In a meeting last year of the SEC’s Investor Advisory Committee, the Committee heard from a panel regarding the continued viability—or rather, lack thereof—of §11 liability following SCOTUS’s decision in Slack Technologies v. Pirani. Slack, as you know, limited §11 liability in direct listings—and, perhaps increasingly, in the context of other offerings as well—given the difficulty of tracing shares to the defective registration statement in direct listings, where both registered and preexisting unregistered shares may be sold at the same time. The presenting panel made a strong pitch for SEC intervention to facilitate tracing and restore §11 liability, ultimately advocating that the Committee make recommendations to the SEC to solve this problem. (See this PubCo post.) Two subcommittees have now crafted a recommendation, and at the recent meeting of the Committee on March 6, there was a brief discussion of that proposal. In the end, the Committee voted in favor of submitting the recommendation to the SEC, with one abstention and one negative vote. Recommendations from SEC advisory committees often hold some sway with the staff and the commissioners, so it’s worth paying attention to the outcome here. But will the new Administration be receptive to recommendations to facilitate the restoration of §11 liability? From the comments of Commissioner Hester Peirce, it doesn’t sound that way.
Background. At last year’s IAC meeting, all panelists strongly urged the SEC to fix this problem. In particular, former SEC Commissioner and current Professor Robert Jackson insisted that “this is the type of problem the SEC should solve.” In the past decade, he said, there have been around 400 cases leading to about $8 billion in liability under §11, so, in his view, this was not a problem to be ignored. In effect, he chastised the SEC for not yet stepping up on this issue, pointing out that, during oral argument on Slack, even SCOTUS was puzzled about why the SEC hadn’t submitted a brief on this issue.
Since the SEC still had done nothing to address the problem (and still hasn’t), Jackson urged the Committee to make recommendations—the SEC often listens to what the Committee has to say, he emphasized. He observed that, compounding the problem arising out of direct listings, some practitioners were advocating, in the context of regular IPOs, that lockup “waivers be conceptualized as an IPO’s competitive response to direct listings.” That is, waivers of lockups could be a strategy to avoid §11 liability. By waiving lockups typically required of existing holders in IPOs, unregistered shares would seep (or flood) into the trading pool, thus tainting the pool for purposes of tracing shares to the registration statement. He presented data showing that use of waivers had significantly increased in recent years—from almost none in the 2004-2005 period to a boatload of waivers granted in 2021.
Draft recommendation. As noted above, the Committee has taken the prior panel’s advice and crafted a draft recommendation. Section 11, the draft recommendation observes, creates “a strong incentive for the accuracy and completeness” of a registration statement by imposing strict liability and by not requiring a demonstration of reliance or loss causation. These more lenient standards were designed “to provide ‘special protection’ to purchasers involved in public offerings of registered securities,” when there is a “significant information gap between issuers and investors, particularly prior to a firm’s initial public offering.” But the tracing requirement limits the pool of potential plaintiffs, and “damages are limited to the difference between the initial offering price and the value received for the share.” Historically, the prevalence of the use of lockups in connection with IPOs facilitated the establishment of tracing, as unregistered shares were “locked up” for a period of months after the IPO and could not trade, allowing many plaintiffs to demonstrate tracing without much difficulty. However, more recently—the recommendation points to 2010 as a turning point—underwriters began to waive lockups with some frequency; in direct listings, lockups are typically not employed at all. Slack made it clear that the presence of “any unregistered shares in the pool available to the public following the offering” could make it “impossible for plaintiffs to trace.” What’s more, as noted above, in an intentional effort to eliminate the availability of §11 liability, “issuers may be incentivized to purposely introduce unregistered shares following an offering.” Together, these changes may serve “to undermine the deterrent effect of Section 11.”
The draft recommendation indicates that, although “there is disagreement regarding the specific approach the Commission should adopt to address this concern, there is a general consensus that the Commission possesses the authority to tackle this issue and should take action to do so.” Some of the suggested solutions have included “technological innovations, such as the use of a distributed ledger system,” applying an “accounting method (first-in-first-out or last-in-first-out) to existing trading data to trace individual shares,” or “requiring different tickers for registered and exempt shares, at least until the Section 11 statute of limitations expires.” The draft recommendation advocates that the SEC address the questions raised in Slack by taking action “to ensure that investors retain their ability to bring claims under Section 11 following an initial offering by establishing a required lockup period” during which only registered shares would be permitted to trade. “This temporary lockup would allow investors who acquire securities during this period to preserve their ability to demonstrate tracing, thereby ensuring their standing under Section 11.”
As to how the lockup should be implemented, the draft recommendation maintained neutrality: the “lockup could be instituted by amending Rule 461, by the Commission exercising its authority under Section 8(a), or by amending Rule 144.” In essence, the SEC could “mandate that issuers maintain Section 11 liability as a precondition for the SEC to accelerate a registration statement.” Alternatively, an amendment to Rule 144 would “require holders of unregistered shares to hold their shares for a certain period of time following the effectiveness of a registration statement, even where they have held the shares for longer than the requisite holding periods (six months or one year)[,]… minimizing—or even eliminating—unregistered shares in the pool for a period following an IPO.”
With regard to the duration of any lockup period, in light of compelling arguments on both sides, the draft recommendation was once again neutral: a “shorter lockup period (e.g., a one-day lockup) may be sufficient to deter misconduct, as these early purchasers would have the ability to trace and assert claims under Section 11. However, any investors who acquire shares after the one-day period may struggle to trace their holdings and may be undercompensated. On the other hand, a longer lockup period (for instance, a ninety-day lockup) similarly serves to deter misconduct but also enables open-market purchasers within that timeframe to assert claims under Section 11. This could enhance investor confidence in the market, but it may also constrain investors who wish to sell during this period and/or expose issuers to a greater risk of frivolous claims made under Section 11.” The draft recommendation suggests that the SEC seek public comment on this issue, as well as on the potential role of technology. (For purposes of comparison, note that a “Working Group” of securities law experts and academics cited in the draft recommendation suggested that the SEC amend Rule 144 to require lockups “extending to the later of ninety days or the issuer’s subsequent 10-Q or 10-K filing. The Working Group contends that ninety days provides adequate time for registered shares to trade without unregistered shares in the market, thereby preserving Section 11’s deterrent impact. The Working Group also emphasizes that the option to release financial statements enables issuers to reduce the holding period.”)
IAC meeting discussion. [Based on my notes, so standard caveats apply.] The discussion of the draft recommendation was introduced by Committee member and Stanford Professor Colleen Honigsberg. One of the problems arising out of Slack, she said, was that, instead of fixing the spotlight on the merits of the case that plaintiffs were bringing, the focus is instead on procedural issues. Litigation should really be about the merits. Moreover, she asserted, unless this issue is addressed, §11 may become just an antique that’s never used, particularly given that, increasingly, the tracing problem has become applicable to all IPOs, referring here to the strategy noted above of using lockup waivers in any IPO to avoid §11 liability. The goal of the draft recommendation, she said, is to restore the historical structural balance by allowing the use of §11 to address information asymmetry when it’s at its highest point.
She then reviewed some of the alternatives suggested by others, such as the Working Group and Clayton and Grundfest, noting that there was some disparity in their suggested lockup periods. The draft recommendation did not advocate a specific time period, suggesting instead the SEC solicit public feedback. The goal would be to balance deterrence and potential harm to sellers and the issuer. As noted above, the Working Group had recommended up to 90 days, which would provide an incentive to the issuer to ensure good disclosure and facilitate a reduction in information asymmetry. It would also offer a larger pool of potential plaintiffs. The recommendation from Clayton and Grundfest was for a one-day lockup—even one second would do it, Grundfest told her, because the objective here is deterrence. Longer term, she suggested, technology may provide even better answers, such as different tickers for registered and unregistered shares.
One Committee member, prompted by the comments from Peirce, asked why this was an important issue for the SEC? Honigsberg responded that there was a lot of interest in this topic: CII had petitioned the SEC to address it, various SEC Commissioners had taken the trouble to submit amicus briefs on it, and SCOTUS had taken the case. In addition, she suggested, it’s certainly possible that §11 liability could be entirely eliminated through an increase in waivers in the future.
As noted above, the draft recommendation was approved. The one dissenter explained that, while she was open to considering the issue, she did not agree with the resort to lockups: that solution may be difficult to regulate and also seemed to ignore the potential impact on existing owners who want to sell their shares, as confirmed by the demands for waivers. Further, the solution could advantage purchasers of registered shares, who would not be subject to lockups. In addition, she said that the panelists at the last IAC meeting had presented a variety of alternative solutions, such as the use of distributed ledger and different stock tickers, but the draft recommendation did not analyze these other options.
As mentioned in the intro, it’s not altogether clear that the SEC will be enthusiastic about pursuing this project. Although Acting Chair Mark Uyeda observed only that the “issue of traceability is a complicated one,” Peirce was clearly not yet convinced, questioning the pervasiveness of the changes in the IPO process that have given rise to the tracing issue. For example, she pointed out,
“although the problem may be broader than direct listings, only 11 direct listings took place from 2021 through 2023. Given that many companies going public want to raise capital, why should we expect that direct listings will increase in the future? Additionally, while early lock-up releases may be on the rise, they are often bespoke and in at least some instances might accord with the Draft Recommendation. Would the Draft Recommendation, if implemented, even change behavior? Shouldn’t we protect underwriters’ ability to waive a lock-up in appropriate circumstances? How large of a problem would this recommendation solve, and should the Commission expend its limited resources to solve it? Does the availability of private rights of action under Section 10(b) mitigate this problem? Given the strict liability standard of Section 11, might attempts to expand its reach do more harm than good for investors given the costs and distraction companies will bear in Section 11 litigation?”
So, while securities experts and academics and former commissioners may all advocate that the SEC address this issue, it’s possible that it won’t go anywhere at all. Time will tell.
