When the SEC was considering the NYSE's proposal to permit direct listings of primary offerings, one of the frequently raised difficulties related to the potential "vulnerability" of "shareholder legal rights under Section 11 of the Securities Act." Section 11 provides statutory standing to sue for misstatements in a registration statement to any person acquiring "such security," historically 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.
SideBar
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. Originally, 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
A number of commenters on the NYSE proposal to allow direct primary listings raised concerns about Section 11. For example, the
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. 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.
Pirani purchased 30,000 shares on day one at
As described by the 9th Circuit, 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 case 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.
The key issue, as framed by the 9th Circuit, 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?" The 9th Circuit looked "directly to the text of Section 11 and the words 'such security.'" Under the NYSE rule, the 9th Circuit reasoned, "a company must file a registration statement in order to engage in a direct listing." 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.
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 9th Circuit 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." 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." The 9th Circuit employed a similar analysis with respect to standing under Section 12. 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,
Here is the question presented:
"Section 11 of the Securities Act of 1933 permits suits alleging misrepresentations in a registration statement only if the plaintiffs 'acquir[ed] such security.' Section 12(a)(2) of the Act provides that someone who 'offers or sells a security ... by means of a prospectus' may be liable for misstatements in that prospectus 'to the person purchasing such security.' For more than 50 years, every court of appeals to consider the question has held that 'such security' in Section 11 means a share registered under the registration statement the plaintiffs claim is misleading. And this Court has held that Section 12 (a)(2) applies only when there is an obligation to distribute a prospectus-an obligation that exists only for registered shares. Gustafson v. Alloyd Co.,
At oral argument, counsel for Slack contended that Sections 11 and 12 of the '33 Act expressly refer to the registration requirements in Section 5 of the Act, where "it's undisputed that 'such security' ... refers only to shares that are subject to registration, never to exempt shares." Accordingly, the term "such security" should have the same meaning in Sections 11 and 12, as confirmed in Gustafson. "Respondent's contrary interpretation" Slack counsel contended, "would run roughshod over the core statutory distinction between registered and exempt shares, which is fundamental to the structure and operation of the '33 Act, and it would dramatically expand the scope of liability, disrupt the capital formation process, and upset settled expectations by overturning decades of case law and SEC interpretation consistently holding that plaintiffs must prove they purchased registered shares." Pirani hadn't identified any cases in the 90-year history of the Act, he contended, where Section 11 liability was imposed in connection with the sale of exempt shares.
Counsel for Pirani acknowledged that "[e]veryone agrees that 'such security' in Section 11 refers in some ways to the registration statement challenged as misleading. The question here is the precise nature of that relationship. Petitioners say 'such security' refers exclusively to what they call registered shares. But the statute doesn't use that term or provide a definition for it, and neither do Petitioners." Registration statements, he said, don't specify individual shares. "Instead, they act at the level of a public offering of securities, not shares, that is, the planned introduction of a group of fungible shares to the market at a particular time. The function of the registration statement is to provide the market the information it needs to value all of those fungible shares in that public offering. And the function of Section 11 is to provide investors confidence that they can rely on the integrity of that market price, even though some of those shares could have been sold in some other transaction without a registration statement. Accordingly, the better view is that 'such security' in Section 11 refers to all of the shares in the public offering for which the registration statement was a prerequisite."
Much was discussed during oral argument, but let me highlight some of the issues:
Does Section 11 mandate tracing?
With regard to Section 11,
What might be the practical impact of a decision? Doesn't either conclusion open a can of worms?
When it came to considering the practical impact of any decision, the Justices seemed, to some extent, caught between Scylla and Charybdis—overturning the 9th Circuit to mandate tracing to the registration statement, as Slack requested, could mean allowing a mechanism to avoid Section 11 liability completely; taking the broad approach that Pirani advocated (and the 9th Circuit took) could mean substantially expanding and extending liability. The challenge was how to navigate those waters?
What if the Court took Slack's position?
Slack counsel responded that it was "clear the SEC knew there would be additional exempt shares that weren't being registered that...would trade and already were free to trade even before the direct listing." In addition, he contended, the issue of tracing was raised by commentators in connection with approval of the NYSE directing listing rule, and the SEC replied that "there are lots of circumstances in which tracing is different in the modern securities market, and that's not a reason not to approve the rule change." In his view, that "conclusively demonstrates...that the argument on the other side that direct listings were supposed to require exempt shares to be registered is just wrong." However, Slack counsel suggested, to the extent there would be a problem, it was one the SEC could fix.
Counsel for Pirani, however, cautioned that the "practical consequence of adopting [Slack's] position, I think, is inevitably going to open the door to this—their stratagem of letting in a few exempt shares, even in traditional IPOs, and arguing that, therefore, you have to trace. And that's generally going to be impossible."
In a
Pirani counsel said that he wasn't aware of anyone raising the issue but he saw "no distinction between the two in terms of the law that's being argued about here." Slack's position, he said, "is that as soon as exempt shares enter the market, you have to trace and show that the shares that you identified are registered shares and not exempt shares. And that—there's no difference between the post-IPO lockup period and a direct listing in that respect." He later suggested this "under-briefed issue about what happens after the expiration of a lockup period in a traditional IPO" should percolate up in the courts. And, counsel for Pirani continued, Slack contends that it's impossible to trace. At least, it's "exceedingly burdensome" for the parties and the courts.
What if the Court took Pirani's position?
SideBar
In the Cornerstone webcast, Grundfest and Clayton observed that the 9th Circuit's interpretation—which would not require any tracing back to the registration statement—would dramatically increase the potential scope of liability, effectively allowing standing to everyone, everywhere, all at once—so to speak. In their amicus brief, they contended that the 9th Circuit opinion "invents an entirely new definition of Section 11 standing that conflicts with all precedent on point. Pirani's proposed definition extends liability far beyond the distribution of securities in and around the direct listing that animates the controversy now before this Court. If literally applied, Pirani's definition of standing would dramatically expand Section 11 liability across a vast array of situations that are entirely unrelated to direct listings. It would achieve those results by substituting a judicially implied remedy for the judgment of
What about Section 12? Do Sections 11 and 12 rise or fall together?
Justice Thomas asked whether Sections "11 and 12 rise and fall together" or, as
"four key differences between the two sections. First, there's no reference in Section 12 to registration; second, Section 12 clearly covers some unregistered shares because it ropes in Section 3 securities; third, Section 12 refers to sales not only by means of a prospectus but also by means of oral communication, which would suggest that we're outside the world of registration; and, fourth, Section 12 creates liabilities for sellers who had absolutely nothing to do with the registration statement, so the class of people who—who might be liable is very different and is not connected to the registration statement. And what that suggests to me is that the two provisions are targeting two very different things, that one is targeting dishonesty in creating a registration statement and the other is targeting dishonesty in certain kinds of sales, period, with or without a registration statement."
Slack counsel contended in response that "there is a clear and unambiguous direct link between the prospectus in Section 12 and the registration statement in Section 5. And only registered securities are subject to that requirement. This Court said that in so many words in Gustafson." In addition, he argued that "Gustafson indicated and the courts of appeals have consistently held 'oral communication' means an oral communication relating to the prospectus, not some
Pirani counsel had the opposite view, contending, in response to Justice Thomas's question, that Section 11 and 12 do not rise or fall together; they have very different language. Section 12, he argued, "unambiguously refers to 'a security,' not 'a registered security.' My friend's reliance on Gustafson is entirely misplaced. The Court wasn't considering anything like this question there.... It was asking the relatively straightforward question of what is a prospectus." In addition, he thought that the plain language of Section 12 "just directly answers the questions here." He found it "not at all surprising that
Why was differentiating between Sections 11 and 12 so important? Are the Justices perhaps floating the potential resolution of this case?
Perhaps
Gorsuch: "I guess another way of asking the question my colleagues are getting at is, would the sky fall should we answer the Section 11 question in your client's [Slack] favor, vacate and remand, without addressing the Section 12 question?"
Slack counsel: "Well, certainly, it would fall in this case because the court of appeals answered that question and it answered it wrongly, and"
Gorsuch: "And we're going to vacate its judgment in light of your arguments—supposing we were, in light of your arguments on Section 11, and maybe it should reconsider its Section 12 ruling in light of that."
Kavanaugh: "And just to add to that, the reason they did reach the conclusion on 12, I believe, is because they thought 11 and 12 should be read together, which all three... judges did, two against you and one in your favor, but if they know—the Ninth Circuit knows that you're actually prevailing on Section 11, who knows what they'd do on Section 12."
Slack counsel: "Yes, certainly, that would be better than where we stand right now. Obviously, we think "
Gorsuch: "I would have thought."
(Laughter.)
....Gorsuch: "But—but that would be an available course to the Court in your mind?"
Where's the SEC in all this? Why are they a no-show?
Is tracing possible even in direct listings?
Slack counsel maintained that the shares had to be traced to the registration statement, which he said was very difficult and, he thought, not possible in this case. He noted, however, that there was a pending state case in which plaintiffs claim they can trace, and that was being litigated. Counsel for Pirani pointed out that they had indicated in the pleadings that the shares were traceable—meaning not every share, but a percentage of them. He thought the traceability question should be left to the lower courts to determine.
What about shifting the burden of proof?
Who should fix the problem?
SideBar
In their amicus brief, Clayton and Grundfest suggest three approaches the SEC could adopt that would preserve Section 11 direct listing liability:
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"First, the SEC can require that registered and exempt shares offered in a direct listing trade with differentiated tickers, at least until expiration of the relevant Section 11 statute of limitations." For successive offerings, the same technique could be applied; "[t]hat approach, combined with unique tickers for each registered offering, could resolve all tracing challenges."
- Or "the SEC could migrate the entire clearance and settlement system to a distributed ledger system or to other mechanisms that would allow the tracing of individual shares as individual shares, and not as fractional interests in larger commingled electronic book entry accounts."
- "Alternatively, the SEC could adopt a narrower approach that resolves the tracing challenge only for direct offerings by requiring that exempt shares not trade until the day after an initial auction that is limited to registered shares. This would, in effect, impose a regulatory one-day lock-up as a method of preserving issuer Section 11 liability."
In addition, Slack counsel referred to an amicus brief submitted by law and business professors that suggested "that a recent regulatory change after this case, the creation of the consolidated audit trail, may facilitate tracing in the future."
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