By Mark S. Nelson, J.D.
A group of professors from Wharton, NYU and Georgetown, some of whom previously worked at the SEC, submitted a petition for rulemaking to the Commission asking for a re-write of Securities Act Rule 144 to add a lockup period for unregistered shares issued via direct listings. According to the rulemaking petition, the soon-to-be-argued Supreme Court case Slack Technologies, LLC v. Pirani exemplifies the need for the requested revision because, under current regulations, the commingling of registered and unregistered shares in direct listings can make traceability nearly impossible and, thus, render liability for issuers under Securities Act Section 11 elusive.
Comingling of shares. The Slack case involved a direct floor listing in which the plaintiff shareholder potentially acquired both registered and unregistered shares. Slack defended against the strict liability imposed by Securities Act Section 11, by arguing that the plaintiff was unable to trace his shares to a registration statement.
The Ninth Circuit majority and dissenting opinions, however, mulled two possible interpretations of Section 11’s phrase “such security,” which were suggested decades ago by Judge Friendly of the Second Circuit: (1) “acquiring a security issued pursuant to the registration statement” (the narrow view); and (2) “acquiring a security of the same nature as that issued pursuant to the registration statement” (the broader view). The Ninth Circuit majority took the latter route and concluded that Slack’s unregistered shares were “such securities” because their public sale required the existence of an effective registration statement.
Moreover, according to the majority opinion, the Slack case presented only one registration statement, unlike many other cases in which multiple registration statements make traceability potentially even more challenging because of the need to trace shares to a particular registration statement. In a footnote, the court took judicial notice of Slack’s Form S-1 and its Form S-8, which Slack had argued was a second registration statement, but noted that the Form S-8 was not part of the record and that, in any event, the forms referenced each other and any misleading statements in the Form S-1 would be part of the Form S-8.
The Slack case is scheduled to be argued before the U.S. Supreme court on April 17, 2023. Given the slower-than-usual pace at which the justices have been issuing opinions this term, and the current backlog of major cases, it is likely that a decision in Slack will come later in the term.
A rulemaking path forward? The professors’ rulemaking petition said they disagreed on the correct outcome in the Slack case, but they agreed with Slack and with several amici that changes to Rule 144 could solve the traceability problem. In the professors’ view, two market developments are driving the traceability problem: (1) IPO lockup waivers; and (2) direct listings without lockups. Both developments can result in the commingling of registered and unregistered shares that can make it difficult for a shareholder to trace their shares to a registration statement, a requirement to have standing under Securities Act Section 11.
According to the professors, the Commission should amend Rule 144 to provide that, when a registration statement becomes effective, the applicable holding periods should be reset to the later of either: (1) 90 days or (2) the filing of the issuer’s next Form 10-Q or Form 10-K. The rulemaking petition explained that the proposed holding period would be half as long as the holding period in traditional IPOs and it could be shortened by an issuer if the issuer releases its post-offering financials. However, the rulemaking petition also suggested that there is today some tension between longer lockup periods and shareholder demands for liquidity, thus resulting in the 90-day proposal that the professors said constitutes the middle ground as compared to proposed shorter and longer lockup periods.
The professors’ rulemaking petition noted a few of the rulemaking options cited by a small number of amici, but a wider look at the briefing throughout the Slack case’s time before the Supreme Court suggests that an amicus brief filed by former SEC Chair Jay Clayton and former SEC Commissioner Joseph Grundfest in support of Slack contains the most options and has drawn the most commentary, negative, positive and neutral.
According to Clayton and Grundfest, Congress need not be the arbiter of how to handle direct listings in the context of Section 11 because the SEC could use its rulemaking authority to clarify how that provision applies to direct listings. Clayton and Grundfest propose three options: (1) use different tickers for registered and unregistered shares; (2) for direct listings only, subject exempt (unregistered) shares to a one-day lockup after the initial auction of registered shares only; or (3) leverage distributed ledger technology (DLT) in a manner to obviate the need for tracing (Clayton and Grundfest described the third option as “ambitious”) (See at pp. 31-34).
With respect to separate tickers, an amicus brief submitted by Law and Business Professors in support of plaintiff/respondent Fiyyaz Pirani seemed cool to a similar approach that would employ separate CUSIPS. “As an aside, while issuing separate CUSIPs for registered and unregistered shares may be technically feasible in some situations, it presents certain practical difficulties, and it is not necessary to engage in tracing” (See at n.7) (Daniel J. Taylor signed both the Law and Business Professors’ amicus brief and the professors’ rulemaking petition).
With respect to a one-day lockup, the professors’ rulemaking petition suggested this approach would have little impact on preserving Section 11 liability in direct listings. Said the rulemaking petition: “As a practical matter, a period that short would significantly constrain the number of investors with standing under Section 11. The result would be to preserve the theoretical possibility of Section 11 liability—while, in reality, weakening the deterrence that Congress designed the statute to achieve.”
With respect to DLT, Slack’s merits brief appeared to agree with the aspiration of a more advanced clearance and settlement system. “Congress or the SEC could also require changes to the financial system to facilitate the tracing of specific shares,” said Slack. The company then added: “Whether technological advancements have made such tracing practicable and whether there is sufficient social benefit to warrant it are questions that only the political branches can answer” (See at p. 47).
The professors’ rulemaking petition also noted that Slack had briefly addressed the question of potential SEC reforms for direct listings in its merits brief. “The SEC would have ample tools at its disposal to address the concerns identified by the courts below if they were problematic,” said Slack. “It could, for example, mandate a lockup period whenever registered shares first become available for trading on a public exchange” (emphasis in original) (See at p. 46).
Pirani’s briefing, however, appears not to have directly addressed how the SEC might reform rules applicable to direct listings, but rather emphasizes the policy choices that likely informed the Ninth Circuit majority. For example, in his merits brief, Pirani noted that while modern offering developments can make tracing more difficult, these are the same type of problems that would have existed when Section 11 was enacted in 1933. “…Congress surely would not have written the statute in a way that would allow such easy evasion of the statute’s central private enforcement provisions” (See at p. 39).
Going back even earlier in the case, Pirani’s opposition to Slack’s certiorari petition also emphasized policy, in that instance suggesting that allowing his case to go forward would not unduly discourage IPOs. Said Pirani: “The Ninth Circuit’s order simply ensures compliance with the existing statutory scheme adopted nearly a century ago, which will not be the death knell of direct listings and other potentially novel methods of going public. Indeed, 2021 was a record year for IPOs. And, although IPOs have slowed in 2022, the slowdown has not been attributed to the Ninth Circuit decision” (See at p. 33).
Securities Regulation Daily, for example, examined the 2022 IPO market, which saw a dramatic turnaround from 2021’s record-shattering numbers. Deals dropped 83 percent year-over-year, while the proceeds raised by IPOs fell 93 percent. A cooling market for special purpose acquisition company (SPAC) offerings, rising interest rates, and geopolitical concerns factored significantly in IPO market activity during the past year. But as Securities Regulation Daily reported earlier this week, the last week of March was the IPO market’s busiest of 2023 so far with 10 new issues and 10 preliminary registrations. Moreover, ongoing competition between traditional IPO markets and private capital markets also may impact a company’s decision about whether to remain private or to go public.