SEC’s Investor Advisory Committee discusses tracing in §11 litigation and shareholder proposals—will they recommend SEC action?

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You might recall that, in 2023, SCOTUS decided Slack Technologies v. Pirani in a unanimous opinion by Justice Gorsuch holding that, even in a registration by direct listing, §11(a) liability extends only to shares that are traceable to an allegedly defective registration statement.  Section 11 provides statutory standing to sue for misstatements in a registration statement (essentially, on a strict liability basis) to any person acquiring “such security,” historically interpreted to mean a security registered under the specific registration statement.   Slack involved a direct listing, not your usual underwritten IPO.  Because, in a direct listing, the shares are not sold in an underwritten offering through an intermediary bank, there are usually no lock-up agreements with a bank that restrict the sale of unregistered shares—as there would be in a typical IPO—allowing both registered and unregistered shares (that are exempt from registration) to be sold to the public, resulting in a mixed trading pool. When Slack went public, it registered 118 million shares for sale by selling shareholders, and 165 million unregistered shares were also available at the same time for sale to the public on the NYSE. Pirani purchased 30,000 shares on day one at $38.50 and 220,000 over the next several months. After Slack’s share price fell substantially, Pirani brought a claim under Section 11, among other provisions, contending that the registration statement was misleading. Slack moved to dismiss, contending that Pirani did not have standing “because he cannot prove that his shares were registered under the allegedly misleading registration statement.” 

The District Court held that Pirani did have standing, and, on appeal, a divided three-judge panel of the 9^th Circuit agreed, ruling that he could recover under §11 even in the absence of tracing to the registration statement for the direct listing.  The key issue, as framed by the 9^th Circuit, was: “what does ‘such security’ mean under §11 in the context of a direct listing, where only one registration statement exists, and where registered and unregistered securities are offered to the public at the same time, based on the existence of that one registration statement?” In a direct listing, the 9^th Circuit reasoned, “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 §11 because their public sale cannot occur without the only operative registration in existence.”

SCOTUS reversed and remanded the case for reconsideration in light of the Court’s decision. The question for the Court came down to this: how to interpret “such security,” which has an imprecise referent in the statute?  SCOTUS looked at various contextual clues and was persuaded that Slack’s reading of the law was the better one. Nor did SCOTUS buy into Pirani’s policy arguments—that his reading would “better accomplish the purpose of the 1933 Act.”  In conclusion, the Court noted that, while its “only function lies in discerning and applying the law as we find it,” Congress could certainly have at it:  “Congress is free to address the scope of liability in connection with direct listings by revising the securities laws at any time.”  (For a more extensive discussion of the case, see this PubCo post.)

It’s worth noting that, during oral argument, Justice Kavanaugh observed that Slack and some amici contended that direct listings were a “new thing,” and that, to take Pirani’s position, “we would have to depart on Section 11 from a lot of law, starting with Judge Friendly, that’s been around for a long time. And rather than doing that—this is their suggestion—we should leave it to the SEC and/or Congress rather than ourselves, kind of departing from that longstanding body of law.” At one point, speaking of the tracing issue, Kavanaugh asked if the SEC could “fix this, or could only Congress fix this? So I know the word ‘fix’ is loaded, but you know what I mean, change this.” Slack counsel responded that “the SEC has ample authority to address this if they think it’s a problem,” referring to the suggestions by amici in their briefs. Not surprisingly, Pirani’s counsel strongly disputed that premise. (See this PubCo post.) Given the difficulty of tracing in connection with direct listings, where both registered and preexisting unregistered shares may be sold at the same time, the question put to Slack counsel by Justice Kavanaugh during oral argument in April still looms large: does the Court’s determination in this case “essentially transform the ’33 Act into an opt-out regime for direct listings”? 

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During oral argument, Justice Kavanaugh had asked for thoughts about why the SEC declined to submit an amicus brief in this case. That was just one of several instances when he implied discomfort about ruling without hearing first from the SEC—he appeared somewhat perplexed that the SEC had not weighed in on this issue. Slack counsel responded that “they chose not to participate in this case, obviously concluding that the prior position they had taken before this Court was—was sufficient.” However, on prompting by Chief Justice Roberts, he acknowledged that he had no evidence to that effect, but was just making a reasonable inference. Pirani counsel responded that he had “no idea why they’re not here.  I will—but I can say with great confidence that the position they expressed before is not a position that directly translates to this case.” On rebuttal, Slack counsel responded that the SEC had recently told SCOTUS that a “plaintiff may seek relief under Section 11 only with respect to securities covered by the registration statement.” And the SEC continued that “even though there could be outstanding securities of the same class, that there would still not be liability even if people had relied on the registration statement with respect to those other shares. So the SEC’s position is perfectly clear.”  Justice Sotomayor said that  she had “read some commentators suggesting that the [SEC] is having trouble with this case and doesn’t know what to do.”  Chief Justice Roberts added that they “[m]ay not be the only one.” (See this PubCo post.)

Separately, on this question of the absence of SEC input, Professor and former SEC Commissioner Joe Grundfest told Reuters “that the Biden administration’s silence is telling. ‘The Solicitor General has obviously read the opinions and the briefs and concluded that not taking a position in this matter best serves the interests of the United States government,’ he said. ‘The government is not willing to support the plaintiffs in this matter and the justices will notice.’” In a Cornerstone Research webcast, when asked why the SEC was a no-show, former SEC Chair Jay Clayton suggested that perhaps it was for the same reasons that the Justices were struggling with the issues.  Grundfest suggested that perhaps the absence reflected a realization that the SEC could have fixed the problem by implementing one of the fixes suggested in their amicus brief—that the SEC use its acceleration authority to require that only registered shares be allowed to come to market on the first day and delay the public resale of any unregistered shares.  (Clayton graciously acknowledged that the Slack offering occurred during his tenure as SEC chair.)

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During oral argument, Slack counsel contended that it was not really possible for Pirani to trace his shares to the registration statement. Counsel for Pirani pointed out that they had indicated in the pleadings that the shares were traceable—meaning not every share, but a percentage of them, a question that he thought should be left to the lower courts. Justice Gorsuch agreed that all they would “need to do is plead facts suggesting that you can trace consistent with the Twiqbal standard [Iqbal and Twombly plausibility standard], as my friends like to call it. (Laughter.)… And—and then you’re off to the races and it really just becomes a matter of damages, as I think you also alluded to.” As a result, he continued “if we were to rule against you on what §11 means, it still would enable you to plead…that there are traceable shares.”

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In this article on the Columbia Law School Blue Sky Blog, Professors John Coffee and Joshua Mitts agreed that “tracing should be required in order to keep the potential liability proportionate to the size of the offering. In our view, the real issue is not whether tracing should be required, but how it should (and can) be done.”   They pointed out that the Consolidated Audit Trail should be of use. The CAT requires “all certified participants in the U.S. securities marketplace…to submit these detailed records into a pooled, centralized system [that] enables regulators to quickly analyze and trace activity throughout the U.S. securities markets….Because these extensive records are held electronically, modern computing has the capacity to process records for any number of transactions, even if the number climbs into the trillions.” While the CAT enabled tracing of the chain of title for securities, it did require use of “a standard accounting convention,” either FIFO or LIFO.  Applying that type of accounting convention, together with computing power, “ends uncertainty and, for example, allows us to follow specifically the typically small number of unregistered shares that might otherwise be asserted to ‘contaminate’ a much larger pool of registered shares and preclude any Section 11 action.”  It would provide an “individualized answer,” they contended, matching “the shares to an individual holder (rather than telling us the much less helpful conclusion that there is a 60 percent chance that these shares were covered by the registration statement).” 

This approach, they suggested, offers the appeal of not requiring either “legislation or even significant new SEC rules. If the court having a Section 11 action before it can be asked to schedule an early hearing at which it schedules any motion to dismiss that defendants wish to bring (and denies a dilatory defendant the right to file a later such motion), then defendants cannot delay or prevent the plaintiffs from obtaining discovery. Because a motion to dismiss in a Section 11 case is unlikely to be successful, plaintiffs will experience little delay. The one juncture that remains critical is the readiness of FINRA and the SEC to give litigants access to CAT, and here the SEC can likely encourage FINRA without adopting any rules.” They advocated that the SEC either adopt a new rule under Section 28 of the Securities Act that “explicitly provides that standard accounting methods shall satisfy Section 11’s tracing requirement.  Short of that step, a desirable approach would be for the SEC to produce a whitepaper or other interpretive guidance that makes clear its views that accounting methods are appropriate to apply to tracing in Section 11 cases.  While courts will ultimately have the decision as to the procedures and conventions to be used, there seems little doubt that the judiciary would benefit from the SEC explaining its views on this topic.”

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The proposal from Arjuna and Follow This asked Exxon to accelerate the reduction of GHG emissions in the medium term and to disclose new plans, targets and timetables for these reductions. Instead of seeking no-action relief from the SEC, Exxon went directly to court, seeking a declaratory judgment that it could exclude their proposal from its 2024 annual meeting proxy statement. (See this PubCo post.) The two proponents then withdrew their proposal, but Exxon would not withdraw its complaint, maintaining that there were still critical issues and a live controversy for the Court to resolve. (See this PubCo post.) The two proponents contended that, because they had withdrawn their proposal and promised not to refile, there was no live case or controversy. As a result, they asserted, Exxon’s claim was moot, and the court had no subject matter jurisdiction. However, the court held that Exxon had the “winning argument,” citing precedent that “a defendant’s voluntary cessation of a challenged practice does not deprive a federal court of its power to determine the legality of the practice.” The court dismissed the case against Follow This, an association organized in the Netherlands, for lack of personal jurisdiction, but allowed the case against Arjuna to proceed on the basis of both subject matter and personal jurisdiction. After the decision was rendered, Arjuna submitted a letter to Exxon in which Arjuna “unconditionally and irrevocably covenants to refrain henceforth from submitting any proposal for consideration by Exxon shareholders relating to GHG or climate change.” (See this PubCo post.) Exxon again attempted to rebut the argument. Ultimately, the court called a halt, issuing an Order that Exxon’s claim was moot and dismissing the action without prejudice. But not before the Court got in a few digs at Arjuna, activism and even at the SEC. (See this PubCo post.)

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In October 2020, the SEC adopted amendments to Rule 14a-8 to modify the eligibility criteria for submission of shareholder proposals, as well as the resubmission thresholds; provide that a person may submit only one proposal per meeting, whether as a shareholder or acting as a representative; prohibit aggregation of holdings for purposes of satisfying the ownership thresholds; facilitate engagement with the proponent; and update other procedural requirements. Proponents thought the amendments reflected an appropriate and necessary rebalancing of the costs and interests of shareholder proponents as against the subject companies and the other shareholders (who must share in the costs). Opponents of the amendments viewed the changes as a restriction on a mechanism for shareholder oversight of management, particularly affecting smaller holders and proposals related to ESG issues. The proposed rulemaking had generated an animated discussion among the commissioners in the course of the long meeting, as well as substantial pushback through the public comment process, discussed in more detail in this PubCo post and this PubCo post. Then-SEC Chair Jay Clayton observed that a “system in which five individuals accounted for 78% of all the proposals submitted by individual shareholders” needed some work, and former Commissioner Jackson characterized the proposal as swatting “a gadfly with a sledgehammer.” (See this PubCo post.)

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The article by Professor Fisch observes that the “proxy rules’ substantive impact on shareholder voting, a subject traditionally relegated to state corporation law, distinguishes them from much of the system of federal securities regulation, which focuses primarily on disclosure. The dominance of state law with respect to shareholder voting raises the question of whether the proxy rules are a legitimate exercise of the SEC’s rulemaking authority—ultimately a question of statutory interpretation. The broad language of Section 14(a) makes it difficult to derive limitations on the SEC’s power from an examination of the text of the rule. Nonetheless, such limitations do exist. An administrative agency can act only under ‘specific, well-defined grants of power.’”  She referred to a decision of the DC Circuit,  Business Roundtable v. SEC, which

“concerned Rule 19c-4, which prohibits national securities exchanges and national securities organizations from listing the stock of any corporation that ‘disenfranchised’ its shareholders. The Rule had the effect of limiting the ability of a listed corporation to modify or reduce the voting rights of common shareholders from a one share-one vote structure. The Business Roundtable claimed that the SEC lacked the statutory authority to promulgate Rule 19c-4. In defense of the Rule, the SEC argued that one source of its authority was Section 14 of the Exchange Act, which authorized the SEC to make rules for the purpose of promoting fair corporate suffrage.  The court reviewed the legislative history and purposes of the Exchange Act and concluded that the SEC’s rulemaking authority under Section 14 could not be construed so broadly. According to the court, Congress authorized the SEC to regulate the proxy process primarily to ensure that shareholders could exercise their votes on an informed basis. Although the court acknowledged the SEC’s authorization to enact regulations to promote ‘fair corporate suffrage,’ the court stated that Congress intended the regulations to bear ‘almost exclusively on disclosure’ as the means of promoting fair suffrage. The court analyzed the operation of Rule 19c-4 and concluded that the rule regulated the distribution of voting power in a corporation. This regulation, said the court, directly interfered with corporate voting, control of which Congress had left to state law.”

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What are these changes in staff legal bulletins? You might recall that, beginning in 2017, Corp Fin issued several new SLBs (I, J and K) addressing, among other things, the exclusions under rules 14a-8 (i)(5), economic relevance, and (i)(7), ordinary business, an exclusion on which companies frequently rely to seek to omit environmental and social proposals.   SLB 14I provided that, under 14a-8(i)(5), when a proposal related to operations that accounted for less than 5% of total assets, net earnings and gross sales, but raised issues of “social or ethical significance,” the test allowed exclusion when the matter was not “otherwise significantly related to the company,” and the staff viewed “the analysis as dependent upon the particular circumstances of the company to which the proposal is submitted.” (See this PubCo post.) Under Rule 14a-8(i)(7), proposals could be excluded if they raised matters that were “so fundamental to management’s ability to run a company on a day-to-day basis that they could not, as a practical matter, be subject to direct shareholder oversight”—unless, that is, the “significant policy exception” applied. That exception would preclude exclusion of the proposal if the proposal “would transcend the day-to-day business matters and raise policy issues so significant that it would be appropriate for a shareholder vote.” In SLB 14K, the staff advised that the issue of policy significance should be company-specific—“whether the proposal raises a policy issue that transcends the particular company’s ordinary business operations”—rather than whether the particular issue is of general significance. That is, under SLB 14K, the staff took “a company-specific approach in evaluating significance, rather than recognizing particular issues or categories of issues as universally ‘significant.’” (See this PubCo post.)

Then, with a new SEC majority in place, in November 2021, Corp Fin issued new SLB 14L, which outlined Corp Fin’s most recent interpretations of the ordinary business and the economic relevance exclusions under Rule 14a-8, and rescinded the three earlier SLBs—SLBs 14I, 14J and 14K. Generally, new SLB 14L presented its approach as a return to the perspective that historically prevailed prior to the issuance of the three rescinded SLBs. (See this PubCo post.) Under SLB 14L, with regard to (i)(7), SLB 14L provided that the staff will “focus on the social policy significance of the issue that is the subject of the shareholder proposal. In making this determination, the staff will consider whether the proposal raises issues with a broad societal impact, such that they transcend the ordinary business of the company.” In addition, Corp Fin said that it would take a “measured approach to evaluating companies’ micromanagement arguments—recognizing that proposals seeking detail or seeking to promote timeframes or methods do not per se constitute micromanagement. Instead, we will focus on the level of granularity sought in the proposal and whether and to what extent it inappropriately limits discretion of the board or management.” “Going forward,” the staff indicated, it would not necessarily exclude a proposal that suggested “targets or timelines so long as the proposals afford discretion to management as to how to achieve such goals.” The effect of SLB 14L was to make exclusion of shareholder proposals—particularly proposals related to environmental and social issues—more of a challenge for companies, smoothing the glide path for inclusion of proposals submitted by climate and other activists, both pro- and anti-ESG.

In this context, it’s worth noting that the National Association of Manufacturers is now challenging the SEC’s use of Rule 14a-8 altogether, claiming that neither the First Amendment nor the federal securities laws allow the SEC to use Rule 14a-8 to compel a company to speak about contentious political or social issues, such as abortion, climate change, diversity or gun control, that are “unrelated to its core business or the creation of shareholder value.” (See this PubCo post.)