Slack Decision Likely to Impede Direct Listing Investor Lawsuits

Investors in companies that go public through a direct listing will have a harder time bringing cases after a Ninth Circuit decision this week, attorneys say.

The decision favoring Slack Technologies LLC highlights how the securities laws passed in the wake of the Great Depression don’t fully account for alternative routes to public markets that have gained in popularity. Slack was at the forefront of a direct listing movement that has since included Warby Parker Inc., Coinbase Global Inc., and Roblox Corp.

When an investor said in a lawsuit that Slack’s 2019 registration statement failed to disclose the extent to which the company would have to provide credits to customers over service disruptions, the messaging app company—now a subsidiary of Salesforce Inc.—argued he lacked legal standing to sue under the Securities Act of 1933 because he couldn’t prove he bought registered shares. The US Supreme Court, hearing that argument, remanded the case to consider that issue.

The US Court of Appeals for the Ninth Circuit on Feb 10 ruled for Slack, saying the suit must be dismissed. The decision reinforced that investors must trace their shares to a registration statement in order to sue over that document under the Securities Act, without a showing of intent. And tracing shares is difficult to do in the context of a direct public offering, where there’s no lockup period keeping previously issued shares off the market.

“This decision potentially gives companies a roadmap on how to evade the disclosure requirements of the Securities Act, which is really concerning,” said John Rizio-Hamilton of Bernstein Litowitz Berger & Grossmann LLP, who represents investors.

Plaintiffs will likely try to prove they can trace their shares, Rizio-Hamilton said. “That will be a big battleground going forward, whether tracing is possible through expert methodologies” such as accounting techniques applied to trading data and account balances, he said.

The Slack appeals court rejected investor Fiyyaz Pirani’s use of statistics to show he must have purchased some registered shares.

‘Hard to Satisfy’

“The Ninth Circuit decision, like the Supreme Court decision before it, doesn’t say that tracing is impossible,” said Boris Feldman of Freshfields US LLP. But that requirement of Section 11 of the Securities Act “will be very hard to satisfy in most direct listings,” he said.

Investors still have securities fraud claims available under section 10(b) of the Securities Exchange Act, said Mark Foster of Skadden, Arps, Slate, Meagher & Flom LLP. “This isn’t a situation where investors don’t have recourse. It just means that the statute was designed to protect investors who actually bought their shares traceable to an offering,” he said of the Securities Act. “There are very few of them who can do that.”

“It’s for those initial investors who take on the initial risk,” he said.

The decision has implications outside the direct listing context as well, said Skadden’s Winston Hsiao. “These tracing arguments come up in a situation of a secondary offering, where you have a similar dynamic,” and where investors often make “a variation of the statistical probability argument that the plaintiffs made in this case,” he said.

“All those arguments are going to be even more difficult to make in light of this decision, if not precluded altogether,” he said.

Effect on Investment Decisions

Investors would never make investment decisions based on legal considerations like the Slack case, said Feldman. “If it’s a company that you believe in, and if it’s at a price that you think is a good price with some upside, I think very few investors will decline to invest” because of litigation rules, just as they haven’t avoided companies with provisions that they can only be sued for breach of fiduciary duty in Delaware, he said.

And companies aren’t likely to have concerns about investors avoiding their direct-listed stock for this reason, said Feldman, who participated in submitting an amicus brief when the case was before the Supreme Court. “From the standpoint of the company considering going public, there are many tradeoffs on an underwritten IPO versus a direct listing to think about,” he said. “I do not think that one of the one of the negatives of going with the DPO is ‘Investors will stay away from us because of the Slack tracing problem.’”

But according to Rizio-Hamilton, “It should raise a red flag for an investor if a company chooses to proceed by direct listing, because it’s a signal that the company may not wish to fully comply with the disclosure requirements of the Securities Act.”

The issue is getting attention among institutional investors, he said. “Whether we see an effect on investment decisions is an open question, but it’s fair to say that investors have noticed this,” the plaintiff-side lawyer said.

Investors, and their advocates, are likely to look for a regulatory or legislative solution to help direct-listed shares become traceable, but nothing is expected in the near term, he said.

Applying Law Narrowly

“For those on the issuer side and the side of investment banks and anybody who’s involved in public offerings in the capital markets, this decision is good news,” said Foster. It will be hard for plaintiffs in direct listing cases to trace shares to a public offering. And the decision benefits issuers because Section 11 claims—which bring the potential for strict liability, or liability regardless of intent—"are often difficult to have thrown out early in a case on a motion to dismiss,” he said.

The decision supports the idea that other elements and components of claims under Section 11—and Section 12, governing prospectuses—should be applied narrowly as well, including who can be liable, Hsiao said.

“If there’s a material misstatement in the registration statement, the company’s on the hook, period, absent some affirmative defenses,” Feldman said of Section 11.

“That’s why I think the Supreme Court, in Slack and in other decisions, has cracked down on the jurisdictional requirements,” he said. “This is a super-potent statute.”