United States: SCOTUS Hears Oral Argument In Slack Direct Listing Case—did The Court Float Its Likely Resolution?

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. Slack Technologies. As the NYSE had observed, only the court in Slack had addressed the issue, and had concluded that, at the pleading stage, plaintiffs could still pursue their claims even if they could not definitively trace the securities they acquired to the registration statement. However, the NYSE noted, the case was on appeal. (See this PubCo post.) The case, Pirani v. Slack Technologies, was decided by a divided three-judge panel of the 9^th Circuit, with the court affirming, with one dissent, the district court's order, ruling that the plaintiff had standing to sue under Section 11. But that decision was appealed to SCOTUS, which granted cert. On Monday, SCOTUS heard oral argument. Justice Kagan may be a bellwether: addressing Pirani's counsel, she advised that "it does seem to me like you have a hard row to hoe here." But that was about Section 11. Section 12(a)(2)? Well, that's another matter.

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 December 2020, the SEC approved the NYSE rule proposal to allow primary direct listings, in which the company issues and registers new shares for direct sale on the exchange.

A number of commenters on the NYSE proposal to allow direct primary listings raised concerns about Section 11. For example, the Council of Institutional Investors contended that the "proposal compounds the problems shareholders face in tracing their share purchases to a registration statement." In response, the NYSE argued that "the Section 11 and traceability concerns are due to the potential lack of lockup agreements, which are neither prohibited nor required by the proposal or any other law or regulation, rather than to anything inherent in direct listings themselves or the Exchange rules permitting them to be listed." In addition, the NYSE contended, the traceability requirement may create difficulties under Section 11 in many situations that do not involve direct listings, and the SEC agreed that the issue of traceability can arise "anytime securities that are not the subject of a recently effective registration statement trade in the same market as those that are so subject." Concerns regarding tracing are not unique to primary direct listings, the SEC contended, and courts have denied standing on the basis of lack of traceability in contexts outside of direct listings. In addition, the SEC said, tracing is not set forth in Section 11, and tracing standards are judicially developed and may vary "depending on the particular facts of the distribution and judicial district." (See this PubCo post.)

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 $38.50 and 220,000 over the next several months. After several Slack service disruptions, the share price fell below $25, and Pirani brought a class action for violations of Section 11, Section 12(a)(2) and Section 15(a) of the Securities Act. According to the opinion, Pirani alleged, among other problems, that "Slack's registration statement was inaccurate and misleading because it did not alert prospective shareholders to the generous terms of Slack's service agreements, which obligated Slack to pay out a significant amount of service credits to customers whenever the service was disrupted, even if the customers did not experience the disruption." Slack moved to dismiss, contending that Pirani did not have standing under Section 11 and Section 12(a)(2) "because he cannot prove that his shares were registered under the allegedly misleading registration statement."

As described by the 9^th 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 9^th 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 9^th 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 9^th Circuit looked "directly to the text of Section 11 and the words 'such security.'" Under the NYSE rule, the 9^th 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 9^th 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 9^th 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, Judge Friendly noted that "the phrase 'any person acquiring such security' lent itself to both a 'narrower reading—acquiring a security issued pursuant to the registration statement' and 'a broader one—acquiring a security of the same nature as that issued pursuant to the registration statement,' and it adopted the narrower reading, which it described as a 'more natural' interpretation of the text. Until today, every court of appeals to consider the issue, including ours, has done the same.... That principle ought to resolve this case." "What appears to be driving today's decision," the dissent asserted, "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 when a company goes public through a direct listing." But, the dissent contended, that issue has been raised as a concern in other contexts. And even so, the company will remain subject to potential liability under Rule 10b-5 for misstatements made with scienter. "More importantly," the dissent reasoned, "whatever the merit of the policy considerations, they are no basis for changing the settled interpretation of the statutory text." Rather, the place to make changes is in the legislature.

SCOTUS oral argument

Here is the question presented:

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, Chief Justice Roberts observed that the reference in Section 11 to "such security," where the antecedent was unclear, was "the big hurdle for [Pirani] to get over." As you can imagine, the discourse necessarily involved a fair amount of textual interpretation, and both sides had their elaborate constructions to suit their purposes—a bit too complicated for this purpose. However, Slack counsel referred to the long line of cases consistent with Slack's interpretation that tracing was required under Section 11, and counsel for Pirani argued that the line of cases referring to tracing was not really on point because those cases referred to successive registration statements, so that all the shares were registered in those cases; that is, the prior cases don't address the question of the distinction between exempt and registered shares. "And if anything," he asserted, the cases "are consistent with our view that the focus of Section 11 is on the registered offering, because everybody who purchases in that offering is going to have their shares valued based on that registration statement, whether the share could have been sold in another kind of transaction or not without a registration statement."

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? Justice Kavanaugh asked Slack counsel about the potential impact of requiring tracing under Section 11 in the context of direct listings—to create an avenue to avoid Section 11 liability altogether: "The former SEC officials' amicus brief suggests that they expected that in a direct listing, the registration statement would cover all the securities, all the shares, and they say that your position would essentially transform the '33 Act into an opt-out regime for direct listings and that we shouldn't do that, and that was contrary to the SEC's expectation when they tackled this issue."

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." Justice Kagan asked why this unsettled question hadn't been tested before, given that "just in a regular IPO, you also include some unregistered shares."

SideBar

In a Cornerstone Research webcast with Stanford Professor and former SEC Commissioner Joe Grundfest and former SEC Chair Jay Clayton discussing the case and the oral argument, Clayton also noted that the issue of sales of exempt shares sold with registered shares was not really a new one. The assumption that, in the paradigmatic IPO, only registered shares would be sold until the lock-up ended was, he maintained, not a correct one; in fact, he said, many exempt shares are sold. [All discussion in this post regarding the Cornerstone webcast is based on my notes and subject to standard caveats.]

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? Justice Kavanaugh then suggested that, under Pirani's theory, in Section 11 cases, liability could go on even after the lockup period—wasn't that a big change from the status quo? Pirani counsel responded that Slack had "not established that that is the general rule in IPOs...that you get to cut off that liability in that way." "One thing," he suggested, "even on our view of the statute, that an issuer can do is withdraw the registration statement at the end of the lockup period." Justice Barrett observed that, "it seems kind of—to Justice Kavanaugh's point, the status quo is that after the lockup period ends, these suits don't go forward under Section 11." It's "because people think they can't bring them."

SideBar

In the Cornerstone webcast, Grundfest and Clayton observed that the 9^th 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 9^th 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 Congress, regulators, and sophisticated market participants."

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 Justice Jackson suggested, does the specific reference in Section 12(a)(2) to some exempt shares undermine the notion that all the liability runs only to registered shares? Justice Gorsuch noted that there was "an internal referent in Section 12 the way there isn't in Section 11." Loosely quoting Judge Friendly, he said, "what helps you with 11 hurts you on 12."

Justice Kagan observed that they "always look at the language of a statute. You know, it's just one of the things that we do." In that context, she identified

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 un-moored type of oral communication." Finally, he contended that "inclusion of one category of exemptions [Section 3] and the exclusion of another category of exemptions [Section 4] strongly supports the conclusion that the second category of exemptions remains exempt."

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 Congress would say that if you use a misleading prospectus to sell a security, it doesn't matter whether you're using it to sell a registered security or...an exempt security. It causes the same harm. And, of course, in a case where you have an intermingling of exempt and what they call registered securities, anybody who is offering those securities for sale is going to make use of that prospectus because they have no way of knowing if they are offering and...advertising and marketing registered shares or not, and in all likelihood, the people are going to buy some of both."

Why was differentiating between Sections 11 and 12 so important? Are the Justices perhaps floating the potential resolution of this case?

Perhaps Justice Gorsuch let the cat out of the bag in this excerpt from the transcript:

Justice Kavanaugh later tested this hypothetical solution on Pirani counsel, who replied that, as the respondents, they were "happy for you to leave the status quo the way it is."

Where's the SEC in all this? Why are they a no-show?

Justice Kavanaugh asked whether Slack counsel knew the SEC's take on this Section 12 issue? That was just the first of several instances when he expressed his discomfort about ruling without hearing first from the SEC—he appeared somewhat perplexed that the SEC had not weighed in on this issue. There were a number of cases on Section 11, but not much about the Section 12 issue, and he was "a bit concerned about deciding that issue without the SEC here, without more law out there" about Section 12: "Why not allow the lower courts to sort out the Section 12 issue before we give a definitive ruling on that?" While there was a lot on Section 11, he was "just worried about making a mistake on Section 12 one way or another because we don't have the kind of thorough consideration we usually have before we give a definitive opinion on something." There were differences in the language of the two sections that struck him "as a big issue for these direct listings and something that I'm not sure we're fully equipped at this moment to chime in on." He had read the Gustafson decision "a lot," but he "didn't come away with, like, this is the clear answer to Section 12 issue." Some of the other Justices seemed to agree that Gustafson was not quite as clear on this point as Slack counsel insisted.

Justice Kavanaugh asked for thoughts about why the SEC declined to submit an amicus brief in this case? Slack counsel responded that "they chose not to participate in this case, obviously concluding that the prior position they had taken before this Court was—was sufficient." However, on prompting by Chief Justice Roberts, he acknowledged that he had no evidence to that effect, but was just making a reasonable inference. Pirani counsel responded that he had "no idea why they're not here. I will—but I can say with great confidence that the position they expressed before is not a position that directly translates to this case." On rebuttal, Slack counsel responded that the SEC had recently told SCOTUS that a "plaintiff may seek relief under Section 11 only with respect to securities covered by the registration statement." And the SEC continued that "even though there could be outstanding securities of the same class, that there would still not be liability even if people had relied on the registration statement with respect to those other shares. So the SEC's position is perfectly clear." Justice Sotomayor said that she had "read some commentators suggesting that the [SEC] is having trouble with this case and doesn't know what to do." Chief Justice Roberts added that they "[m]ay not be the only one."

SideBar

Professor Grundfest told Reuters "that the Biden administration's silence is telling. 'The Solicitor General has obviously read the opinions and the briefs and concluded that not taking a position in this matter best serves the interests of the United States government,' he said. 'The government is not willing to support the plaintiffs in this matter and the justices will notice.'" In the Cornerstone webcast, when asked why the SEC was a no-show, Clayton suggested that perhaps it was for the same reasons that the Justices were struggling with the issues. Grundfest suggested that perhaps the absence reflected a realization that the SEC could have fixed the problem by implementing one of the fixes suggested in their amicus brief—that the SEC use its acceleration authority to require that only registered shares be allowed to come to market on the first day and delay the public resale of any unregistered shares. (Clayton graciously acknowledged that the Slack offering occurred during his tenure as SEC chair.)

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. Justice Gorsuch agreed that all they would "need to do is plead facts suggesting that you can trace consistent with the Twiqbal standard [Iqbal and Twombly], as my friends like to call it. (Laughter.)... And—and then you're off to the races and it really just becomes a matter of damages, as I think you also alluded to." As a result, he continued "if we were to rule against you on what Section 11 means, it still would enable you to plead...that there are traceable shares."

What about shifting the burden of proof?

Justice Sotomayor indicated that she was "intrigued by some amici suggesting that we adopt a burden-shifting framework." If they were concerned about specific efforts to evade liability with direct listings, "the burden-shifting idea made some sense." Counsel for Slack argued that "Congress has spoken very specifically to the question of burden allocations. And this Court should not essentially redo Congress's work for it and decide that additional burdens should be placed on the plaintiffs."

Who should fix the problem?

Justice Kavanaugh observed that Slack and some amici contended that direct listings were a "new thing," and that, to take Pirani's position, "we would have to depart on Section 11 from a lot of law, starting with Judge Friendly, that's been around for a long time. And rather than doing that—this is their suggestion—we should leave it to the SEC and/or Congress rather than ourselves, kind of departing from that longstanding body of law." At one point, speaking of the tracing issue, Kavanaugh asked if the SEC could "fix this, or could only Congress fix this? So I know the word 'fix' is loaded, but you know what I mean, change this." Slack counsel responded that "the SEC has ample authority to address this if they think it's a problem," referring to the suggestions by amici in their briefs. Not surprisingly, Pirani's counsel strongly disputed that premise.

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