On September 20, 2021, the Ninth Circuit took aim at a foundational requirement in securities litigation that has long bedeviled plaintiff’s attorneys. In a 2-1 decision in Pirani v. Slack Technologies, the court imposed a strict liability standard under Section 11 of the Securities Act of 1933 for shares sold as part of a direct listing. This includes shares normally subject to an exemption from registration requirements, the baseline for Section 11 litigation. While this is a case of first impression, given the unique circumstances of Slack’s IPO, the ruling may still have major implications for the standards of pleadings in Section 11 litigation.

Muddying the Waters – Using Direct Listings to Stir the Pot

The problems began for Slack when it chose to go public through a direct listing  rather than a traditional IPO. In a direct listing, shares are sold directly by the company, existing shareholders, or both via a public auction on the exchange where the company chooses to list. In theory, it is more efficient because it eliminates the need for investment banks serving as underwriters and sets the price through open trading.

As a result of the absence of underwriters, other shares not subject to the registration statement of the newly public company may be sold immediately following the direct listing, provided there is a relevant exemption permitting the sale. In the case of Slack, 118 million shares were sold subject to a registration statement filed with the SEC. 165 million additional shares were also available under various exemptions, primarily SEC Rule 144. However, in our view, and in the view of the average investor, what is actually being registered is the offering itself. There is no difference between the 118 million shares and the 165 million. A purchaser received the same securities for effectively the same price at effectively the same time.

According to Slack, there was no difference between the pools from which the plaintiffs purchased their stock. As a result, when these shareholders filed suit alleging misinformation in the company’s registration statement, Slack argued that they lacked standing because they could not trace the source of their shares and so the company moved to dismiss on the case. The district court, and the Ninth Circuit correctly disagreed, finding that, regardless of the source of the shares, any alleged misinformation or misleading statements would affect all shares.

The Ninth Circuit focused primarily on the major policy concern of granting such a motion. To challenge a registration statement under Section 11(a), plaintiffs must demonstrate that they purchased “such security” a term the court majority interpreted to include any type of Slack shares that were publicly available at the time the registration statement became effective. This had the effect of applying the registration statement associated with the 118 million shares to all 283 million shares available for sale.

The majority correctly points out that, if the term were not viewed this way, a company could very easily avoid any Section 11 liability via “a loophole large enough to undermine the purpose” of the law simply by “muddying the waters:” making available some number of exempt securities. Under Slack’s view, by mixing them with registered securities, there would be no way to ever achieve standing to assert Section 11 claims associated with the registered shares. Of course, this would only apply if it were that there should be a distinction between registered shares and exempt shares.

Rewriting Rule 144 or Recognizing the Likelihood for Abuse?

Some have argued that the Ninth Circuit’s ruling has effectively gutted the exemption under Rule 144. However, it is a matter of timing. For holders of restricted, unregistered securities, which are available for sale regardless of the effectiveness of the registration statement, deciding when, to whom, and for how much to sell shares is strictly an investment decision. As Feldman, Solum, and Gavril have pointed out, these shares had already met the holding requirements. But timing is key; These shares were freely tradeable under Section 4(a)(1) regardless of whether any registration statement existed, let alone whether it was effective. However, these investors did not seek to sell their shares before Slack went public. Nor did they seek to hold their shares after Slack went public and then sell. Instead, they chose to sell during a period when, in a traditional IPO, they would have been locked in. As a result, any reasonable purchaser would equate these 165 million exempt shares with the 118 million registered shares.

For major shareholders, particularly longtime insiders and early investors who have long had access to significant information, this presents an opportunity to dump shares and avoid some degree of liability by abusing the Rule 144 exemption. As long as they hold their shares for the requisite period, those with the most influence on the content and timing of the registration statement can hide behind the sale.

Sacrificing Section 11 for Rule 144

If we assume the Ninth Circuit erred, consider the implications for direct listings. Rather than gut Rule 144, a different decision would have effectively gutted Section 11 as it applied to direct listings with either exempt securities or multiple registration statements. As discussed, the issuer would need only to mix the securities and make it nearly impossible to track shares so that plaintiffs would lack standing.

The Ninth Circuit has already acknowledged this. In the two cases cited by Feldman, Solum, and Gavril as providing the authoritative definition of “such security,” the court said it was nearly impossible to trace shares where there were multiple registration statements. While Slack had only one, with the multiple groups of exempt shares, the effect was the same.

In re Century Aluminum Co. Sec. Litig., the court noted that plaintiffs could successfully trace their shares if they demonstrated they purchased directly from the offering or could trace it via the aftermarket. Citing Barnes v. Osofsky, the court recognized that it and other courts have “long noted that tracing shares in [via chain of title in the aftermarket] is ‘often impossible,’ because ‘most trading is done through brokers who neither know nor care whether they are getting newly registered or old shares.’” Further complicating the problem, in the post Iqbal world, the court further held that, for plaintiffs in cases with multiple registration statements, “a greater level of factual specificity will be needed before a court can reasonably infer that shares purchased in the aftermarket are traceable to a particular offering.”

In short, the law as it would stand were Slack reversed acknowledges that plaintiffs face a nearly impossible hurdle to even get into the court. If Slack is based on weak policy grounds, then the basis for Century Aluminum and its sister cases are even weaker. Citing the legislative history of Section 11, the court found that, while the pleading standards are “difficult to meet,” this is the condition Congress has imposed. That misses a critical point, however. At the time of the passage of the ’33 and ’34 Acts, there were still physical shares that were relatively easy to trace. The complex, over-the-counter rapid trading we know today did not exist until nearly three decades later.

How Do We Fix This?

The ruling in Slack is extraordinarily harsh for the defendants and opens companies seeking to go public via direct listing to significant risk associated with their registration statements. The imposition of potential liability on Slack and other companies doing direct listings for shares they had long expected would be exempt does seem unfair. However, what is the alternative?

If the holding in the Slack case were reversed, it would essentially allow companies to escape nearly all Section 11 liability in direct listings, which already allow key players like financial advisors to escape such liability. Either liability can be easily avoided or it is imposed for the sake of a compelling policy position. Just as Rule 144 was implemented to allow for an exemption from liability, Section 11 was enacted to ensure that there would be repercussions for misrepresentations. However, this strict liability may be a temporary fix. Other methods are readily available to allow restoration of the status quo under both Section 11 and exemptions like Rule 144.

Companies can and should implement blockchain-based ledgers for their shareholders. Many states, including Delaware, have already authorized such ledgers, and jurists and practitioners have all noted their potential benefits. Broker-dealers should be obliged to maintain records of the source of the shares they distribute to their clients. While courts have noted that many distribute shares as a portion of “an undivided interest in the [brokerage] house’s position,” there is nothing preventing them from actually keeping track. Finally, in the short term, the SEC should encourage investors with securities available for sale under certain exemptions to hold them for a stabilizing period immediate after a direct listing. By avoiding muddying the waters during the going public transaction, traceability questions will be significantly reduced later on.

Where Slack Goes from Here

Following the Ninth Circuit’s ruling, Slack has petitioned for rehearing en banc. Its argument is based on reversing precedent, the resulting circuit split, and what it views as a misinterpretation of the relevant statutes and rules. What Slack does concede in its petition is the relative absurdity of its position. In it, the company notes that numerous courts, including the Ninth Circuit, have held “Section 11 cannot be interpreted differently simply because new developments in the marketplace, including new offering types, might limit its application.” The company also notes that plaintiffs have been denied standing in a particularly extreme Fifth Circuit decision where 99.85 percent of shares were registered because they couldn’t account for the remaining 0.15 percent.

In addition to Slack’s own petition, an amicus brief in support of its position has been filed by former SEC commissioner and Stanford Law School Professor Joseph Grundfest. In his brief, Grundfest raises valid concerns about the open-ended nature of the panel’s decision. Numerous questions remain as to correct registration statements, offerings with multiple statements, and, perhaps most important, whether or not the ruling now applies to traditional, underwritten IPOs. In his mind, the panel’s “ad hoc rulemaking is untethered from any limiting principle.”

The Ninth Circuit must now decide whether to rehear the matter. Should it decline, the case would return to the district court for further proceedings. It has yet to be heard on the merits, and it is possible that Slack will avoid any liability. But the plaintiffs have a chance to be heard on claims whose legitimacy Slack has not yet denied. Slack has since been acquired in a $27.7 billion acquisition by Salesforce.

Regardless of the outcome, this case should serve as a warning to companies going public, whether by direct listing, traditional IPO, or some other method. It should encourage more in-depth disclosure from these firms and help ensure an accurate flow of public information leading up to companies’ entry into public markets. Further complicating the matter, Slack went public via a secondary direct listing. Since doing so, the major exchanges with the permission of the SEC have greenlit primary direct listings, allowing companies to raise money as well as provide liquidity. While this should encourage companies to consider direct listings as an alternative to traditional IPOs, this decision may unintentionally cool the market for direct listings.

This post comes to us from John Livingstone, a recent graduate of Case Western Reserve University School of Law, and Anat Alon-Beck and Robert Rapp, professors at the school. It is based on their recent article, “Investment Bankers as Underwriters: Barbarians or Gatekeepers? a Response to Brent Horton on Direct Listings,” available here.