to other breaches.
The court found that Marquez’s claimed interest constituted a form of phantom equity, which, although not defined by the merger agreement, is typically conceived as “an unsecured contractual right that takes on economic characteristics of the employer’s equity.” Because OpticalTel’s capitalization representations provided there was no outstanding phantom equity, the court held that such representations, without a de minimis qualifier, were necessarily rendered false when OpticalTel failed to adequately explain Marquez’s interest.
“Ultimately,” the court held, “it is not for this court to question the business wisdom of [Antin’s] decision to terminate. [Antin] negotiated for the ability to terminate if the capitalization representations were not accurate in all respects, and this decision enforces that right.”
This decision sheds some light on the seemingly mysterious term “phantom equity.” Given that the term may encompass third-party claims that are tethered to equity participation such as those at issue in this case, the decision points to the potential importance of materiality qualifiers, particularly when it comes to the cap table.
New York Federal Judge Rejects and Criticizes SEC Request for a $2M Civil Penalty as Too Low in Bifurcated Insider Trader Settlement, Instead Imposes $15.5M Penalty for “Egregious” Market Manipulation Scheme
On May 25, 2023, a New York federal judge imposed a hefty $15.5 million fine against a New Jersey trader for the alleged manipulation of more than 18,000 trades over a five-year period. The trader, James David O’Brien, allegedly coordinated these trades by buying and selling from 18 accounts at 14 different brokerage firms to artificially pump or deflate share prices and thus induce investors to sell and purchase shares at artificial prices. According to the SEC, despite multiple inquiries and warnings by various brokerage firms and an investigation by the SEC, O’Brien repeatedly continued to open new accounts at different firms to perpetuate the scheme.
O’Brien had previously reached a so-called bifurcated settlement with the SEC, in which he neither admitted nor denied any wrongdoing and agreed to entry of an injunction, while the parties agreed to litigate the remaining open question of monetary penalties before US District Judge Denise Cote. The SEC requested $5.2 million in disgorgement of trading profits and a $2 million civil fine. Judge Cote, however, went far beyond the SEC’s request and imposed a whopping $10.3 million in civil penalties for O’Brien’s “egregious” conduct, in addition to disgorgement and pre-judgment interest. In imposing the civil penalty, Judge Cote reasoned that it was “not disproportionate to the amount of disgorgement” of nearly $5.2 million, as it was just “a fraction of the amount permitted if the maximum fine were calculated per violation. That calculation would amount to [a] fine of over $4.014 billion.” Moreover, Judge Cote noted that, even after reaching a settlement with the SEC that precluded him from arguing that he did not violate the law, O’Brien nevertheless “used the opportunity presented by the process to assess disgorgement and penalties to deny that he had engaged in any violation.”
This case is an outlier—generally defendants agree to a bifurcated settlement because they believe the SEC is asking for an excessive penalty or remedy, and it is highly atypical for a court to impose an economic award greater than that requested by the SEC (or for that matter, any plaintiff or movant). But this case does send a clear message to those considering a bifurcated settlement that there is always the possibility of the strategy backfiring. It is also another example of where the SEC simply misperceives how courts and others will react to its litigation positions.
Delaware Court of Chancery Rejects Proposed Settlement Based on Governance Reforms
On June 1, 2023, the Delaware Court of Chancery rejected a proposed settlement of a derivative action challenging equity grants awarded to directors and officers of Universal Health Services, Inc. (UHS) during a period of market volatility related to the COVID-19 pandemic in mid-March 2020. The plaintiff, a purported stockholder in UHS, claimed that the compensation committee breached its fiduciary duties by granting awards that were based on an artificially and temporarily deflated share price. The parties reached a proposed settlement in which, in exchange for dismissal of the action and a full release of claims, UHS agreed to adopt targeted governance reforms designed to strengthen control over UHS’s compensation practices. UHS also agreed not to oppose the plaintiff’s application for an award of attorneys’ fees and expenses of $925,000.
The court rejected the proposed settlement, concluding that it did “nothing of consequence,” and the parties were encouraged to “confer about an amended settlement with meaningful benefits for the Company.” As an initial matter, the court declined to consider any reforms that were implemented before the proposed settlement. The court found that the remaining enhancements were largely aspirational and did not remove the potential for influence by certain officers, alleviate the inherent conflicts in self-compensation, or require a markedly different process than the existing process. The court reasoned that, because the “give” was a full release, the “get” was insufficient, particularly since the case did not settle shortly after it was filed, and certain claims had survived a motion to dismiss.
As this case shows, the Court of Chancery can and will scrutinize proposed settlements, rejecting deals that it considers too insubstantial.
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