Saturday, September 25, 2021

An Embarrassment of Riches: Slack, Brookfield, Activision, and the Death of Aronson

Sometimes, there’s not a whole lot new to blog about – and other times you get the Slack decision, the Brookfield decision, an SEC investigation of Activision, and Aronson’s demise all in a single week.  So in this post, I am going to tackle the first three and save United Food and Commercial Workers Union v. Zuckerberg for maybe another time, but if you really want to know my immediate reaction to the Zuckerberg case, I tweeted a thread here.  Professor Bainbridge also has a long blog post on the Zuckerberg decision here.


I previously blogged about this case here, and the short version is that Slack went public via direct listing, and filed a Securities Act registration statement for slightly fewer than half of the shares that became available to trade on the opening day, because the rest of the shares did not need to be registered in order to trade under Rule 144.  Stock purchasers claimed that the registration statement contained false statements in violation of Section 11 of the Securities Act; the question was whether they’d need to establish that theirs were the registered shares before they’d be able to bring a claim – an impossible task, which would functionally prevent any shareholders from bringing any Section 11 claims at all.  The district court said no, they did not have to do that, and earlier this week, the Ninth Circuit affirmed by a 2-1 vote

The Ninth Circuit’s logic was unexpected, to say the least.  The Court interpreted NYSE Listed Company Manual, Section 102.01B Footnote E, to mean that NYSE direct listings are legally not possible unless a Securities Act registration statement is filed.  According to the court:

Per the NYSE rule, a company must file a registration statement in order to engage in a direct listing.  See NYSE, Section 102.01B, Footnote E (allowing a company to “list their common equity securities on the Exchange at the time of effectiveness of a registration statement filed solely for the purpose of allowing existing shareholders to sell their shares”) (emphasis added).... As indicated, in contrast to an IPO, in a direct listing there is no bank-imposed lock-up period during which unregistered shares are kept out of the market. Instead, at the time of the effectiveness of the registration statement, both registered and unregistered shares are immediately sold to the public on the exchange. See NYSE, Section 102.01B, Footnote E.  Thus, in a direct listing, the same registration statement makes it possible to sell both registered and unregistered shares to the public.

Slack’s unregistered shares sold in a direct listing are “such securities” within the meaning of Section 11 because their public sale cannot occur without the only operative registration in existence. Any person who acquired Slack shares through its direct listing could do so only because of the effectiveness of its registration statement….

Slack’s shares offered in its direct listing, whether registered or unregistered, were sold to the public when “the registration statement . . . became effective,” thereby making any purchaser of Slack’s shares in this direct listing a “person acquiring such security” under Section 11.

Now, the reason this is surprising is that the argument almost seems to have come out of nowhere.  It was not the basis for the district court’s decision, and though it was alluded to by the plaintiffs in their Ninth Circuit briefing, neither the defendants, nor their amici, seems to have addressed it, and the issue was only barely mentioned at oral argument.  And no one cited Section 102.01B Footnote E of the NYSE Listed Company Manual at all.

Plus, I gotta say, this is not the most convincing reading of the NYSE rules.  Here’s what the NYSE Listed Company Manual, Section 102.01B Footnote E, actually says:

Generally, the Exchange expects to list companies in connection with a firm commitment underwritten IPO, upon transfer from another market, or pursuant to a spinoff. However, the Exchange recognizes that some companies that have not previously had their common equity securities registered under the Exchange Act, but which have sold common equity securities in one or more private placements, may wish to list their common equity securities on the Exchange at the time of effectiveness of a registration statement filed solely for the purpose of allowing existing shareholders to sell their shares, where such company is listing without a related underwritten offering upon effectiveness of a registration statement registering only the resale of shares sold by the company in earlier private placements. …Consequently, the Exchange will, on a case by case basis, exercise discretion to list [such] companies …

That doesn’t sound like the NYSE is prohibiting direct listings in the absence of a Securities Act registration; it sounds more like the NYSE has not contemplated that an issuer might want to list without one. 

Now, to be fair, maybe that doesn’t matter.  The NYSE, in creating its rules (which had to be approved by the SEC), only contemplated direct listings accompanied by a Securities Act registration statement, so that’s all that’s currently authorized. (Subsequent correction: I have since learned that, in fact, the SEC required some S-1 be filed as a condition of direct listing.)

Still, the legal effect of the registration statement was not, despite the Ninth Circuit’s holding, that it allowed the unregistered securities to trade publicly.  Rule 144 allowed them to trade publicly without any registration statement at all.  What the registration statement arguably allowed was for them to trade publicly on the Exchange, which is not the same thing.

Which gets to what I think was really the driving force behind the Ninth Circuit’s decision: policy.  As the Ninth Circuit explained:

interpreting Section 11 to apply only to registered shares in a direct listing context would essentially eliminate Section 11 liability for misleading or false statements made in a registration statement in a direct listing for both registered and unregistered shares. While there may be business-related reasons for why a company would choose to list using a traditional IPO (including having the IPO-related services of an investment bank), from a liability standpoint it is unclear why any company, even one acting in good faith, would choose to go public through a traditional IPO if it could avoid any risk of Section 11 liability by choosing a direct listing.  Moreover, companies would be incentivized to file overly optimistic registration statements accompanying their direct listings in order to increase their share price, knowing that they would face no shareholder liability under Section 11 for any arguably false or misleading statements.  This interpretation of Section 11 would create a loophole large enough to undermine the purpose of Section 11 as it has been understood since its inception.

And this is why the dissent is dissenting; in Judge Miller’s view, these policy considerations should not override the plain text of Section 11, which only permits claims by “any person acquiring such security,” meaning, “such security” as was registered on the faulty registration statement. 

Now, I suspect we’re not done here, because defendants will likely seek rehearing and/or certiorari, but if this is the final word, I note that the Ninth Circuit’s decision may have implications for ordinary IPOs, when issuers forego the traditional 180-day lockup and instead allow insiders to trade unregistered shares right away.  I previously blogged about this problem in connection with Robinhood’s IPO; per Law360, a lot of companies are now eliminating the traditional lockup.  Under prior law, one would expect the immediate trading of unregistered shares to bar, or at least inhibit, Section 11 claims, but by the Ninth Circuit’s logic, as I understand it, for these companies, the Securities Act registration statement is a necessary step to allow the unregistered shares to trade on the Exchange, and that might be enough to eliminate the tracing requirement.  The Ninth Circuit distinguished situations where shares were issued pursuant to more than one registration statement, see op. at 12, 14, but it also suggested – as other courts have held – that tracing is not an issue when the two registration statements contain identical misstatements, see op. at n.5; see also In re IPO Sec. Litig., 227 F.R.D. 65 (S.D.N.Y. 2004).  Point being, this decision, if it stands, could become the basis for eliminating the tracing requirement for exchange-traded shares so long as there has only been either one registration statement, or all registration statements contain identical misstatements.

What the Ninth Circuit decision does not resolve, though, is how losses/damages would be calculated in these kinds of situations, which – as I blogged in connection with Slack and Robinhood – remains an issue. 

My final observation is that the SEC could make most of this go away by refusing to accelerate the effectiveness of a registration statement for any issuer that does not agree to waive tracing defenses for shares purchased in the first 180 days.


Short version: Ordinarily, if a corporation issues new shares in exchange for inadequate consideration, this is a derivative harm to existing shareholders, but Gentile v. Rossette created an exception to that rule by holding that if the shares are issued to a controlling shareholder, who thereby increases his/her/its level of control, the harm is both direct and derivative.  Gentile sat uneasily amongst Delaware precedent for a long time, as Delaware courts increasingly narrowed its application, until finally, in Brookfield Asset Management v. Rosson, the Delaware Supreme Court eliminated it.  As the court put it:

Gentile is premised on the presence of a controlling stockholder that allegedly used its control to “expropriate” and extract value and voting power from the minority stockholders.  Controlling stockholders owe fiduciary duties to the minority stockholders, but they also owe fiduciary duties to the corporation.  The focus on the alleged wrongdoer deviates from Tooley’s determination, which turns solely on two central inquiries of who suffered the harm and who would receive the benefit of any recovery. That shift has led to doctrinal confusion in our law. The presence of a controller, absent more, should not alter the fact that such equity overpayment/dilution claims are normally exclusively derivative because the Tooley test does not turn on the identity of the alleged wrongdoer.

Still, this direct/derivative problem is not entirely settled because – as the Delaware Supreme Court pointed out – “To the extent the corporation’s issuance of equity does not result in a shift in control from a diversified group of public equity holders to a controlling interest, (a circumstance where our law, e.g., Revlon, already provides for a direct claim), holding Plaintiffs’ claims to be exclusively derivative under Tooley is logical and re-establishes a consistent rule that equity overpayment/dilution claims, absent more, are exclusively derivative …. we see no practical need for the ‘Gentile carve-out.’ Other legal theories, e.g., Revlon, provide a basis for a direct claim for stockholders to address fiduciary duty violations in a change of control context.”

In other words, if you’re a shareholder in a company without a controller, and directors sell enough of an interest to create a controller, then, even if there was no change in the character of the shares you personally hold, you can still bring a direct, Revlon-standard review challenge to that action.  Which to be honest I was not, until now, sure was a clear thing, though there have been some decisions that suggested as much.  See In re Coty Stockholder Litigation, 2020 WL 4743515 (Del. Ch. Aug. 17, 2020).  But I will say, given the malleability of the standard for what counts as control – see my numerous blog posts on the subject – any cases that arise will be hilarious to watch.  On the one hand, plaintiffs will want to argue that the party receiving the new stock was a controller already, so that the MFW standards for cleansing apply; on the other, plaintiffs will want to argue that the party receiving the new stock was not a controller already, in order to be able to bring claims directly.  And defendants will have the opposite incentives. 

I’ll also note that in Brookfield itself, plaintiffs offered the alternative argument that they had a direct claim because the company undersold shares to a 51% controller, in a manner that brought the controller’s holdings to 65%.  This was significant, claimed the plaintiffs, because certain charter provisions could only be amended upon a 2/3 vote, so increasing the controller’s power to that level gave the controller even more substantive control. 

And the Delaware Supreme Court did not reject the argument as a theoretical matter!  Meaning, it’s not only a direct claim if the company goes from no control to control; it’s a direct claim if the company goes from control to next-level control.  But, the Supreme Court said, the plaintiffs had not made their factual case here because 65% < 2/3. 

Which I have to say is pretty unconvincing; I mean, Delaware will accept that someone with 49% of the vote in a public company is a controller, because that additional 1% it needs will come from somewhere; I don’t see why the same argument couldn’t be used to say that 65% is functionally the same as 66% when it comes to public companies.  But that only highlights the problem here: once legal significance is attached to going from no control to control, or from control to next-level control, defining what we mean by control becomes very hard to do.

A final note on this: I previously blogged that in the Tesla trial, VC Slights could theoretically resolve the entire matter without ever deciding whether Elon Musk is, or is not, legally a controlling shareholder; as I said at the time, the only wrinkle that might force such a decision on him were the plaintiffs’ direct claims brought under a Gentile theory.  Now that that theory is kaput, it will be even easier for Slights to avoid the is-he-or-isn’t-he question, if the facts allow it and that’s something he wants to.


Activision Blizzard, according to reports, has a very serious sexual harassment/sex discrimination problem.  So serious that the California Department of Fair Employment and Housing filed a lawsuit after a 2-year investigation.  The EEOC has also been investigating the company since 2020.

Given all this, it’s no surprise that when the news broke, a shareholder lawsuit was filed against Activision, generally alleging that the company misrepresented its employment policies to investors.

What was more surprising, though, was the news that the SEC was investigating Activision, because usually that’s not the kind of fraud that the SEC gets involved with.  It’s hard to exactly articulate the difference, but the SEC tends to stay its hand when the allegation is that the company was doing non-financially bad things and did not disclose those bad things to investors.

What gives?

I have no special insight, of course, but if I had to guess, this is about the fact that the SEC only recently made the following addition to Item 101 of Regulation S-K:

(c) Description of business….

(2) Discuss the information specified in paragraphs …[(c)(2)(ii)] of this section with respect to, and to the extent material to an understanding of, the registrant's business taken as a whole, except that, if the information is material to a particular segment, you should additionally identify that segment….

(ii) A description of the registrant's human capital resources, including the number of persons employed by the registrant, and any human capital measures or objectives that the registrant focuses on in managing the business (such as, depending on the nature of the registrant's business and workforce, measures or objectives that address the development, attraction and retention of personnel).

And indeed, in its 2020 10-K, filed in February 2021, Activision included these statements under the heading “Human Capital”:

Activision Blizzard takes an active role in the entirety of the employee lifecycle, from candidates to alumni. Recognizing that ours is a rapidly changing industry with constant technological innovation, we remain focused on attracting, recruiting, enabling, developing, and retaining a diverse and innovative employee population.

Diversity, Equity, and Inclusion (“DE&I”): We believe that a culture of inclusion and diversity enables us to create, develop, and fully leverage the strengths of our workforce to exceed players' and fans' expectations and meet our growth objectives. We remain committed to building and sustaining a culture of belonging, built on equitable processes and systems, where everyone thrives. By embedding DE&I practices and programs in the full employee lifecycle, we work to recruit, attract, retain, and grow world-class talent. Our employee resource groups play an active role in our DE&I efforts by building community and awareness. We also offer leadership and management development opportunities on the topics of unconscious bias and inclusive leadership and train our recruiting workforce in diverse sourcing strategies….

Compensation and Benefits: The main objective of our compensation program is to provide a compensation package that attracts, retains, motivates, and rewards top-performing employees that operate in a highly competitive and technologically challenging environment. We seek to do this by linking compensation (including annual changes in compensation) to overall Company and business unit performance, as well as each individual’s contribution to the results achieved. The emphasis on overall Company performance is intended to align our employee’s financial interests with the interests of our shareholders. We also seek fairness in total compensation by reference to external comparisons, internal comparisons, and the relationship between development and non-development, as well as management and non-management, remuneration. We believe in equal pay for equal work, and we continue to make efforts across our global organization to promote equal pay practices….

Employee Experience: We capture and act on the voice of our employees through regular company-wide pulse surveys. We emphasize to employees that this is their chance to “provide honest, candid feedback about their experience working for the company.” Our survey participation rates (regularly 75% or higher) demonstrate our collective commitment that Activision Blizzard remains a great place to work. The survey—and other forms of employee feedback—result in actionable steps that lead to positive improvements to the employee experience at the company-wide, business unit, and team levels. Our employee feedback is dynamic and relevant to our employees’ immediate needs. …

That … sounds rather at odds with a company that is alleged to have tolerated extreme levels of sexual harassment, discriminated against women in pay and promotion opportunities, and actively discouraged women from reporting their complaints to HR.  Notably, the California DFEH and EEOC investigations were well underway when this 10-K was filed, but I can’t find mention of either.

So if I had to guess, the SEC views this situation as potentially a way of communicating that no, it’s actually not kidding when it says that human capital disclosure is a required line item under Item 101 of Regulation S-K.

Assuming my speculations are correct, this is not about the SEC demanding that companies preemptively accuse themselves of uncharged wrongdoing; it’s not even about whether Activision’s practices ultimately turn out to be legal or illegal under California or federal law.  This is about the SEC, having recognized that in the knowledge economy, workforce management is an important contributor to corporate wealth, responded to investor demand by requiring a new level of transparency surrounding it.  And in the very first year after those requirements took effect, one digital company – exactly the type of knowledge/skills-based company that inspired the new requirements – may have blatantly misdescribed to investors the facts surrounding its internal policies.  And that possibility is what the SEC is looking into.

And - that’s as much as I can handle this week!

Ann Lipton | Permalink


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