Section 12's Photo Bomb

There is so very much to say about the Slack Technologies v. Pirani case pending before the Supreme Court.  Oral argument was held Monday; here is a link to the transcript.

Slack went public via direct listing, which as a practical matter meant: Slack itself did not sell new shares to the public; it merely enabled existing shareholders to sell by listing its shares on the NYSE.  Existing shareholders were largely early investors – who had purchased under Rule 506 exemptions – or employees – who had purchased under Rule 701 exemptions.

At the time of the listing, a little more than half of these early investors were legally free to sell their shares to the public, and did.  A little fewer than half were still bogged down by SEC rules for holding periods in private sales.  For these shares – and these shares only – Slack filed an S-1 registration statement, allowing everyone to trade at once.

Subsequently, purchasers of Slack stock on the open market alleged the S-1 was false, and sought to bring Securities Act claims.  Problem was, Section 11 of the Securities Act – providing a remedy for false statements in registration statements – requires the plaintiff to “trace” the shares they bought to a particular false registration statement.  Slack’s pool of shares was an undifferentiated mix of registered shares and unregistered shares.  The Ninth Circuit held, eh, let everyone sue; Slack wants to let no one sue.  Thus the Supreme Court case.

I blogged about the Slack case at the district level and the Ninth Circuit level here and here; I also blogged about a similar problem that arises in IPOs, when companies permit early investors to trade their unregistered shares right away, so that the pool of stock available to trade contains both unregistered and registered shares. 

Anyway, when Slack came up for oral argument, all attention was on this issue of Section 11 tracing.  But oral argument took kind of an unexpected turn when the Supreme Court wandered down the path of Section 12 of the Securities Act, which allows investors to sue for false statements in prospectuses.  Section 12 claims were alleged in the Slack case but they didn’t seem to be the main event, until they did.

What’s going on there?

And this is going to get long – behind the cut it goes.

Let’s start at the beginning.  The reason plaintiffs want to sue under Section 11 and 12 is that neither of these statutes requires the plaintiffs to prove reliance, or to prove scienter.  The only other option for false statement claims – Section 10(b) – would require proof of both.  So it’s very much to plaintiffs’ benefit if they can bring their claims under Sections 11 and 12.

Let’s assume Section 11 is off the table; I explained the difficulties in my prior blog posts, and the transcript of the Supreme Court oral argument suggests at least some Justices are leaning in the direction of reversing the Ninth Circuit on this issue.

Section 12 broadly imposes liability for sales accomplished by means of a “prospectus” that contains untrue or misleading statements.

Section 2 of the Securities Act defines “prospectus” to mean “notice, circular, advertisement, letter, or communication, written or by radio or television, which offers any security for sale.”  And an offer, according to longstanding SEC interpretation, includes any document that is calculated to condition the market or stimulate investor interest.  See In re Carl M. Loeb, Rhoades & Co., 38 S.E.C. 843 (1959).  So the definition of “prospectus” is potentially really broad!

Plus, Slack registered its securities on Form S-1.  The first part of a Form S-1 is by definition, a prospectus.  

So you might think, Slack put this prospectus out there – the first part of the S-1 – that influenced trading, therefore, all market traders can sue under Section 12.

But you would be wrong.

Because Supreme Court caselaw has sharply limited the reach of Section 12, in two ways relevant here.

The first concerns the issue of privity.  As I previously blogged, in Pinter v. Dahl, 486 U.S. 622 (1988), the Supreme Court suggested that Section 12 liability requires some kind of direct contact or contractual privity between the defendant and the plaintiff.  Lower courts took that suggestion and ran with it, until the age of social media and cryptocurrencies.  Some more recent decisions, including out of the Ninth Circuit, relax the privity requirement to permit liability to lie against persons who advertise to the market generally.

So, in Slack, the first thorny Section 12 question is whether Section 12 does in fact require contractual privity with the defendant (as most cases have held, and which presumably would not be present with respect to Slack itself, at least not for secondary market traders) or whether instead the newer standards involving widespread marketing would apply. 

But after that, we run into Gustafson v. Alloyd Co., 513 U.S. 561 (1995).  Because the second way that the Supreme Court has limited Section 12 liability is by narrowing the definition of a “prospectus.”

To understand, you have to begin with the framework of the registration requirements.  The Securities Act starts by saying all securities must be registered before they can be sold – that’s Section 5. 

After that, Sections 3 and 4 contain a series of exemptions to the registration requirement.  Section 3 mostly deals with securities which, by their nature, simply do not need to be registered (government securities, for example), but it also has a few other types of exemptions (one for offers and sales that occur entirely within a single state, and so forth).  Section 4 has a second series of exemptions for certain kinds of transactions that are deemed not to pose too many dangers to the public, and therefore do not require registration – private sales by an issuer, for example, or most secondary market sales among traders unaffiliated with the issuer. 

In Gustafson, the plaintiffs purchased stock in a private sale exempt from registration under Section 4, and eventually claimed that the materials associated with the sale contained false statements.  The plaintiffs brought suit under Section 12, relying on the broad definition of “prospectus” in Section 2 to claim that the transaction involved a false “prospectus” under the Securities Act.

In that context, the Supreme Court held that the term “prospectus” in Section 12 is not interpreted by reference to the broad statutory definition in Section 2.  Instead, the Court observed that when sales are registered under Section 5, then Section 10 of the Act requires that certain information be included in all prospectuses.  From there, the Court concluded that when Section 12 imposed liability for false “prospectuses,” it necessarily defined “prospectuses” to mean documents that were regulated by Section 10.  And since Section 10 only applies to sales that are required to be registered under Section 5, Section 12 is only available for offerings that must be registered.

That alone would be a convoluted reading of Section 12 – normally, if one part of the statute uses a word (“prospectus”), you go to the definitional section of the Act to find out what it means.  Plus, it would make Section 12 kind of pointless; it becomes almost entirely duplicative with Section 11.  The Court’s reasoning on this point was quite openly rooted in policy; the majority believed that imposing liability for all prospectuses – as broadly defined by Section 2 – would simply be too onerous.

But it gets worse.

Because Section 12 can’t just apply to documents regulated by Section 10/Section 5.  Section 12 by its terms explicitly applies to sales that are exempt from registration under Section 3.  To wit:

Any person who—…

offers or sells a security (whether or not exempted by the provisions of [Section 3] of this title, ….), … by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading … shall be liable….

Acknowledging this, the Supreme Court in Gustafson qualified its holding by saying that a sales document is a “prospectus” for Section 12 purposes if the document is either regulated by Section 10 – a sale subject to registration under Section 5 – or one subject to an “overriding exemption,” such as, the Court noted, the exemptions in Section 3.

But it gets worse.

Because Section 4 also has exemptions! The very sale before the Court involved a Section 4 private sale!  Are those also “overriding exemptions”?

So the Court went further, and said that the word “prospectus” in Section 12 meant “a document soliciting the public to acquire securities.”  It repeated that concept of “public” dissemination multiple times as defining what a prospectus is for Section 12 purposes, which necessarily would exclude private sales.  And then it held that “The liability imposed by § 12(2) has nothing to do with the fact of registration… Instead, the liability imposed by § 12(2) turns on misstatements contained in the prospectus.  And, one might point out, securities exempted by § 3 of the Act do not require registration, although they are covered by § 12. [That] has nothing to do with the question presented here: whether a prospectus is a document soliciting the public to purchase securities from the issuer.” 513 U.S. at 579.

Well, now things are a hopeless mess.  I’ll spare the extensive discussion but what it comes down to is that this language leaves it very unclear as to when Section 12 applies in a variety of contexts – because we know it goes further than registered securities, but when it applies to exempt sales, we don’t know whether it’s triggered by “publicness” in the sale or a Section 3 exemption specifically or something else entirely.  

Making matters worse, the year after Gustafson was decided, Congress passed the National Securities Markets Improvement Act, which gave the SEC the power to invent new exemptions in the public interest, in what is now Section 28 of the Securities Act.  See 15 USC 77z–3.  Lots of exempt offerings today are not made under either Section 3 or Section 4, but are pursuant to Section 28.  For example, Rule 147A, which permits intrastate sales, is more flexible than the intrastate exemption in Section 3 – and was promulgated a few years ago, pursuant to the SEC’s general exemptive authority.  Rule 701 – the exemption for sales to employees – was originally promulgated as a Section 3 exemption, but now falls under the general NSMIA exemptive authority.  Same with the current Rule 504. 

Where the exemption does not come from either Section 3 or Section 4, but the sale was very possibly “public” (especially if the test for “public” is the one used in SEC v. Ralston Purina, 346 U.S. 119 (1953)), does the sale involve “prospectuses” within the meaning of Section 12?  I have no idea.

But I digress.  Slack.

The class in Slack is essentially one of secondary-market traders, some of whom bought shares that had been registered on the S-1, and some of whom did not.  In general, courts have interpreted Section 12 not to apply to sales documents used in secondary market transactions, because, technically, the secondary market sale is exempt from registration under Section 4 – you do not need a new registration statement and delivery of a prospectus regulated by Section 10 in order to trade.  That’s true even if the secondary market transaction involved securities that were issued in a registered public offering originally.  The first sale by the issuer required a Section 10 prospectus, of course, but not sales by traders after that point.  See, e.g., Yates v. Mun. Mortg. & Equity, LLC, 744 F.3d 874 (4th Cir. 2014).  But that’s not a necessary interpretation of Gustafson, especially since Gustafson did not itself involve a public offering at all.  True, Gustafson scoffed at the notion that Section 12 would apply to secondary market sales, but in so doing, it seemed to be rejecting Section 12 liability only for communications between the buyer and seller in the secondary market, i.e., by persons unaffiliated with the issuer.  513 U.S. at 571, 578.  What if the communication is a widely-disseminated, issuer-generated prospectus?

The point is moot when you also require privity – but if that’s going to be relaxed … wild card.

And that lack of clarity seemed to have the Justices’ attention during oral argument.

The problem for the plaintiffs, though, is that while all of this is maddening and indeterminable, whatever else Section 12 requires, it requires that the sale have been accomplished “by means of” a false prospectus.  And the prospectus in this case – the first part of the S-1 – rather explicitly only applied to the registered shares, giving the plaintiffs kind of an uphill battle to say that sales of the unregistered shares were also accomplished by means of the same prospectus.  I mean, it can’t possibly be the case that every time a company sells new registered securities – say, for example, shares to employees registered on Form S-8 – all traders in the preexisting secondary market can now treat that new prospectus as a sales document triggering Section 12 liability for the company’s entire float.  And that puts us back in the tracing boat.  

But I have a question. Let’s say one takes Gustafson seriously that a Section 12 prospectus is a public, widely disseminated formal document by the issuer.  Let’s even interpret it to mean that exempt sales may involve Section 12 prospectuses so long as such a public, widely disseminated document is involved. 

Well, Slack did file such a document for all of its shares, as part of its requirement to register under the Exchange Act before trading on the NYSE.  And that document explicitly incorporated by reference its S-1.  Raising the question whether that document should be deemed to be a Section 12 prospectus that covers all of the shares, even the ones that were not registered on Form S-1.

Okay, fine, that’s just me playing around; I don’t really think a court (let alone the Supreme Court) would accept that argument,[1] and I’m sure some regulatory maven will identify some problem with it anyway.  The fact of the matter is – as a couple of Justices noted during oral argument – this is really something the SEC should be clearing up.  The SEC did not even file a brief in this case, though I suppose that was understandable, since the SEC handwaved away investor concerns about Section 11 liability and tracing when it promulgated the direct listing rules in the first place.

But the SEC could make this problem go away tomorrow, if it caused the Exchanges to condition direct listings on the waiver of tracing defenses, at least for, say, purchases made in the first 180 days after trading begins.  Similarly, in IPOs – where issuers seem to be increasingly allowing unregistered shares to mix in with the registered ones right off the bat – the SEC could condition acceleration of effectiveness on the waiver of tracing defenses.  So, ball’s in SEC’s court.

 

[1] Plus, Exchange Act registration forms are updated to incorporate any new prospectuses filed by the issuer when it sells new securities.  So interpreting Exchange Act registration forms as “prospectuses” would have the same problem as my Form S-8 example above; it would reopen the entire float to Section 12 liability every time a false prospectus was filed for any new share issuance.  Well, to be fair, maybe that isn’t a bad thing.