In its long-awaited decision in Slack Technologies, LLC v. Pirani, 598 U.S. ___, No. 20-200 (June 1, 2023), the Supreme Court ruled that the tracing requirement of Section 11 of the Securities Act of 1933 applies to suits brought by investors in direct listings. Although the ruling definitively resolves an ambiguity in the statutory text, it leaves the door open to adverse consequences for both companies and investors in direct listings.
Section 11’s Traceability Requirement
The only issue before the Supreme Court was whether the statutory text of Section 11 should be applied more broadly in the unusual case of a direct listing. Section 11 is a strict liability statute allowing investors to bring suit based on material misrepresentations or omissions in a registration statement. Section 11 is a powerful safety net for investors in newly listed companies because, unlike Section 12, it does not require that a plaintiff prove scienter; rather, a plaintiff need only show that misrepresentations or omissions were material. Because strict liability for such misrepresentations or omissions provides strong downside protection to investors, Section 11 has a tendency to drive good disclosure practices by companies and to fortify investor confidence in IPOs in U.S. capital markets.
The tracing requirement is a judicially created doctrine from the 1960s that deals with an ambiguous phrase in the statute as enacted. Section 11(a) entitles “any person acquiring such security” to bring suit, but no preceding clause refers to any security. Since Barnes v. Osofsky was decided in the Second Circuit, courts have construed “such security” to mean that the security must have been purchased “pursuant to the registration statement,” rather than “of the same nature as that issued pursuant to the registration statement.” 373 F.2d 269, 271 (2d Cir. 1967).
Practically speaking, tracing becomes significant where multiple offerings (or multiple types of offerings) may cause shares to be commingled. Say a company IPOs with a first offering in January, then undertakes a follow-on offering in June. An investor who purchases shares from an underwriter in the IPO between January and May would be unlikely to face difficulties tracing their shares to the IPO S-1, since the only registration in effect at that time would have been the January registration. However, shares purchased from the follow-on June offering become commingled with prior shares so as to create an impossible situation for potential plaintiffs: “Courts have long noted that tracing shares in this fashion is ‘often impossible,’ because ‘most trading is done through brokers who neither know nor care whether they are getting newly registered or old shares,’ and ‘many brokerage houses do not identify specific shares with particular accounts but instead treat the account as having an undivided interest in the house’s position.’” In re Century Aluminum Co. Sec. Lit., 729 F.3d 1104, 1107 (9th Cir. 2013) (quoting Barnes, 373 F.2d at 271-72).
The tracing requirement is also significant in the context of a lockup period. In a traditional IPO, registered shares are sold first, then unregistered shares become available after a 180-day lockup period for reasons specific to the underwriting process for an IPO. Similar to the multiple-offerings situation described above, an investor purchasing shares after the lock-up period would have challenges bringing a Section 11 action because the shares would by then be so commingled as to make tracing “virtually impossible.” In re Initial Pub. Offering Sec. Litig., 227 F.R.D. 65, 118 (S.D.N.Y. 2004).
The Special Case of Direct Listings
Enter the “direct listing,” which features no lockup period and immediately introduces commingled shares that are both registered and unregistered.
In 2018, the SEC approved with modifications new NYSE proposed rules to facilitate and regulate direct listings. As Justice Gorsuch noted in the Slack decision, the traditional IPO has its drawbacks, and raising capital may not be “the only reason firms might wish to go public; some may simply wish to afford their shareholders (whether investors, employees, or others) the convenience of being able to sell their existing shares on a public exchange.” Slack, slip op. at 3.
The direct listing provided a vehicle to do exactly that. In a direct listing, companies do not need to issue new shares, thus obviating the need for an underwriter. Instead, they can simply make existing shares available to the general public. Thus, existing shareholders—such as employees, board members, and VC investors—are often not subject to a lockup period and can sell their shares immediately upon listing.
Slack was only the second major company to go public via direct listing in June 2019, following Spotify’s listing in April 2018. Only about a dozen other companies have gone public by direct listing since.
More recently, in December 2022, the SEC approved both for the NYSE and the Nasdaq a hybrid form of “primary direct floor listings” that allows companies to raise new funds while also providing a quick exit for existing investors. These hybrid listings have the same traceability issues as direct listings.
The Slack Lawsuit
The plaintiff in the Slack case, investor Fiyyaz Pirani, purchased 30,000 shares of Slack the day it went public and subsequently purchased another 220,000 shares. Slack’s price per share dropped shortly thereafter and Pirani filed suit, alleging that Slack filed a materially misleading registration statement in violation of Section 11. Specifically, Pirani claimed Slack failed to warn shareholders in its registration statement that increased demand for their product and services brought on network outages that required the company to pay over $8 million in customer credits.
Slack moved to dismiss based on the nature of its direct listing: 118 million of the company’s shares were registered pursuant to a registration statement filed with the SEC, but 165 million were shares not registered under any registration statement, and both sets of shares became available on the market the same day.
The district court denied the motion to dismiss, adopting a broader reading of Section 11 to allow the suit to go forward based on the detailed statutory analysis conducted in the Barnes case. On interlocutory appeal, a divided Ninth Circuit affirmed on different grounds: that allowing Slack to escape liability in this case would create a loophole contrary to the intent of the Securities Act.
The Supreme Court reversed in a short ten-page decision focused solely on the statutory text, noting at the end that “Congress remains free to revise the securities laws at any time, whether to address the rise of direct listings or any other development.” Slack, slip op. at 9. The Court also vacated for reconsideration of whether the same analysis applies to Section 12 of the Securities Act, which is not a strict liability statute but requires a showing of scienter.
Takeaways for Industry Professionals
The Slack decision has several salient takeaways for industry professionals, whether they be companies considering going public through a direct listing or investors considering purchasing shares in such a listing:
- The strict liability of a Section 11 suit is unlikely to apply to future direct listings, where the tracing requirement applies and shares are likely commingled immediately upon listing.
- The unavailability of a Section 11 cause of action removes an important safety net for investors, who will face greater risk of loss if they purchase shares in a direct listing.
- Because of that greater risk of loss, direct listings may become less attractive for investors. This in turn may create more risk for companies opting for a direct listing.
- The new hybrid “primary direct floor listings” present the same issues.
- Still unresolved is the question of whether a Section 12 cause of action also requires tracing. This question will wind its way back down to the Ninth Circuit on remand, and may again end up at the Supreme Court. It is significant that a Section 12 lawsuit is more difficult to mount than a Section 11 lawsuit, because it requires a showing of scienter.
