On April 20, 2018, the Court of Appeals for the Ninth Circuit held in Varjabedian v. Emulex Corp. that a violation of Section 14(e) of the Securities Exchange Act of 1934, 15 U.S.C. § 78n(e) (Exchange Act), which governs tender offers, requires a showing of negligence, not scienter.[1] In so holding, the Ninth Circuit departs from five other Circuit Courts—the Second, Third, Fifth, Sixth, and Eleventh Circuits—that have held that Section 14(e) claims require proof of scienter (the intent to defraud).
BACKGROUND
In February 2015, Emulex Corp. (Emulex) and Avago Technologies Wireless Manufacturing, Inc. (Avago) announced that they had entered into a merger agreement, with Avago offering to pay $8.00 for all shares of outstanding Emulex stock as consideration. The $8.00 per share price reflected a premium of 26.4 percent on Emulex’s stock price the day before the merger was announced. A little more than a month later, a subsidiary of Avago, Emerald Merger Sub, Inc. (Merger Sub), initiated a tender offer of Emulex’s outstanding stock. Emulex filed a recommendation statement with the Securities and Exchange Commission that supported the tender offer and recommended that shareholders tender their shares. In that recommendation statement, Emulex elected not to include a summary of a one-page premium analysis that had been performed by an outside bank showing that the transaction premium fell within the normal range but was below average.
In April 2015, a class of plaintiffs brought a putative securities class action against Emulex, Avago, the Merger Sub, and the Emulex Board of Directors (collectively, Defendants) alleging that Defendants violated various federal securities laws, including Section 14(e) of the Exchange Act, by failing to summarize the premium analysis in the recommendation statement. [2] Plaintiffs alleged that a claim under Section 14(e) required only a showing that Defendants were negligent by failing to include the premium analysis in the recommendation statement. The District Court for the Central District of California disagreed, concluding that “the similarities between Rule 10b-5 and § 14(e) require a plaintiff bringing a cause of action under § 14(e) to allege scienter.”[3] In so holding, the District Court relied on decisions from five other Circuit Courts—the Second, Third, Fifth, Sixth, and Eleventh Circuits—that have held that Section 14(e) claims require scienter.[4] The District Court dismissed the complaint with prejudice for failure to plead a strong inference of scienter in connection with the alleged violations of Section 14(e). Following that decision, Plaintiff appealed to the Ninth Circuit.
THE NINTH CIRCUIT’S DECISION
On appeal, a panel of the Ninth Circuit reversed the District Court’s dismissal of the complaint and remanded the case for reconsideration of Defendants’ motion to dismiss under a negligence standard. The Ninth Circuit disagreed with the district court’s as well as the five Circuit Courts’ interpretation of Section 14(e).
In making this determination, the Ninth Circuit relied on two decades-old Supreme Court decisions. In the first Supreme Court decision, Ernst & Ernst v. Hochfelder, the Supreme Court held that claims under Section 10(b) of the Exchange Act and Rule 10b-5 must allege scienter.[5] In that case, the Supreme Court began by addressing the text of Rule 10b-5(b), which provides that “It shall be unlawful . . . [t]o make any untrue statement of a material fact or omit to state any material fact . . .” Interpreting that phrase, the Supreme Court stated that viewed in isolation, this “could be read as proscribing, respectively, any type of material misstatement or omission . . . whether the wrongdoing was intentional or not.”[6] In other words, Rule 10b-5(b) could be reasonably read as imposing a scienter or a negligence standard. Thus, said the Ninth Circuit, “Rule 10b-5(b)’s text, and by extension the identical phrasing in the first clause of Section 14(e), did not necessarily compel finding a scienter requirement.”[7]
In Ernst & Ernst, the Supreme Court nonetheless went on to conclude that Rule 10b-5 requires a showing of scienter.[8] The Ninth Circuit observed that the Supreme Court reached this conclusion given the relationship between Rule 10b-5 and its authorizing legislation, Section 10(b) of the Exchange Act. According to the Ninth Circuit, “Rule 10b-5 requires a showing of scienter because it is a regulation promulgated under Section 10(b) of the Exchange Act, which allows the SEC to regulate only ‘manipulative or deceptive device[s].’ This rationale regarding Rule 10b-5 does not apply to Section 14(e), which is a statute, not an SEC Rule.”[9]
In concluding that only a negligence standard applies to Section 14(e), the Ninth Circuit also reasoned that Section 14(e) differs fundamentally from Section 10(b) because the SEC is authorized under Section 14(e) to regulate a broader array of conduct than under Section 10(b). According to the Ninth Circuit, “[i]f the SEC can prohibit ‘acts themselves not fraudulent’ under Section 14(e), then it would be somewhat inconsistent to conclude that Section 14(e) itself reaches only fraudulent conduct requiring scienter.”[10] Further, the Ninth Circuit noted that the legislative history of the Williams Act—under which Section 14(e) was added as an amendment to the Exchange Act—supports its interpretation with its “emphasis on the quality of information shareholders receive in a tender offer [rather] than on the state of mind harbored by those issuing a tender offer.”[11]
The Ninth Circuit also relied on the Supreme Court’s 1980 decision, Aaron v. SEC.[12] That case involved the Supreme Court’s interpretation of Section 17(a)(2) of the Securities Act of 1933, 15 U.S.C. §§ 77a–77aa (the Securities Act).[13] The Ninth Circuit noted that both Section 17(a)(2) and the first clause of Section 14(e) contain nearly identical wording, as each section prohibits “any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statement made . . . not misleading.”[14] The Ninth Circuit determined that because the Supreme Court in Aaron held that Section 17(a)(2) does not require a showing of scienter,[15] neither does Section 14(e).[16]
At the same time, the Ninth Circuit expressed doubt about whether the particular omission alleged by Plaintiffs—the failure to include the premium analysis in the recommendation statement—was a material fact. The Ninth Circuit noted that it is “difficult to show that this omitted information was indeed material” and suggested that the level of culpability that Plaintiffs would need to demonstrate as something closer to gross negligence.[17]
SIGNIFICANCE
In light of the Ninth Circuit’s stark departure from five other Circuit Courts’ interpretation of Section 14(e), this issue may eventually make its way up to the Supreme Court to resolve the current circuit split. In the meantime, we expect plaintiffs to file Section 14(e) cases in the Ninth Circuit wherever possible to avail themselves of the more plaintiff friendly negligence standard. Potential acquirers of public companies should be mindful of the changed landscape in the Ninth Circuit. While it is uncertain how Varjabedian will affect acquirers’ behavior moving forward, it is possible that acquirers may begin to increase the level of detail and amount of information contained in disclosure documents, which already commonly run hundreds of pages long. The Ninth Circuit’s decision, paired with the increase in federal court proxy cases in the current mergers and acquisition environment, instructs companies and their counsel to be more vigilant when preparing disclosure documents.
ENDNOTES
[1] No. 16-55088, 2018 WL 1882905 (9th Cir. Apr. 20, 2018).
[2] Section 14(e) provides that: “It shall be unlawful for any person to make any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading, or to engage in any fraudulent, deceptive, or manipulative acts or practices, in connection with any tender offer or request or invitation for tenders, or any solicitation of security holders in opposition to or in favor of any such offer, request, or invitation. The Commission shall, for the purposes of this subsection, by rules and regulations define, and prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive, or manipulative.” 15 U.S.C. § 78n(e).
[3] Varjabedian v. Emulex Corp., 152 F. Supp. 3d 1226, 1233 (C.D. Cal. 2016), aff’d in part, rev’d in part and remanded, No. 16-55088, 2018 WL 1882905 (9th Cir. Apr. 20, 2018).
[4] See, e.g., Flaherty & Crumrine Preferred Income Fund, Inc. v. TXU Corp., 565 F.3d 200, 207 (5th Cir. 2009); In re Digital Island Sec. Litig., 357 F.3d 322, 328 (3d Cir. 2004); SEC v. Ginsburg, 362 F.3d 1292, 1297 (11th Cir. 2004); Conn. Nat’l Bank v. Fluor Corp., 808 F.2d 957, 961 (2d Cir. 1987); Adams v. Standard Knitting Mills, Inc., 623 F.2d 422, 431 (6th Cir. 1980).
[5] 425 U.S. 185, 193 (1976).
[6] Id. at 212 (emphasis added).
[7] Varjabedian, 2018 WL 1882905, at *5.
[8] See 425 U.S. 185 at 212–14.
[9] Varjabedian, 2018 WL 1882905, at *5 (internal citation omitted).
[10] Id. at *7.
[11] Id.
[12] 446 U.S. 680 (1980).
[13] Section 17(a)(2) provides that: “It shall be unlawful for any person in the offer or sale of any securities (including security-based swaps) or any security-based swap agreement . . . by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly . . . to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.” 15 U.S.C. § 77q(a)(2).
[14] Varjabedian, 2018 WL 1882905, at *6.
[15] 446 U.S. 680 at 696–97.
[16] Varjabedian, 2018 WL 1882905, at *6.
[17] See id. at *8. In observing this, the Ninth Circuit cited Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981, 991 (9th Cir. 2009) (“[T]he plaintiff must plead a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it”).
This post comes to us from Arnold & Porter Kaye Scholer LLP. It is based on the firm’s memorandum, “Departing from Five Other Circuit Courts, the Ninth Circuit Holds That Section 14(e) of the Exchange Act Requires Only a Showing of Negligence,” dated May 3, 2018, and available here.