On June 1, 2023, the US Supreme Court held in a unanimous decision in Slack Technologies LLC v. Pirani that Section 11 of the Securities Act of 1933 (Securities Act) "requires a plaintiff to plead and prove that he purchased shares traceable to the allegedly defective registration statement." Direct listings can involve the simultaneous sale of both registered and unregistered shares. This feature makes it difficult, if not impossible, to trace whether any given share was purchased pursuant to the registration statement and prospectus issued in the direct listing. The avoidance of Section 11 liability risk could be a meaningful benefit of pursuing a direct listing as opposed to a traditional IPO.
What Is a Direct Listing?
In a traditional IPO, a company issues new shares to the public with the assistance of an underwriter that acts as an intermediary. The underwriter, typically an investment bank, works with other broker-dealers to sell and distribute the company's stock. Therefore, IPOs are generally associated with high fees and costs for the issuer. Underwriters usually require insiders (management, employees, early investors and the like) to enter into "lock-up agreements" to prevent them from selling their older, pre-existing and unregistered shares for a set period of time.
By contrast, a direct listing is a newer mechanism for companies to list their shares (either newly-issued or pre-existing shares) on an exchange without a related underwritten offering from a bank. Prices are established via a live auction of undefined size on the morning of the listing, after receipt of all the buy and sell orders. Direct listings normally do not have lock-up agreements restricting the sale of older, unregistered shares, and thus provide immediate liquidity to existing shareholders. Therefore, from the first day of a direct listing, both unregistered and registered shares may be available to the public. Direct listings often use a financial advisor rather than an underwriter to guide them through the process and plan the offering, resulting in significantly lower transaction costs. Direct listings also have a few drawbacks. For example, direct listings lack the built-in price stabilization mechanisms typically found in IPOs, which can result in higher volatility and potentially significant price fluctuations during the first few days and weeks of the initial trading. In addition, direct listings have less access to institutional investors since they don't have underwriters – who perform due diligence, vouch for the credibility of the issuer going public, and have existing relationships with large institutional investors. It should be noted, however, that, for a variety of reasons and despite stock exchange efforts to make the direct listing process more attractive, there have been only 16 direct listings completed since 2018, generally limited to large, well-known and already well-capitalized companies.
Background and Procedural History
In June 2019, Slack Technologies, Inc. went public via a direct listing. The Securities Act requires a company to register the securities it intends to offer to the public with the U.S. Securities and Exchange Commission (the "SEC"). Slack filed a registration statement for a set number of registered shares. Throughout Slack's direct listing, holders of pre-existing, unregistered shares were free to sell them to the public immediately. Slack's direct listing released 118 million registered shares and 165 million unregistered shares into the public market for purchase. Plaintiff Fiyyaz Pirani bought 30,000 Slack shares on the day Slack went public and later bought 220,000 additional shares. Pirani, on behalf of himself and other investors who acquired Slack stock during the direct offering, later brought a class action lawsuit claiming that Slack's registration statement and prospectus were misleading. Among other claims, the complaint alleged that the Slack defendants violated Section 11 of the Securities Act. Section 11 allows investors to sue an issuer, directors and other enumerated individuals under a strict liability theory for material misstatements or omissions in a registration statement.
The Slack defendants moved to dismiss on the ground that Pirani lacked standing because he could not prove that his shares had been issued pursuant to the allegedly misleading registration statement. Slack's use of a direct listing meant that registered and unregistered shares (the latter category of which are not subject to Section 11) were comingled from day one of the offering. As a result, Pirani could not show which of the shares he bought were registered, as opposed to exempt. The district court ruled that Pirani had standing under Section 11 because all of his shares, whether or not issued pursuant to a registration statement, were "of the same nature." By a 2-1 decision in an interlocutory appeal, a Ninth Circuit panel affirmed the district court's decision as to Pirani's standing under Section 11, but it used a purportedly different rationale to reach the same result.
Section 11(a) provides that, "in case any part of the registration statement, when such part became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, any person acquiring such security" may sue certain defendants. (Emphasis added.) Thus, the statute authorizes suit when an individual has acquired such security. The term such security is not defined in Section 11(a). The Ninth Circuit panel reasoned that Slack's unregistered shares sold during the direct listing were such securities within the meaning of Section 11(a) because "their public sale cannot occur without the only operative registration in existence," and therefore all of Slack's shares, "whether labeled as registered or unregistered, can be traced to that one registration." The panel opined that a contrary interpretation of the words such security would create a significant loophole to undermine the purpose of Section 11, and predicted that, if Slack's argument prevailed, "companies would be incentivized to file overly optimistic registration statements accompanying their direct listings in order to increase their share price, knowing that they would face no shareholder liability under Section 11 for any arguably false or misleading statements."
Judge Miller dissented from the panel majority's conclusion that such security encompasses even unregistered securities that can only be sold due to the existence of one registration statement. He argued that prior precedent and legislative history suggest that such securities include only those issued "pursuant to" or "sold upon" a registration statement. In his view, the majority's decision was driven not by the text or history of Section 11, but rather the court's concern that it would be bad policy to extinguish Section 11 liability when a company goes public through a direct listing. Judge Miller emphasized the importance of the tracing requirement and claimed that Pirani did not have statutory standing to bring a Section 11 claim.
Supreme Court Limits Section 11 Liability
Earlier this month, the Supreme Court vacated the Ninth Circuit's decision concerning the scope of Section 11 liability, holding that the "narrower reading," i.e., to bring a claim under Section 11, the securities held by the plaintiff "must be traceable to the particular registration statement alleged to be false and misleading" was more "natural" and correct. The court characterized its holding as consistent with the decisions of every court of appeals to consider the issue since the 1960s, up until the Ninth Circuit's opinion in the case before it. To decipher the meaning of the term such securities in Section 11, the Supreme Court looked at contextual clues provided by other sections of the Securities Act, including Sections 5, 6, and 11(e), as well as the dictionary. The court was not willing to agree with Pirani's public policy argument that a broader reading of Section 11 would better effectuate the purpose of the Securities Act, noting that "it seems equally plausible that Congress sought a balanced liability regime that allows a narrow class of claims to proceed on lesser proof," that is, strict liability under Section 11 versus the higher, scienter-based standard of proof built into the antifraud laws. The high court conceded that Congress could have been clearer in the statute and remains free to amend the securities laws at any time.
Takeaways
The Supreme Court's ruling in Slack clarifies that, even in the context of direct listings, a plaintiff's ability to recover damages under Section 11 of the Securities Act is constrained by a "tracing" requirement, i.e., plaintiffs suing under Section 11 must plead and prove that they bought shares registered under (and thus directly traceable to) the precise registration statement they are challenging. Direct listings often comingle registered and unregistered securities, thus making it very difficult for plaintiffs to trace any shares they acquired back to a specific registration statement. As the Ninth Circuit observed, applying the Supreme Court's narrow interpretation of Section 11 liability to direct listings may encourage companies to favor direct listings over traditional IPOs since it eliminates strict liability for misleading statements or omissions in a registration statement. Notwithstanding the narrowing of Section 11 liability, issuers should be aware that plaintiffs can still file suit under other avenues, such as Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Unlike Section 11, those provisions require proof of scienter, which is often difficult to prove.
The Supreme Court declined to address whether Section 12 of the Securities Act — a statute that creates liability for any person who offers or sells a security through a prospectus or an oral communication containing a material misstatement or omission — requires proof of purchase of registered shares. The high court "express[ed] no views about the proper interpretation of §12 or its application to this case." The Slack decision and other circuit court precedents set a strong foundation for a narrow reading of Section 12 liability, but this is not guaranteed and will likely become clearer if and when the plaintiffs' bar litigates the scope of this provision in the context of direct listings.
In the meantime, due to the Supreme Court's embrace of a strict tracing requirement in the Slack case, some companies may give additional consideration to direct listings as a means to go public.
The authors appreciate the assistance of Katten summer associates Kimberly Pilatovsky and Lillianna Johanknecht with this article.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
SLACK TECHNOLOGIES, INC. 
