Northern District Of California Denies In Part Motion To Dismiss Securities Act Claims Against Software Company, Finding That Plaintiff Met Section 11 “Tracing” Requirements In Connection With Direct Listing Of Preexisting Shares
On April 21, 2020, Judge Susan Illston of the United States District Court for the Northern District of California granted in part and denied in part a motion to dismiss a putative class action lawsuit asserting claims under Sections 11, 12(a)(2), and 15 of the Securities Act of 1933 (the “Securities Act”) against a software company (the “Company”), certain of its executives and directors, and three venture capital firms (the “VC Defendants”) that held a significant percentage of the Company’s voting power. Fiyyaz Pirani v. Slack Technologies, Inc., et. al., No. 19-cv-05857-SI (N.D. Cal. Apr. 21, 2020). Plaintiff alleged that defendants were liable for materially misleading statements and omissions concerning the Company’s service outages, competition, scalability, and growth strategy in offering materials in connection with the Company’s direct listing of preexisting shares to the public. The Court granted in part and denied in part defendants’ motion to dismiss, and granted plaintiff leave to amend to cure the amended complaint’s deficiencies.
The Company provides cloud-based workspace collaboration and productivity platforms. On June 20, 2019, rather than conducting an IPO, the Company opted for a direct listing, whereby no new shares were issued, but insiders and early investors of the Company were permitted immediately to sell their preexisting shares to the public. In preparation for the direct listing, the Company filed a Form S-1 resale shelf registration statement and a Form 424B4 prospectus (collectively, the “Offering Materials”) with the Securities Exchange Commission (“SEC”). In addition to the preexisting shares being offered pursuant to the Offering Materials, the Company simultaneously offered additional shares for sale that were exempt from registration pursuant to SEC Rule 144. Plaintiff allegedly purchased shares of the Company’s common stock on the first day of its public listing, and allegedly made additional purchases throughout the proposed class period.
As an initial matter, the Court considered whether plaintiff sufficiently alleged standing under Section 11. Defendants argued that plaintiff lacked standing because he could not “trace” his stock purchases to the shares listed pursuant to the Offering Materials. The Court first considered the history of the “tracing” requirement, noting that it stemmed from the Second Circuit’s decision in Barnes v. Osofsky, 373 F.2d 269 (2d Cir. 1967), in which the Second Circuit considered two possible interpretations under Section 11: (i) a narrower reading of “acquiring a security issued pursuant to the registration statement”; and (ii) a broader reading of “acquiring a security of the same nature as that issued pursuant to the registration statement.” The Court further noted that it considered this issue to be one of first impression, because “shares of [the Company’s] common stock became available for purchase on the NYSE immediately on June 20, 2019, from two simultaneous entry points: under the Securities Act registration statement and under the SEC Rule 144 exemption from registration. According to the Court, unlike a traditional IPO—where there would be a “lockup” period between the listing of registered shares and the listing of unregistered shares, thereby creating a period of time when purchases could be directly traced to the registration statement—“[i]n a direct listing, the impossibility of tracing begins on the very first day of listing due to the simultaneous offering of unregistered and registered shares.” As such, the Court considered it to be a question of first impression regarding “whether an investor who purchases a security in a direct listing in which registered and unregistered shares are made publicly tradeable at the same time may bring a Section 11 claim.” Applying the Second Circuit’s analysis in Barnes, the Court noted that the broader “tracing” interpretation “would not be such a violent departure from the [statute] that a court could not properly adopt it if there were good reason for doing so,” and that the unique circumstance of a simultaneous direct listing of registered and unregistered shares amounted to “good reason for doing so.” In so holding, the Court emphasized that applying the “narrower reading” of the statute in the context of the Company’s direct listing “would cause the exemption provision . . . to completely obviate the remedial penalties of Sections 11, 12 and 15.”
The Court separately rejected defendants’ argument that even if plaintiff met the “tracing” requirement, plaintiff cannot allege damages under Section 11, because the direct listing did not involve an offering price. The Court agreed with plaintiff that he was “not required to establish damages at the pleading stage” and that purported lack of damages is an affirmative defense. The Court separately noted that plaintiff could pursue a value-based theory of damages, which is a fact-intensive inquiry that the Court held is not appropriate for resolution at the pleadings stage.
The Court next considered defendants’ argument that plaintiff lacked standing under Section 12(a)(2), because “defendants are not statutory sellers within the scope of Section 12.” Focusing on the “privity requirement” present in Section 12, the Court held that plaintiff “alleged enough facts to support an active solicitation theory” against certain of the individual defendants because they signed the Offering Materials, solicited sales, and/or were financially motivated to solicit sales.
Having held that plaintiff sufficiently alleged standing, the Court turned to plaintiff’s substantive allegations that the Offering Materials contained various material misstatements and omissions. The Court found that allegations of material misstatements and omissions concerning: (i) scalable architecture; (ii) competition and the Company’s position within the market; (iii) key benefits; and (iv) the Company’s growth strategy, were inactionable for various reasons, including that the Offering Materials contained adequate risk disclosures, and that the alleged misstatements were immaterial, constituted puffery, failed to allege falsity, and/or were forward-looking. As to alleged misstatements and omissions concerning the Company’s statements concerning its vulnerability to service outages, the Court found that those allegations survived defendants’ motion to dismiss. Specifically, plaintiff argued that, in addition to the highly putative nature of the Company’s service level agreements (“SLAs”), the Company allegedly misstated these occurrences as “hypothetical,” when they were in fact “known issue(s) to defendants and the company was automatically paying out significant amounts” to resolve them. The Court held that plaintiff plausibly pled material omissions, as well as violations of Items 105 and 303, with respect to the outages and SLAs because, while the Company did disclose the existence of the putative SLAs, “the unusual nature of the SLAs’ terms is an omitted and ‘significant factor that make[s] an investment . . . risky.’” Furthermore, the Court held that “although the question of whether the seven months of outages in 2018 constitute a ‘trend’ is a factual inquiry for a later stage of these proceedings, it is plausibly pled that [the Company] was aware of those outages at the time of its disclosures, and that future outages would have an ‘unfavorable impact . . . on revenues’ due to the SLA terms.”
After determining that certain allegations concerning plaintiff’s Section 11 and 12(a)(2) claims were adequately pled, the Court addressed Section 15 standing for control person liability for the VC Defendants. The Court noted that “in addition to the plaintiff’s allegations of the traditional indicia of control, plaintiff also allege[d] that a direct listing primarily enables the resale of existing shares by insiders and early investors such as the VC Defendants.” The Court further noted that plaintiff alleged that the VC Defendants “caused [the Company] to effectuate this unusual listing in order to cash out their shares.” Because of this, the Court held that “it is plausible that a factual record of control can be developed through discovery here,” and therefore denied the VC Defendants’ motion to dismiss the Section 15 claims.