Slack Wins: Section 11 Claims Require Tracing

Going public through a direct listing just got more attractive thanks to the recent Supreme Court ruling in Pirani v. Slack Technologies Inc. In a unanimous decision, the Court held that to bring a claim under Section 11 of the Securities Act of 1933, plaintiffs have to be able to trace the shares they purchased to the registration statement they are alleging is deficient.

This article explains why the Slack ruling is important for companies considering going public through a direct listing and how the decision may affect D&O insurance rates.

Slack's Direct Listing Put Registered and Unregistered Shares Into the Public Market

Long-time readers of this blog will recall that Slack went public through a direct listing process. As a result, some of the Slack common stock being traded on the New York Stock Exchange was registered pursuant to Slack’s S-1 registration statement, but certainly not all of it.

Specifically, the company registered 118 million shares for sale pursuant to its S-1 registration statement. At the same time, the direct listing process allowed an additional 165 million unregistered shares to be sold in the public market.

When the price of Slack’s shares dropped, shareholders brought suit pursuant to Section 11 of the 1933 Securities Act. The plaintiffs alleged that Slack’s S-1 registration statement was materially misleading.

As I discussed in an earlier article on this topic, plaintiffs suing Slack under Section 11 of the Securities Act of 1933 asserted that they did not have to meet Section 11’s typical tracing requirement. The plaintiffs wanted to avoid the tracing requirement because the mix of registered and unregistered shares in the market made it all but impossible to tell if the shares they purchased were shares that were registered on the S-1 or not.

The plaintiffs’ argument contradicted what was otherwise regarded as a settled requirement under the law.

The justices of the United States Supreme Court were not impressed. In a unanimous decision, the court held that Section 11 cases require that plaintiffs both plead (allege) and prove that they purchased shares that can be traced back to the allegedly deficient registration statement.

The Court remanded the case back to district court. There are other issues implicated by direct listings that remain in play. These issues will be decided as the case progresses—assuming the parties do not settle the case first.

Are the Direct Listing Floodgates Now Open?

As a reminder, from 2018 through 2022, there were only 13 direct listings. This compares to more than 1,000 IPOs and more than 400 de-SPAC transactions in the same five-year period.

There may have been various reasons for the comparative lack of popularity of direct listings. The biggest issue, of course, is that a company going public through a normal direct listing takes on all the burdens, including the cost of becoming a public company, without raising capital for itself at the same time.

This is because direct listings involve the registration of secondary shares, meaning the public is buying shares from existing shareholders.

As a result, the proceeds of the sales go to the sellers, not the company. (Traditional direct listings are also referred to as “selling shareholder direct floor listings.”)

Slack’s offering was a selling shareholder direct floor listing. As such, the direct listing did not raise any capital for Slack itself.

However, for companies that want to go public through a direct listing and also need to raise capital, there is a solution to this fundraising problem in the form of a “primary direct listing” (also known as a “primary direct floor listing”).

The idea is that at the same time a company is using the direct listing process to register secondary shares and go public, the company could also raise money for itself by selling primary shares.

There have been no primary direct floor listings to date. However, in December 2022, the Securities and Exchange Commission (SEC) approved certain additional new rules for both the NYSE and the Nasdaq that should make it easier for companies to raise new capital through the sale of primary shares while also selling secondary shares in a direct listing.

(The SEC has previously approved primary direct listings, but technical issues made doing one very difficult. This memorandum by the law firm Ropes and Gray explains why the more recent rule changes are helpful).

Sounds complicated? Perhaps. However, the other traditional way to go public, through an IPO, often involves a combination of primary and secondary shares.

The wrinkle here, of course, is that after Slack, a primary direct listing may seem like a way to circumvent Section 11 liability because plaintiffs’ tracing problem will persist, making it impossible for plaintiffs to bring a Section 11 claim.

So, will there now be a lot more direct listings? On the one hand, some companies may prefer to engage in a going-public process that is free from the specter of Section 11 liability.

On the other hand, some have suggested that investors will be disinclined to purchase shares in a direct offering since the protections of Section 11 are absent.

One likely outcome is that direct listings will continue to appeal to some companies and not others, depending on their specific economic circumstances.

The question of whether there is Section 11 liability is unlikely to be a determining factor when a company is deciding how it wants to go public. At the same time, it is unlikely that a large cohort of investors is making investment decisions based on whether, if things go badly, they can recover a portion of their investment by joining a Section 11 securities class action lawsuit.

Finally, given that the Slack case has been remanded
back to district court, the liability framework for direct listings is still
somewhat in flux.

What Does the Slack Decision Mean for D&O Insurance?

After the Slack decision, one hopes that insurance carriers will discount the cost of D&O insurance for a company doing a pure direct listing compared to what they might charge a company going public through a normal IPO process.

It is not surprising that the cost of D&O insurance for new public companies is normally much higher than for mature public companies. After all, new public companies are sued more frequently than mature public companies.

One reason for the higher litigation rate is that new public companies, particularly those with less-experienced management teams, may be more prone to the type of process and disclosure foot faults that lead to stock drops and subsequent litigation.

Another reason, until the decision in Slack, is that both IPOs and direct listings were subject to Section 11 litigation. Plaintiffs are eager to pursue these claims since companies have strict liability for material misstatements and omissions in a registration statement.

Indeed, if shortly after an IPO, a company’s stock price falls below its IPO price due to the disclosure of bad news, Section 11 securities class action litigation often follows.

These suits are easier than Section 10b suits, where plaintiffs have the burden of proving that misstatements and omissions were intentionally made.

However, after the Slack decision, plaintiffs will not be able to bring a Section 11 case against a directly listed company after the company’s stock price falls below its initial reference price since it will usually be impossible for plaintiffs to trace their shares back to the registration statement.

But this is not a free pass.

Nothing about the Slack ruling diminishes plaintiffs’ enthusiasm for Section 10b litigation, not to mention scrutiny by the SEC.

For this reason, and all other things being equal, while direct-listed companies may enjoy a discount compared to what IPO companies are paying, the cost of D&O insurance for new direct-listed companies will still likely be higher than what well-run, mature public companies are paying.

Woodruff Whiteboard Breakdowns: Sides A, B & C of a D&O Liability Insurance Policy