HARRIS BLUM—Congress enacted the Securities Act of 1933 to implement a full and fair disclosure regime in connection with public offerings of stock. The Act’s linchpin is its registration requirement, which forces companies (“issuers”) to file a registration statement with the SEC before selling shares to the public. A registration statement contains extensive disclosure about an issuer, including, but not limited to, the issuer’s financial and operational history. Section 11 of the Act promotes the accuracy of that information by imposing liability on issuers when their registration statement contains misleading information. But a new way for companies to distribute shares, called a direct listing, threatens Section 11’s vitality. This article explains why that is and suggests that courts ought to employ a textual approach to remain faithful to the statute’s manifest purpose.
In 2018, Spotify became the first company to sell its shares publicly on the NYSE using a direct listing rather than a traditional IPO. Direct listings are becoming more popular by the day, and the SEC recently approved a proposal that will expand their utility. Experts laud this development because direct listings reduce transaction costs and allow everyday-retail investors to buy stock in initial public offerings—investments typically dominated by Wall Street firms and institutional investors. In a traditional IPO, investment banks arrange with an issuer to sell the issuer’s shares. These investment banks then embark on a weeks’ long “roadshow,” during which they meet with mutual funds, pension funds, and the like, committing to sell large blocks of shares to those groups on the first day of trading. In a direct listing, by contrast, the issuer simply floats its shares onto the stock exchange on the first day of trading, making them available to the most willing buyers. And that cuts the investment bank out of the selling process altogether.
For the purpose of this article, eliminating the investment banker has a major, practical effect: no lockup agreements. A lockup agreement is a contract provision that prevents company insiders who already have shares (e.g., angel investors, employees, founders, and so on.) from selling their shares for a certain time period. Investment bankers bargain for these provisions because company insiders usually own substantial percentages of the companies’ stock. If those insiders flood the market with their shares too early, the stock’s price will drop. The key takeaway here is that company insiders can sell their shares on the first day of trading when a company opts for a direct listing.
The fact that company insiders can sell their shares on the first day of trading means that unregistered and registered shares enter the market at the same time. That’s because existing regulations exempt many company insiders from the 1933 Act’s registration requirement. Yet for a plaintiff to have “standing” to sue under Section 11, they must “trace” their shares to a registration statement. So in a traditional IPO, a plaintiff must allege that they bought shares during the initial distribution when the unregistered shares were still subject to lockup agreements. Absent lockup agreements, however, both types of shares flood the market at the same time, making it impossible for an investor to tell which type they are buying. That also makes it impossible for investors to trace shares bought in a direct listing—which, again, lacks lockup agreements. For that reason, some investor groups and, indeed, two SEC Commissioners have decried direct listings, positing that they deprive investors of the opportunity to recover for misleading statements made in public offerings.
Setting to one side matters of policy, such as the promising innovations presented by direct listings, a fundamental question remains: Should courts abandon the tracing requirement, at least for direct listings? The tracing concept originated in the seminal case, Barnes v. Osofsky, decided by the Second Circuit Court of Appeals in 1967. The court pointed to a textual ambiguity in Section 11, which could bear two meanings: One that would require tracing and another that would not. More specifically, Section 11 says if a registration statement is misleading, then the parties involved are liable to “any person acquiring such security.” Under the reading that requires tracing, “such security” means only those securities acquired pursuant to the registration statement. Under the alternative, broader reading, “such security” means those securities acquired in the same distribution or “of the same nature” as the registered securities. The Second Circuit adopted the former, more narrow reading, noting the lack of a “good reason” to adopt the broader one.
Direct listings present a “good reason” to adopt the broader reading, however. For starters, it’s a fundamental principle of statutory interpretation that ambiguous text should be interpreted in a way that avoids rendering key provisions inoperable. The Supreme Court applied that canon as early as 1824 when it avoided an interpretation that would render a “law in a great measure nugatory and enable offenders to elude its provisions in the most easy manner.” So too here. Section 11 is key to the 1933 Act’s “full and fair disclosure” regime. By imposing liability for misleading Form S-1s, Section 11 fosters accuracy in that document. Requiring tracing, however, removes Section 11’s teeth, thus enabling “offenders to elude [the 1933 Act’s] provisions in the most easy manner.” On that basis, the Northern District of California held in Pirani v. Slack that the tracing doctrine was inapplicable to direct listings. Meanwhile, some have criticized the Priani decision, arguing that courts should allow direct listings to “sink or swim within the existing regulatory environment, with investors presumably pricing the risk of losing standing into their purchase of shares in a directly listed company.” But arguments like these are misplaced. Article III courts exist to apply the laws that Congress enacts, and doing so in the face of a textual ambiguity means construing the text in a way that does not render key provisions inoperable. Here, that means eliminating the tracing requirement, at least for direct listings.