By Zach Swartz
The Supreme Court seldom takes up issues around the federal securities laws. But in June, it handed down an important decision involving Section 11 of the Securities Act. Section 11 imposes strict liability on companies when their Securities and Exchange Commission (SEC) registration statements contain material misstatements or misleading omissions. The Court’s decision could alter the calculus for companies looking to go public.
In Slack Technologies, LLC v. Pirani — a 2021 case where a Slack shareholder sued the company for filing a misleading registration statement — the Court decided in favor of the company, ruling that the shareholder failed to show that the stock he bought was issued under the registration statement, as required to bring a Section 11 claim.
In doing so, the Court overruled the Ninth Circuit and confirmed a long-held standard: Only plaintiffs who can trace their shares to a company’s registration statement can sue under Section 11. Plaintiffs who allege a misleading statement, but who can’t satisfy this “tracing requirement,” must prove that the company intended to deceive, manipulate, or defraud — a far more difficult task.
Direct Listings Versus IPOs
Numerous factors are at play here. But the most important involves how Slack went public. Slack chose a direct listing — where it applied to list its shares on the New York Stock Exchange (NYSE), and filed a registration statement with the SEC that included 118 million shares. Upon the NYSE’s approval of Slack’s listing application and the SEC’s declaring the registration statement effective, holders of those 118 million shares were free to sell them to the public right away.
However, Slack also had 165 million preexisting unregistered shares that were not included in the registration statement, but still potentially able to be sold to the public in reliance on certain Securities Act exemptions. As a result, the Slack plaintiff couldn’t prove that the shares he bought had been included in the registration statement.
Tracing shares to a registration statement is often easier in the context of a conventional initial public offering (IPO), because the investment banks that underwrite IPOs typically negotiate agreements that bar pre-IPO insiders from selling their shares for an extended period of time after the IPO.
Depending on the company’s pre-IPO capital structure, these lockup agreements may cover a substantial portion of the company’s unregistered shares following the IPO. With these lockup agreements in place, plaintiffs seeking to pursue a claim under Section 11 can more easily trace the shares that they purchased to the registration statement.
Protecting Against Liability
Slack’s victory raises an interesting question: In structuring their go-public deals, could companies seek to insulate themselves from Section 11 liability by permitting a large amount of unregistered shares to be free from lockup agreements upon going public?
One sign of this would be if more companies begin to favor direct listings over IPOs — making shares harder to trace, and thus making Section 11 claims harder to pursue. Direct listings are generally better for companies that already have many shareholders and don’t need to raise capital at the time of the listing. Direct listings also provide liquidity for a company’s existing investors, and don’t dilute the value of existing shares through the issuance of new shares, as IPOs do.
IPOs, on the other hand, allow companies to raise fresh capital. Underwriters often insist that companies that list through a conventional IPO have lockup agreements in place in an attempt to mitigate the risk that near-term sales by company insiders and certain key investors could weigh on the share price following the IPO.
Another way that companies and their underwriters might aim to help protect against liability would be to lock up fewer pre-IPO shares. As with a direct listing like Slack’s, this approach would potentially make more unregistered shares immediately available for sale to the public than would an IPO in which every (or nearly every) company insider and pre-IPO shareholder is locked up, and thus make shares more difficult to trace.
But this extra protection could come at a cost: The absence of contractual restrictions on the ability of certain pre-IPO shareholders to sell their shares following the IPO could place downward pressure on the share price.
Weighing the Tradeoffs
There are a number of considerations for companies deciding whether and how to go public. A need for capital, the current shareholder base, underwriter fees, disclosure requirements, and market volatility, for example, may all weigh on companies’ minds to varying degrees.
The Slack decision has highlighted another variable that companies should consider — potential liability under the securities laws. Companies may be able to mitigate the risk of a Section 11 claim through how they structure their go-public transactions. These choices may involve tradeoffs, however, and companies will need to work with their legal and financial advisors to determine what makes the most sense for them.
Zach Swartz is a partner at Vinson & Elkins LLP, practicing in the firm’s M&A and Capital Markets group.
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