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Robinhood is gearing up for its IPO, and one of its gimmicks is to allot 20-35% of its newly issued shares to its own customers, who trade on its platform.  This unusual allocation is being billed, in part, as evidence of its commitment to “democratize finance,” and it’s not the first time a company has used its IPO allocations as, essentially, a branding mechanism.

But this New York Times piece also points out that Robinhood is allowing its own employees to trade up to 15% of their shares right away, which is pitched as being of a piece with Robinhood’s nontraditional stock allocations.  And, in fact, Robinhood’s S-1 says:

up to 15% of the shares of our outstanding Class A common stock and securities directly or indirectly convertible into or exchangeable or exercisable for our Class A common stock held, as of the date of this prospectus, by our directors, officers and current and former employees and consultants (other than our founders and our Chief Financial Officer, who are discussed above) …, with such 15% calculated after excluding any shares withheld for taxes associated with IPO-Vesting Time-Based RSUs, may be sold beginning at the commencement of trading on the first trading day on which our Class A common stock is traded on Nasdaq

The registration statement says that another 15% of employee shares can be sold after 90 days.

Now, I’m not going to speculate as to Robinhood’s actual motives for permitting its employees and directors to trade 15% of their stock immediately, but I will note that if these shares – which were presumably issued pursuant to a Rule 701 plan and are not registered – become immediately tradeable, that will make it much more difficult for open-market purchasers in the future to bring any Section 11 claims.

Section 11, of course, permits purchasers of registered securities to sue when the security’s price drops below the offering price, if the registration statement contains false or omitted information.  Section 11 claims don’t require a showing of scienter, but there’s a catch: the plaintiff must be able to show that his or her shares were, in fact, issued pursuant to the defective registration statement; unregistered shares, or shares issued pursuant to some other registration statement, won’t qualify.  Which means, if there’s a “mixed” pool of shares trading – some of which were issued on the defective registration statement, and some of which were not – an open-market purchaser will have trouble establishing that his or her shares were part of the registered group, which could bar Section 11 claims no matter how deceptive the registration statement may turn out to have been.

As I previously posted, this requirement has already created some havoc in the context of direct listings – and the Slack case, described in my blog post, has been pending before the Ninth Circuit basically forever – but most traditional IPOs require that pre-IPO shares be locked up at least for 180 days after the offering.  The lockup means that at least for the first 180 days, all shares available to trade are registered shares, and anyone who buys in that period will be able to show that their shares were traceable to the registration statement.  If there’s a problem with that registration statement, those early purchasers will be able to advance Section 11 claims.

Attorneys have in the past proposed that lockups be made less strict, essentially as a method of stymieing Section 11 claims; if unregistered shares are mixed in with the registered shares as soon as trading begins, the theory goes, no open-market purchaser will be able to trace their shares to the registration statement.  Robinhood (whatever its actual motivation) seems to be adopting that strategy. 

Now, I’m going to do something very dangerous: I’m going to try to read the S-1 and do math, and I’m not at all certain I’m getting this right, so everything I’m about to say should be taken with a pillar of salt. 

But, if I’m reading the S-1 correctly, Robinhood is registering and selling 60.5 million shares (including the greenshoe, and registered insider sales).  And it looks like the additional employee shares that will be available to trade right away number a little over 7 million.  Plus, as I understand it, there’s an additional 45 million shares or so that may be free to trade soon after the IPO as a result of certain note conversions, but these additional shares will be registered on a separate registration statement soon after the IPO.  Let’s assume that this new registration statement contains the same information as in the IPO registration statement.  And after 30 days ish, I believe another 45 million shares can be converted, and will also be free to trade, but these will also be registered on the second registration statement.

(Again, I really need to emphasize I am not at all certain I’m catching everything, so really just take this as a vague sort of ballpark thing)

My point – however inexact my calculations may be – is this: if it turns out that the registration statement(s) contain false information, or omit required information, we’re looking at an open-market pool of (at various times) as many as 105 to 150 million registered shares, and maybe 7 million unregistered ones, for at least the first 90 days of trading.  Of course, not all holders will trade; that’s just an approximation of the shares available.

Which means any open-market purchaser is very likely to have bought registered shares; but is not certain to have done so. 

Will that be enough to bar Section 11 claims?

Well, the law’s not exactly clear on this.  The Fifth Circuit famously held that even if there was over a 90% probability that shares purchased by the plaintiffs were registered, they would not be able to bring Section 11 claims.  See Krim v. pcOrder.com, Inc., 402 F.3d 489 (5th Cir. 2005); see also Doherty v. Pivotal Software, 2019 WL 5864581 (N.D. Cal. Nov. 8, 2019) (following Krim).  But in In re Snap Securities Litigation, 334 F.R.D. 209 (C.D. Cal. Nov. 20, 2019), the court held that 100,000 unregistered shares mixed in with 200 million registered shares would not be enough to bar Section 11 claims.  In so doing, the court noted, “As a policy matter, barring use of statistical tracing in litigation following a major IPO would mean that waiving the lock-up period for even nominal number of pre-IPO investors would effectively inoculate a corporation against nearly all potential Section 11 liability it might face for misstatements or omissions in its registration statement.”

Which means – I don’t know what happens with a pool that’s maybe 4.5% unregistered, and I really don’t know whether a court is likely to split the baby and distinguish between pleading Section 11 standing and actually proving it later in the case, either on the merits or at class certification.

Now, obviously, maybe there won’t be any Section 11 claims!  Maybe the shares will never trade below their IPO price; maybe there won’t be any false statements in the registration statement.  But considering the overwhelming regulatory risks that Robinhood’s business model poses (and of course its S-1 describes these), I think there’s a nonzero chance all this is going to be tested.  And I’d assume Robinhood’s lawyers are gearing up for that possibility.*

*Another problem might concern the issue of multiple registration statements.  Now, if the two registration statements contain identical misstatements and omissions, it isn’t necessary that a plaintiff trace her shares to either one simply to show that she purchased shares pursuant to a defective registration statement.  But – and this is an issue I discuss in my Slack blog post – Section 11 damages are tied to the “the price at which the security was offered to the public,” and for shares issued pursuant to note conversions, that price, I assume, is likely to be the conversion price.  But the note conversion price is a different, and lower, price than the offering price for the IPO shares.  That would mean that a damages calculation might require an open-market purchaser to identify whether her shares originally are traceable to a note conversion, or to the IPO (which, of course, will be impossible once trading in both begins, and since there are a lot of note-conversion shares, the probabilities will work less in plaintiffs’ favor than the issue of registered vs. unregistered shares).  But the Slack court held that the issue of damages did not have to be decided at the pleading stage, and if Robinhood’s share price were to fall even below the note conversion price, a plaintiff class might be willing to just agree that the note conversion price will be treated as the offering price for the entire class.

Edit: See comments; the converted stock may be registered only for resale at the market price.  Which means, the converted stock won’t have a specific offering price, creating a similar issue as occurred in the Slack case, i.e., figuring out how to define an offering price when shares are registered only for resale by someone other than the issuer.  A court might decide the offering price for Section 11 purposes should be defined as the conversion price, but might decide the offering price should be defined as something else, or even that there is no offering price at all.

Last year, Anthony Rickey and I published a paper highlighting potential conflicts of interest that can arise between securities class action plaintiffs, their counsel, and the class.  Our article suggested that courts could discourage troublesome practices by requiring law firms to disclose past findings of misconduct when they apply for lead counsel appointments.  The idea is to make sure that future judges know what happened in past cases so they can protect the class.

Recently, Judge Alsup of the Northern District of California issued this type of order after two of the country’s largest plaintiff-side securities litigation firms hurled allegations of misconduct back and forth.  The fallout from this decision demonstrates a potential shortcoming of mandatory disclosure orders:  they are not self-enforcing.

The Case:  SEB Investment Management AB v. Symantec Corp., et al., No. 3:18-cv-02902-WHA (N.D. Cal.)

Judge Alsup’s April 20, 2021 order briefly summarizes the troublesome facts of a securities class action involving Symantec Corporation.  When SEB Investment Management AB (“SEB”) became lead plaintiff in 2018, the court ordered SEB to interview law firms to serve as class counsel.  SEB selected Bernstein, Litowitz, Berger & Grossman, LLP (“BLBG”), its original counsel, to lead the litigation “even though BLBG asked for a richer fee proposal than others.”

The litigation ran over two years.  Then, in late 2020, a Norfolk County pension fund represented by Robbins, Geller, Rudman & Dowd, LLP (“RGRD”) filed a “Notice of Potential Conflict of Interest” informing the Court that Hans Ek, the staff member at SEB selected to oversee the case, had left SEB and joined BLBG.

This development concerned the court because it opened the door to the “allegation that [BLBG] engaged in play to pay, which means, ‘you hire me as counsel, and I’ll make it up to you down the road.’”  Judge Alsup explained that this kind of deal, if it existed, is “adverse to the interests of the class because class counsel should be selected as the best lawyer for the class.”

At a hearing on January 22, 2021, Judge Alsup designated a special counsel from RGRD to report after taking discovery from SEB and BLBG.  The following conflict between two class action titans is required reading for anyone seeking to understand potential conflicts of interest between class plaintiffs and their counsel.

The special counsel alleged that BLBG’s arrangement with Ek would result in tens of thousands of dollars paid to SEB as offsets to Ek’s severance package.  The report described this as a “side benefit” from BLBG to SEB, lowering its compensation expenses.  (Our article pointed to similar indirect benefits given to institutional plaintiffs, such as when a local counsel agreed not to raise its monthly retainer after the firm received a share of the national counsel’s class action award.)  BLBG argued that this setoff was a standard provision not particular to BLBG.  Given that Ek was employed by other entities as well as BLBG, and could have gained employment elsewhere, BLBG denied that its payments constituted a conflict of interest.

Counterattacking, BLBG described the conflict as stemming “from a contentious relationship between [BLBG] and Robbins Geller” or “a personal vendetta being pursued by senior named partner Darren Robbins—who felt slighted because he believed his firm’s checkered past of Rule 11 violations precluded it from seeking a leadership position.”  In an earlier letter to the court, BLBG had described RGRD as “seek[ing] revenge for its not being appointed Lead Counsel in this Action.”  BLBG noted that RGRD had not responded to SEB’s request for proposal to become lead counsel, and suggested it abstained because it did not want to disclose a history of sanctions from federal courts.[1]  In later filings, BLBG accused RGRD of likewise employing former employees of lead plaintiffs that it has represented as lead counsel and David J. Hoffa, grandson of James R. Hoffa of Teamsters fame.  RGRD responded that it had employed one former employee of a plaintiff over a decade after she left employment, and that Mr. Hoffa had never worked for an organizational lead plaintiff.  And RGRD shot back with references to payments allegedly made by BLBG to the Kwame Kilpatrick Civic Fund and allegations of pay-to-play made in Bernstein v. Bernstein Litowitz Berger & Grossman LLP, unsealed by the Second Circuit back in 2016.

This summary does not do justice to the dispute between BLBG and RGRD.  In most class actions, the adequacy of representation element amounts to formalistic box-ticking, with plaintiff’s counsel insisting on their own excellence and defendants holding their tongue.  One can’t settle with an inadequately-represented class, after all.  The papers in this case show what two major law firms can dig up after even minimal discovery.  Policymakers and academics should look closely at this case for examples of where the class action system may be failing and for where to look to get another angle on what Professor Coffee described as a hidden market for access to and influence with institutional investors capable of serving as lead plaintiffs.

In the end, Judge Alsop’s order largely looked past the pointed barbs flying back and forth.  The court found itself “unable to determine whether the move of Mr. Ek to BLBG was coincidental versus culpable,” although it noted that “[t]he appearance alone raises eyebrows, arched eyebrows.”  However, rather than replacing SEB or BLBG, the court ordered further notice be provided to the class members, who received a new opportunity to opt out.  (The revised notice is available on the settlement website.)  The order then required that:

[I]n future cases, both SEB in seeking appointment as a lead plaintiff and BLBG in seeking appointment as class counsel shall bring this order to the attention of the assigned judge and the decision-maker for the lead plaintiff who is to select counsel.  This disclosure requirement shall last for three years from the date of this order.

Disclosure Requirements and Conflicts of Interest

The SEB decision highlights the need for increased efforts to address conflicts of interest in class action cases.  Our article proposed two reforms related to candor.  First, we recommend that candor should be made an explicit component of adequacy of representation, such that plaintiffs who fail to disclose conflicts should be removed from the case.  Second, courts should issue what could be called “firmwide disclosure orders,” such as the SEB ruling above, requiring firms to disclose negative findings to other courts in other cases.  SEB suggests that both reforms are necessary, while the latter is insufficient on its own.

As always, the non-adversarial nature of the settlement approval process limits the effect of potential reforms.  A firmwide disclosure order is neither self-interpreting nor self-executing.  For instance, does the SEB order’s reference to “future cases” mean “future instances in which a firm seeks approval as class counsel?”  Affected law firms have every reason to limit the requirement to “cases filed after April 20, 2021.”  As a practical matter, class counsel’s interpretation will control unless the court issuing the firmwide disclosure order takes up the burden of continually monitoring the law firm.

To test this aspect of the SEB order, we first looked for examples of class settlements approved by the Delaware Court of Chancery after April 20, 2021.  We focus on the Court of Chancery for two reasons:  many securities class actions can also be brought as fiduciary actions in Delaware courts, and the File&ServeXpress docket system is more expensive, and thus less transparent, than PACER.  Simply put, Chancery is the court where non-disclosure of the SEB order would be least likely to be observed.

We found one settlement:  Weiss v. Burke, et al., C.A. No. 2020-0364-PAF.  The Court of Chancery preliminarily approved BLBG as class counsel on April 19, 2021, one day before the SEB order.  The plaintiff then moved for final approval of class certification and the settlement.  Reviewing the dockets and the transcript of the settlement hearing, we find no sign that the SEB order was ever provided to the Court of Chancery or the class.  On June 15, 2021, the Court of Chancery awarded attorneys’ fees of $3.45 million, although it is impossible to know how much BLBG received.

On the other hand, BLBG did disclose the SEB order in a footnote to their opening brief in support of a motion for consolidation and appointment as lead counsel in ISZO Capital LP v. MHR Fund Management LLC, et al., C.A. No. 2021-0497-JRS, a case filed on June 8, 2021.  (This raises another interpretation issue:  does a footnote satisfy the requirement to bring something to the attention of a court?) What influence, if any, the SEB order will have on the Court of Chancery remains to be seen.  However, Weiss and ISZO Capital are consistent with a narrow interpretation of the SEB order.  Although nationwide electronic document searches are far from reliable, we found no example of the order being provided to any court in a case filed before April 20, 2021.

While it is still early days, we suspect that the SEB order, and firmwide disclosure orders, will have limited effect on the incentives of class counsel.  As we noted in our article, issues related to conflicts of interest rarely surface through nonadversarial settlement review processes.  Just as Milberg Weiss’s malfeasance came to light after a former client agreed to testify against the firm, and issues with the Arkansas Teacher Retirement System emerged only after a Boston Globe investigation, the SEB court remained unaware of Ek’s hiring until another stockholder provided notice.  Such intervention is rare.  (And notably, neither BLBG nor RGRD investigated the kind of conflict discussed in our article and highlighted by the ATRS v. State Street case:  the ability of counsel to benefit their clients indirectly by sharing fees with local counsel.) Without stringent consequences for failing to reveal potential conflicts—consequences that go to a firm’s bottom line—class counsel have little incentive to change course.

More certain or severe penalties will be necessary to deter bad conduct.  The best solution would be for courts (or Congress) to affirmatively require disclosure as a component of adequacy of representation, such that firms that do not inform courts of potential conflicts risk being removed as class counsel.  Alternatively, less severe sanctions would be necessary if it were more likely that bad conduct would come to light.  Thus, our article recommended that courts routinely appoint class guardians to conduct the type of discovery that RGRD’s special counsel did in SEB.  Counsel facing the prospect of routine scrutiny of their claims would be more likely to voluntarily disclose potential conflicts of interest.

This post was co-authored with Anthony Rickey of Margrave Law LLC. 

[1]           From BLBG’s February 10, 2021 letter: “Apparently, given its history as a repeat offender under Federal Rule 11, Robbins Geller believed that it could not even respond to the RFP. If it had, Robbins Geller knew it would have to disclose, including to this Court, that it has been repeatedly sanctioned by numerous federal courts. For example, Robbins Geller was sanctioned in City of Livonia Employees’ Retirement System v. Boeing Co. for engaging in ‘repeated misconduct’ in the litigation and ‘ma[king] fundamental misrepresentations to the court.’ 306 F.R.D. 175, 182-83 (N.D. Ill. 2014). In Boca Raton Firefighters’ & Police Pension Fund v. Devry Inc., Robbins Geller was sanctioned for filing a ‘frivolous’ complaint and allegations that ‘prolonged a strike suit.’ 2014 WL 1847833, at *8 (N.D. Ill. May 8, 2014). And, in Plumbers Union Local No. 12 Pension Fund v. Ambassadors Group, the court sanctioned a former Robbins Geller partner for misrepresenting the firm’s expenses in connection with a securities class action settlement. 2012 WL 1906384, at *3-4 (E.D. Wash. May 25, 2012). There, the court only refrained from also sanctioning the firm itself because Robbins Geller committed to ensuring that it would not make such ‘misleading statements’ to a tribunal again—an obligation it apparently disregarded by engaging in the conduct that resulted in Robbins Geller being sanctioned in Devry and Boeing. See Ambassadors, No. CV-09-0214-JLQ, ECF No. 230 at 5.”