Slack Investor’s Suit Brings Direct Listing Puzzle to High Court

A 2018 New York Stock Exchange rule allowing the public trading of shares without an initial public offering has given rise to a potential new accountability issue that the US Supreme Court will take up on Monday.

At issue is whether people who purchase shares in a so-called direct listing have standing to sue the issuing company for making misrepresentations in its statement registering the stock with the Securities and Exchange Commission just prior to making it publicly available.

A divided panel of the US Court of Appeals for the Ninth Circuit ruled in September 2021 that investor Fiyyaz Pirani could sue communication platform operator Slack Technologies LLC for misrepresentations under Section 11 of the Securities Act of 1933.

Slack’s supporters say the ruling, if affirmed, would significantly widen liability for publicly traded companies. But investors and their advocates say the Ninth Circuit was right to point out a giant loophole by which direct listed companies could avoid such accountability—effectively eviscerating protections of the Great Depression-era law.

Pirani is “fighting upstream,” securities lawyer Susan Hurd said. He’s asking for a change in decades of case law for direct listings, which are a “little-used vehicle,” she said. Hurd, who’s with Alston & Bird LLP in Atlanta, pointed to a 2022 article counting fewer than 15 direct listings since they began in 2018.

Slack Technologies direct listed in 2019.

Registered, Unregistered Shares

The case presented the Ninth Circuit with a question of first impression over the NYSE’s Direct Listing Rule, which allows private companies’ securities already held by employees and others to be sold through direct listing on the exchange. By contrast, companies traditionally go public by selling their own shares via an IPO.

In an IPO, a company issues new shares under a registration statement that registers those securities with the SEC. Investment banks help companies sell the shares, but also impose a “lock-up period” during which no unregistered shares issued prior to the IPO can be sold, the Ninth Circuit explained. That lock-up period allows registered shares to be distinguished from unregistered ones.

Under the new rule, both registered and unregistered shares can be sold directly to the public through a direct listing on a national securities exchange. Companies file registration statements only for the purpose of allowing existing shareholders—such as employees and early investors—to sell their shares on an exchange, the court said.

Pirani bought Slack stock through a direct listing offered after Slack filed its registration statement. He later sued the company for allegedly violating Sections 11 and 12 of the Securities Act of 1933 by making misleading statements in its registration statement and prospectus. Slack, a unit of Salesforce Inc., understated its potential liability to users for service disruptions and misrepresented the extent of its competition with Microsoft Teams, Pirani said.

The sentence in Section 11 conferring standing allows suits by “any person acquiring such security.” There is, however, no antecedent for “such” in the sentence.

Slack argued investors must trace their shares to the registration statement, which it said Pirani couldn’t do because there’s no way to distinguish registered and unregistered shares without a lock-up period.

Ninth Circuit Ruling an ‘Outlier’?

The Ninth Circuit, affirming a ruling of the US District Court for the Northern District of California, pointed to the requirement that a company file a registration statement with the SEC before it can begin selling securities through a direct listing. Any person who bought Slack stock through the direct listing could do so only because of that statement, and so Pirani has standing, it said.

The same reasoning applies to Section 12 liability, which prohibits issuing a misleading prospectus, to the extent it parallels Section 11, the court said.

Hurd said she assumed the Supreme Court took the appeal because the Ninth Circuit’s decision “was an outlier,” inconsistent with a large body of caselaw. It doesn’t “seem likely that the Supreme Court granted cert to engage in a wholesale rewriting of the case law in this area,” she added in an email.

The new rule, with the traditional tracing requirement in place, wouldn’t create a “playground for fraudsters,” she said. The SEC can sue, and private plaintiffs can use Section 10(b)(5) of the Securities Exchange Act, she said.

But antifraud concerns are significant, according to investors, professors and others who submitted amicus briefs in support of Pirani.

“When a transfer of ownership from insiders to outsiders occurs via the public markets, the strongest rules ought to apply,” said Richard Bodnar of Rolnick Kramer Sadighi LLP in New York. Bodnar and others at the firm submitted a friend of the court brief on behalf of an investment management company.

“The common sense outcome would be to treat direct listings like IPOs and other direct offerings, and afford investors all of their rights under the Securities Act,” he told Bloomberg Law in an email. Any other result “would undermine both investor confidence and the carefully balanced regulatory protections of the capital markets,” he said.

Tracing Implications

Joseph A. Grundfest, an emeritus professor at Stanford Law School and a scholar of securities fraud litigation, disagreed with the Ninth Circuit’s decision and said the inability to trace direct-listing shares can be remedied through agency action.

“If the SEC simply required that registered shares come to market a day before exempt shares were allowed to trade, Section 11 liability would be preserved,” he said in an email. “There would be no need to torture the statutory text or to abandon decades of precedent to address this challenge.”

Grundfest, who submitted a brief supporting Slack with former SEC Chairman Jay Clayton, said the Ninth Circuit’s decision “effectively also erases the tracing requirement for a large number of cases that do not involve direct offerings.”

Hurd said that’s a reason the Supreme Court is likely to be cautious. “People are more concerned about what the case says about successive offerings” following an IPO than about the direct-listing situation, she said. “I don’t see the Supreme Court wanting to open that up.”

Oral argument is likely to focus on whether the phrase “such security” carries a traceability requirement or not. But that isn’t the only issue briefed by the parties and friends of the court. If the phrase is found ambiguous, should the high court turn to the legislative purpose and allow standing? Or should it deny standing given that Section 11 imposes strict liability?

Slack told the court in its opening brief that the Ninth Circuit “justified its departure from settled law based on a perceived policy concern” about undermining the purposes of Section 11. But the panel majority’s view “disrupts the delicate balance Congress struck” and “exposes issuers and others to massive and previously uncontemplated liability without fault,” it said.

Meanwhile, briefs submitted by former SEC officials and by the investment management firm argued that under the SEC-approved NYSE rule, all the shares are registered.

The case is Slack Technologies LLC v. Pirani, U.S., No. 22-200, oral argument scheduled 4/17/23.