In this article, the authors review in detail Slack Technologies, LLC v. Pirani - a case currently before the U.S. Supreme Court with potentially far-reaching consequences.
For individual investors purchasing corporate securities on the public markets, Section 11 of the Securities Act of 1933 (the Securities Act) and Section 10(b) of the Securities & Exchange Act of 1934 (the Exchange Act)(and Rule 10b-5 promulgated thereunder) are the primary bases to seek redress for misstatements in connection with the purchase or sale of a security. Those statutes, however, operate under differing frameworks that reflect the fundamental economic differences between the underlying transactions they cover.
Section 11 focuses on company stock offerings and holds issuers strictly liable for making "an untrue statement of a material fact or omitt[ing] to state a material fact required . . . to make the statements therein not misleading"1 in a registration statement provided that the investor can trace its purchase back to the offering.
On the other hand, Section 10(b) focuses on exchange transactions made on secondary markets and holds issuers and officers liable for making material misstatements or omissions only if those misstatements or omissions were made with an intent to deceive, manipulate or defraud (that is, with scienter) in connection with the purchase or sale of a security, upon which the plaintiff relied and pursuant to which the plaintiff suffered a loss caused by the material misrepresentation or omission.
The separate liability standards reflect the differing purposes of the two statutes and the economic realities of the transactions they are designed to cover. Applying strict liability under Section 11 makes sense in the context of public offerings because the issuer receives a direct economic benefit in the form of capital raised from the offering that relates directly to the contents of its registration statement. Plainly, where an issuer receives a direct economic benefit as a result of a misrepresentation, even if innocent or negligent, it should not be enriched at the expense of an investor that is ignorant of such misstatement.
By contrast, Section 10(b) and Rule 10b-5 are antifraud provisions, designed to penalize fraud that may affect transactions on impersonal markets, but where the speaker does not (or is extremely unlikely to) receive proceeds directly from the underlying transaction. Rather, in a typical Section 10(b)/Rule 10b-5 claim, an unknown seller of securities is likely to be the unwitting beneficiary of a transaction where the value of shares is inflated by a material misrepresentation. The lack of direct economic benefit in an exchange transaction helps explain why Section 10(b) and Rule 10b-5 require a showing of fraudulent intent and issuers are not strictly liable for misstatements or omissions.
In Slack Technologies, LLC et al. v. Pirani,2 the U.S. Supreme Court granted certiorari to defendants in a case that, unless overturned, has the potential to upend the economic theory and congressional intent that underlie the strict liability regime in place for Section 11 claims.
Slack addresses whether the requirement under Section 11 that a plaintiff trace its purchase in an offering to the misleading registration statement should apply to direct listings. In a direct listing, the registration statement often applies only to some, but not all, of the company's shares offered to investors. Unlike in initial public offerings (IPOs), where all shares sold into the market are traceable to the offering because unregistered shares are contractually prohibited from trading during the IPO and immediately thereafter because of customary lock-up periods, direct listings pose an obstacle for shareholders seeking to trace the securities they purchased in the market. In a direct listing, unregistered shares are often sold into the market pursuant to Rule 144 of the Securities Act, thereby co-mingling registered and unregistered shares in the market at the same time, rendering tracing nearly impossible.
In light of the differences between a direct listing and an IPO and the policy decisions that animate the different legal frameworks provided under Section 11 of the Securities Act and Section 10 of the Exchange Act, strict liability should not apply to direct listings where the plaintiff cannot trace its purchase to a materially misleading registration statement.
Rather, if investors cannot trace their shares to the offending registration statement, they should be required to show scienter under Section 10 to recover for any misstatements.
SLACK TECHNOLOGIES, LLC V. PIRANI
In a case with potentially far-reaching consequences, the Supreme Court is set to address the applicability of the tracing requirement under Section 11 to direct stock listings. In Slack, an investor, Pirani, brought Section 11 claims in the U.S. District Court for the Northern District of California challenging statements Slack made in a registration statement in advance of its direct listing. Slack had gone public on June 20, 2019, opting to do so by a direct listing rather than the more common IPO. For the direct listing, over 290 million shares became available for sale to the public, but only 118,429,640 were offered pursuant to the registration statement that Slack filed. By way of an SEC-authorized exemption, the remaining shares were unregistered and could lawfully be sold without registration.
Direct listings, like the one pursued by Slack, are more similar to a typical market exchange of shares than they are to an IPO. In a typical direct listing, a previously private company allows its private shareholders to sell their shares on the public market.3 Among these private shareholders are affiliates of the issuer, defined by SEC Rule 144 as "a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer."4 Generally, in order for these affiliate shareholders to be able to sell their shares, the sale must be registered. Non-affiliates, on the other hand, may sell their shares in a private or newly public company without registration if they have held them for one year. Therefore, as happened in Slack, companies in direct listings register at least some of their shares in order to allow their affiliate shareholders to sell shares on the public market, creating a mix of registered and unregistered shares entering the market at the same time. In effect, the issuer takes itself public without necessarily selling shares directly to the public in exchange for capital. This is distinct from an IPO for many reasons, including that the issuer does not receive the benefit of any (or at least all) of the capital proceeds from the transactions. In that way, direct listings are similar to the typical transaction on an open-market exchange where unknown buyers and sellers buy and sell securities at a market-clearing price.
Three months after Slack's direct listing, Pirani commenced a class action lawsuit under, inter alia, Section 11 of the Securities Act, claiming that he and similarly situated investors had suffered financial losses after purchasing shares of Slack that were issued pursuant to a materially misleading registration statement. Specifically, Pirani alleged that Slack's registration statement was misleading because it did not disclose that Slack was obligated to pay all customers service credits whenever Slack's service was disrupted and failed to disclose the frequency of these disruptions. Pirani also alleged that the registration statement downplayed the competition that Slack was facing from Microsoft Teams.5
On a motion to dismiss, Slack argued that Pirani could not establish standing because he purchased shares in the open market subsequent to a direct listing in which both registered and unregistered shares were being sold at the same time, so there was no way for Pirani to distinguish whether he bought from the pool of registered or unregistered shares. Accordingly, Slack argued that Pirani had no ability to trace those shares back to the purportedly false registration statement as required under Section 11 and the claim should be dismissed.
The district court denied Slack's motion to dismiss and rejected Slack's argument, finding that the plaintiff could sufficiently trace his shares to the allegedly misleading registration statement, notwithstanding the existence of market-exchanged unregistered shares that were also sold at the time of the direct listing. The district court reasoned that in the context of a direct listing where all shares purchased were "of the same nature," regardless of whether they were registered, they were all purchased "pursuant to" i.e., traceable to the registration statement.6 On a motion from Slack, the district court certified its order for interlocutory appeal to the U.S. Court of Appeals for the Ninth Circuit.
THE NINTH CIRCUIT'S DECISION
The Ninth Circuit, over Judge Miller's dissent, affirmed the district court on different grounds, holding that because all Slack shares could only be offered and acquired once the registration statement was made effective, even the unregistered shares could not have entered the market prior to registration. The court stated: "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."7 The Ninth Circuit determined that this was sufficient to demonstrate that purchasers of all shares in the direct listing could trace their shares back to the registration statement.
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Footnotes
1. 15 U.S.C. § 77k.
2. Slack Technologies, LLC et al. v. Pirani, No. 22-200.
3. A New York Stock Exchange rule, proposed in April 2022 and approved by the Securities and Exchange Commission on December 15, 2022, permits a company to issue primary shares directly at the same time (though to date, no company appears to have taken advantage of this option). https://www.sec.gov/rules/sro/nyse/2022/34-96514.pdf.
4. 17 C.F.R. § 230.144. The SEC typically defines "control" as "the power to direct the management and policies of the company in question, whether through the ownership of voting securities, by contract, or otherwise." OFF. OF INV. EDUC. & ADVOC., U.S. SEC. & EXCH. COMM'N, RULE 144: SELLING RESTRICTED AND CONTROL SECURITIES (2013).
5. Pirani v. Slack Techs., Inc., 13 F. 4th 940, 944 (9th Cir. 2021).
6. Pirani v. Slack Techs., Inc., 445 F. Supp. 3d 369, 381 (N.D. Cal. 2020).
7. Pirani v. Slack Techs., Inc., 13 F. 4th 940, 947 (9th Cir. 2021).
Originally published by The Banking Law Journal.
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.
