Robinhood and the Section 11 Defense

Robinhood is gearing up for its IPO, and one of its gimmicks is to allot 20-35% of its newly issued shares to its own customers, who trade on its platform.  This unusual allocation is being billed, in part, as evidence of its commitment to “democratize finance,” and it’s not the first time a company has used its IPO allocations as, essentially, a branding mechanism.

But this New York Times piece also points out that Robinhood is allowing its own employees to trade up to 15% of their shares right away, which is pitched as being of a piece with Robinhood’s nontraditional stock allocations.  And, in fact, Robinhood’s S-1 says:

up to 15% of the shares of our outstanding Class A common stock and securities directly or indirectly convertible into or exchangeable or exercisable for our Class A common stock held, as of the date of this prospectus, by our directors, officers and current and former employees and consultants (other than our founders and our Chief Financial Officer, who are discussed above) …, with such 15% calculated after excluding any shares withheld for taxes associated with IPO-Vesting Time-Based RSUs, may be sold beginning at the commencement of trading on the first trading day on which our Class A common stock is traded on Nasdaq

The registration statement says that another 15% of employee shares can be sold after 90 days.

Now, I’m not going to speculate as to Robinhood’s actual motives for permitting its employees and directors to trade 15% of their stock immediately, but I will note that if these shares – which were presumably issued pursuant to a Rule 701 plan and are not registered – become immediately tradeable, that will make it much more difficult for open-market purchasers in the future to bring any Section 11 claims.

Section 11, of course, permits purchasers of registered securities to sue when the security’s price drops below the offering price, if the registration statement contains false or omitted information.  Section 11 claims don’t require a showing of scienter, but there’s a catch: the plaintiff must be able to show that his or her shares were, in fact, issued pursuant to the defective registration statement; unregistered shares, or shares issued pursuant to some other registration statement, won’t qualify.  Which means, if there’s a “mixed” pool of shares trading – some of which were issued on the defective registration statement, and some of which were not – an open-market purchaser will have trouble establishing that his or her shares were part of the registered group, which could bar Section 11 claims no matter how deceptive the registration statement may turn out to have been.

As I previously posted, this requirement has already created some havoc in the context of direct listings – and the Slack case, described in my blog post, has been pending before the Ninth Circuit basically forever – but most traditional IPOs require that pre-IPO shares be locked up at least for 180 days after the offering.  The lockup means that at least for the first 180 days, all shares available to trade are registered shares, and anyone who buys in that period will be able to show that their shares were traceable to the registration statement.  If there’s a problem with that registration statement, those early purchasers will be able to advance Section 11 claims.

Attorneys have in the past proposed that lockups be made less strict, essentially as a method of stymieing Section 11 claims; if unregistered shares are mixed in with the registered shares as soon as trading begins, the theory goes, no open-market purchaser will be able to trace their shares to the registration statement.  Robinhood (whatever its actual motivation) seems to be adopting that strategy. 

Now, I’m going to do something very dangerous: I’m going to try to read the S-1 and do math, and I’m not at all certain I’m getting this right, so everything I’m about to say should be taken with a pillar of salt. 

But, if I’m reading the S-1 correctly, Robinhood is registering and selling 60.5 million shares (including the greenshoe, and registered insider sales).  And it looks like the additional employee shares that will be available to trade right away number a little over 7 million.  Plus, as I understand it, there’s an additional 45 million shares or so that may be free to trade soon after the IPO as a result of certain note conversions, but these additional shares will be registered on a separate registration statement soon after the IPO.  Let’s assume that this new registration statement contains the same information as in the IPO registration statement.  And after 30 days ish, I believe another 45 million shares can be converted, and will also be free to trade, but these will also be registered on the second registration statement.

(Again, I really need to emphasize I am not at all certain I’m catching everything, so really just take this as a vague sort of ballpark thing)

My point – however inexact my calculations may be – is this: if it turns out that the registration statement(s) contain false information, or omit required information, we’re looking at an open-market pool of (at various times) as many as 105 to 150 million registered shares, and maybe 7 million unregistered ones, for at least the first 90 days of trading.  Of course, not all holders will trade; that’s just an approximation of the shares available.

Which means any open-market purchaser is very likely to have bought registered shares; but is not certain to have done so. 

Will that be enough to bar Section 11 claims?

Well, the law’s not exactly clear on this.  The Fifth Circuit famously held that even if there was over a 90% probability that shares purchased by the plaintiffs were registered, they would not be able to bring Section 11 claims.  See Krim v. pcOrder.com, Inc., 402 F.3d 489 (5th Cir. 2005); see also Doherty v. Pivotal Software, 2019 WL 5864581 (N.D. Cal. Nov. 8, 2019) (following Krim).  But in In re Snap Securities Litigation, 334 F.R.D. 209 (C.D. Cal. Nov. 20, 2019), the court held that 100,000 unregistered shares mixed in with 200 million registered shares would not be enough to bar Section 11 claims.  In so doing, the court noted, “As a policy matter, barring use of statistical tracing in litigation following a major IPO would mean that waiving the lock-up period for even nominal number of pre-IPO investors would effectively inoculate a corporation against nearly all potential Section 11 liability it might face for misstatements or omissions in its registration statement.”

Which means – I don’t know what happens with a pool that’s maybe 4.5% unregistered, and I really don’t know whether a court is likely to split the baby and distinguish between pleading Section 11 standing and actually proving it later in the case, either on the merits or at class certification.

Now, obviously, maybe there won’t be any Section 11 claims!  Maybe the shares will never trade below their IPO price; maybe there won’t be any false statements in the registration statement.  But considering the overwhelming regulatory risks that Robinhood’s business model poses (and of course its S-1 describes these), I think there’s a nonzero chance all this is going to be tested.  And I’d assume Robinhood’s lawyers are gearing up for that possibility.*

 

*Another problem might concern the issue of multiple registration statements.  Now, if the two registration statements contain identical misstatements and omissions, it isn’t necessary that a plaintiff trace her shares to either one simply to show that she purchased shares pursuant to a defective registration statement.  But – and this is an issue I discuss in my Slack blog post – Section 11 damages are tied to the “the price at which the security was offered to the public,” and for shares issued pursuant to note conversions, that price, I assume, is likely to be the conversion price.  But the note conversion price is a different, and lower, price than the offering price for the IPO shares.  That would mean that a damages calculation might require an open-market purchaser to identify whether her shares originally are traceable to a note conversion, or to the IPO (which, of course, will be impossible once trading in both begins, and since there are a lot of note-conversion shares, the probabilities will work less in plaintiffs’ favor than the issue of registered vs. unregistered shares).  But the Slack court held that the issue of damages did not have to be decided at the pleading stage, and if Robinhood’s share price were to fall even below the note conversion price, a plaintiff class might be willing to just agree that the note conversion price will be treated as the offering price for the entire class.

Edit: See comments; the converted stock may be registered only for resale at the market price.  Which means, the converted stock won’t have a specific offering price, creating a similar issue as occurred in the Slack case, i.e., figuring out how to define an offering price when shares are registered only for resale by someone other than the issuer.  A court might decide the offering price for Section 11 purposes should be defined as the conversion price, but might decide the offering price should be defined as something else, or even that there is no offering price at all.