Is it Really that Bad? Follow-On Offerings and Section 11 Suits in State Court

More than a year has passed since the Cyan case was decided by the Supreme Court in March 2018, and we are still absorbing the implications. The ramp up of state court suits against IPO companies was immediate.

But what about follow-on offerings? The current thinking of some leading insurance carriers seems to be that the risk of state court litigation is the same for IPOs and follow-on offerings.

But is the risk really that bad? Based both on the underlying mechanics of the securities laws as well as the data reviewed later in this post, the answer is no.

Not All Follow-On Offerings Are the Same

Once public, many companies will register more shares in future offerings. Each of these offerings has the potential for Section 11 liability under the Securities Act of 1933.

After Cyan, the law of the land is that plaintiffs alleging material misstatements or omissions in a registration statement can bring Section 11 suits in state or federal court.

Different types of post-IPO offerings are not, however, equally likely to end up in litigation, state court or otherwise. This is due to the tracing requirement for Section 11 claims. (More on this later.)

The four main categories of post-IPO registered offerings are:

1. Follow-On Offerings: These are public offerings of shares issued and sold by an issuer (sometimes referred to as "primary shares"). Some issuers do these once or twice in their lifetime; others do them routinely as part of their regular cadence of fundraising. Note that sometimes folks refer to the first follow-on offering after an IPO as a "secondary offering," unfortunate terminology as we'll see in a moment. As with IPOs, there are at least two types of follow-on offerings: firm commitment and best efforts. In the former, the first buyer of the entire offering is the investment bank (usually a syndicate of investment banks); this may or may not be true with other types of follow-on offerings.
2. Secondary Offerings: These are public offerings of shares being registered by the issuer but sold by selling shareholders. Selling shareholders originally received their shares either from the issuing company or from other shareholders. The proceeds of secondary offerings go to the selling shareholders, not the company. Secondary offerings are commonly done when a large percentage of an issuer's shares are held by a few people (e.g., founders or large early investors). When a public offering includes shares being sold by the issuer and selling shareholders, the IPO is one that has both primary and secondary shares (a "piggyback offering").
3. M&A Offerings: These occur when a public company uses its stock as currency to purchase another company. These are registered offerings, typically of primary shares. In exchange for shares of the target company it is purchasing, the acquiring company issues its own shares directly to the target company's stockholders. When the deal closes, the former target company's shareholders become shareholders of the acquiring company.
4. Direct Offerings: This is a registered offering of shares where there is no banker acting as an intermediary. It can be an IPO (e.g., Spotify's recent direct listing). PIPEs and DRIPs are other common types of direct offerings. There are others.

IPO Shares are Sued Relatively Frequently

I mentioned earlier that not all post-IPO offerings are equally likely to end up in litigation due to tracing requirement for Section 11 claims. Tracing refers to the requirement that plaintiffs pursing a Section 11 class action suit must first establish that the shares in the class can be traced to the allegedly deficient registration statement.

If plaintiffs cannot meet the tracing requirement, they do not have standing to sue under Section 11. Without standing, plaintiffs are not able to sue for material misstatements and omissions in the registration statement pursuant to Section 11.

Tracing can be a rigorous, difficult requirement—but not shortly after an IPO. Immediately after an IPO, the only shares in the float (being traded in the market) are the shares that were shares registered by the IPO's S-1 registration statement.

This usually remains true until the expiration of the lock-up on all shares that existed before the IPO. (A "lock-up" refers to the near-universal practice of investment bankers requiring that existing shareholders agree to continue to hold their shares for six-months after an IPO.)

Since shares being traded in the market shortly after an IPO are easy to trace back to their S-1 registration statement, IPO companies make appealing Section 11 litigation targets for the plaintiffs bar. As we all know, the data bears this out.

Note that Boris Feldman of the law firm Wilson Sonsini and other securities law luminaries have suggested that investment bankers could solve the litigation problem that currently confronts IPOs by modifying the way lock-ups work. The idea would be to release a certain amount of shares over time (but starting close to the IPO date) instead of simultaneously at the conclusion of the lock-up. Doing this would mix non-registration statement shares in the market early on, making tracing more challenging.

IPO companies with market power may want to talk to their investment bankers about Boris Feldman's proposal to change how lock-ups work. Currently, investment bankers do not have the same level of motivation to address the litigation risk of IPOs that issuers do. This is for reasons that include that IPO companies typically fully indemnify investment bankers for their exposure—including legal fees—for registration statement-related litigation.

Not All Follow-On Offerings Are Equally Likely to be Sued

After IPOs, the next most likely type of offering to experience Section 11 litigation is the registration of shares for M&A. That's because tracing is relatively easy.

After all, there is a ready list of purchasers who received the registered shares: the list of the target shareholders . No surprise, this was the next type of case we started seeing filed in state courts after Cyan, as I wrote last year.

For reasons similar to those for M&A offerings, tracing would be relatively easy in the case of direct offerings, especially closer to the date of the offering (before the shares in question were re-sold to other parties).

What about follow-on and secondary offerings? The timing of these offerings is clearly a factor vis-à-vis tracing: The longer a company has been public, the more shares there are in the float that were issued other than via a particular offering. Even if the follow-on offering is conducted on one day and at a set price (as opposed to an "at the market" or "ATM" offering), shares are fungible and thus are easily co-mingled with other shares, making tracing difficult.

The way in which the offering is handled may also be consequential. For example, in a firm commitment offering, the investment bank is the first buyer. Consider what may happen if the investment bank also has shares of the issuer in its house accounts. If, as sometimes happens, the new follow-on shares are co-mingled with these older shares before shares are sold to third parties, it might be difficult for a third party to establish tracing back to the follow-on offering registration statement.

Consider, too, the difference between an investment bank that sells the entire offering to just a few institutional shareholders versus to a widely distributed number of shareholders. As more time passes, shareholders who purchased shares directly from the bank may further distribute their shares, which may also make tracing more difficult.

When Does Tracing Have to be Established?

There is a circuit split on the question of just what it takes to establish tracing and at what stage must this be established in litigation.

Some courts are content in the initial pleading stage with a mere assertion, while other courts such as courts in the Ninth Circuit (which includes California) require much greater specificity of facts to establish tracing.

Also, we don't really know what a state court judge might do on the question of standing to bring a suit: dismiss early for lack of standing the way the Ninth Circuit would, or allow the plaintiffs to move forward with their case?

A 2017 case in California state court might be instructive. In Jensen v. iShares Trust, holders of ETF shares purchased in a secondary market, i.e. not directly from the issuer, attempted to bring a Section 11 suit against the issuer.

A San Francisco court granted a motion to dismiss due to the plaintiffs' inability to comply with Section 11's tracing requirements. The judge in this case (a case that is being appealed) issued a statement of decision in which he observed that the plaintiff's efforts to avoid the tracing requirement would mean that "all securities, including those sold in an initial offering pursuant to a perfectly innocent registration statement, could be the subject of a Section 11 suit if the securities ended up in the hands of someone—anyone—after a much later infirm registration statement ."

Of course, it remains to be seen whether other state courts will take the same rigorous approach this San Francisco court did.

Reviewing the Current Data

Woodruff Sawyer took a look at the list of state court cases concerning follow-on offerings from Stanford Securities Litigation Analytics, the same dataset that my good friend, the inimitable Kevin LaCroix, examined in a recent blog post on his nationally recognized blog, The D&O Diary.

(A big thank-you here to Jason Hegland, co-founder and executive director of Stanford Securities Litigation Analytics for his help gathering and analyzing the relevant data.)

First, when you compare the number of non-IPO follow-on offerings of all types conducted each year to the number of suits that have been filed against follow-on offerings, there are not many cases. This alone suggests that the threat of state court litigation over follow-on offerings is relatively muted. It's certainly much less than for IPOs.

Recently, we had heard from D&O insurance underwriters that they are particularly concerned that litigation rates against IPO companies that do a follow-on offering shortly after an IPO might be elevated in the post-Cyan world.

We attempted to examine this question using the D&O Databox, Woodruff Sawyer's proprietary dataset of D&O-related litigation, by doing a deep dive on the state court litigation for follow-on offerings.

Of course, we excluded M&A-related suits and suits against companies that were more than 15 years away from their IPO. We also excluded one case involving a company that went public on the OTC in 2012. This left us with 16 cases for our dataset.

Turning to our dataset: Timing was an interesting variable. Of the cases remaining in our dataset, we saw that the average time that passed from the IPO to the follow-on in question was 1.2 years, and the median was 0.6 years.

There were two cases where the time that had passed between the IPO and the follow-on in question was 3.7 and 3.8 years respectively; both of these were life science companies that had conducted several offerings between the IPO and the follow-on that suffered litigation.

A quick word on our decision to exclude from our 16-case dataset the case against Endo International plc, a troubling Section 11 Pennsylvania state case with a $50 million settlement: Kevin LaCroix has detailed the circumstances of this case in his popular blog, The D&O Diary. It's a notable case. We believe that it's proper to exclude them from our dataset because their trading on a US Exchange began back in 2000 (i.e. outside of our 15-year IPO window). In addition, it has a set of facts that makes the case particularly difficult (the alleged deteriorating performance relates to the company's portfolio of pain medications and controlled substances). Nevertheless, given the size of the settlement and the press it has received, we wanted to make special note of its exclusion from our dataset.

What Can We Conclude?

It's true that it's still early days for the post-Cyan world. Nevertheless, the early returns on follow-on offerings show that not all Section 11 offerings are equally likely to be sued—and certainly not at the same rate as IPO companies.

A seasoned company that does a follow-on has not turned its risk profile into that of an equally sized IPO company. Due to the tracing requirements, it will be much harder for the plaintiffs' bar to successfully sue issuers for Section 11 liability for follow-on offerings. The scarcity of Section 11 suits against follow-on offerings—particularly against follow-on offerings conducted by issuers that have been public for a while—supports this conclusion.