U.S. Court of Appeals for the Ninth Circuit – Jason Doiy/ALM

The troublesome issue of scienter, as a necessary ingredient of various securities acts violations, remains in flux. In a decision that roiled the securities industry and those specializing in mergers and acquisitions, the Ninth Circuit held in Varjabedian v. Emulex that to prove a violation of Section 14(e) of the Securities Exchange Act of 1934, which governs tender offers, a plaintiff need only show negligence, not scienter. The Supreme court granted certiorari, but after oral argument in April dismissed the writ as improvidently granted.

The underlying facts are simple enough. A predecessor in whose shoes Emulex stood, made a tender offer for the stock of Emulex. Goldman Sachs, engaged by Emulex, opined that it was fair. Emulex, after summarizing this opinion, recommended that stockholders accept the tender offer. But Emulex did not include or refer to one specific page in the Goldman Sachs report—a chart comparing the merger premium of 26.4% over the Emulex share price on the day of the offer with the prevailing range of selected semiconductor quotations, within which the Emulex tender fell, but well below the 50.85% average. In their complaint plaintiffs alleged that defendants were negligent in failing to include this premium analysis, in violation of section 14(e): “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….not misleading or to engage in any fraudulent, deceptive, or manipulative acts or practices, in connection with any tender offer….” The district court dismissed, holding that “the similarities between Rule 10b-5 (promulgated under the Securities Act of 1933) and Sec. 14(e) require a plaintiff bringing a cause of action under Sec. 14(e) to allege scienter or a strong inference of scienter,” as five Circuits had ruled. Rule 10b-5, in language almost identical to a portion of 14(e), prohibits “the use of manipulative and deceptive practices in connection with the purchase or sale of any security,” for the violation of which the Supreme Court has held a plaintiff must plead and prove scienter, i.e. a knowing or reckless violation of the statute.

The Ninth Circuit reversed, rejecting the 10b-5 analogy and finding that 14(e) includes two distinct prohibitions. “The use of the word 'or' separating the two clauses in Section 14(e) shows that there are two different offenses that the statute proscribes; to construe the statute otherwise would render it 'hopelessly redundant' and would mean 'one or other phrases is surplusage.'”

The court also rejected the application of the Supreme Court decision on which the other five circuits had relied when they applied the Rule 10b-5 scienter holdings to 14(e), namely Ernst & Ernst v. Hochfelder (1976). Hochfelder indeed had held that claims under Rule 10b-5 must prove scienter, but, as the 9th Circuit pointed out, the Supreme Court preliminarily observed that Rule10b-5 first provides: “It shall be unlawful…(to) make any untrue statement of a material fact or to omit to state any material fact.” “In isolation,” the Supreme Court acknowledged,  “this could be read as proscribing respectively any type of material misstatement or omission, “whether the wrongdoing was intentional or not.”  “In short,” the Ninth Circuit concluded, “Rule 10b-5 could reasonably be read as imposing scienter or a negligence standard.” “This means that Rule 10b-5(b), and by extension the identical phrasing in the first clause of Sec. 14(e) did not necessarily compel finding a scienter requirement.” Rather, the Supreme Court's holding that Rule 10b-5 demands a showing of scienter was based on the relationship between the rule and the underlying purpose and “long history of the 1933 Securities Act which speaks so specifically in terms of manipulation and deception and of implementing devices and contrivances. “ “Put simply,” the Ninth Circuit summarized, “Rule 10b-5 requires a showing of scienter because it is a regulation promulgated under Section 10b-5 of the Exchange Act (sic) which allows the SEC to regulate only “manipulative or deceptive device(s).” But, the Ninth Circuit wrote, under 14(e), the SEC is authorized to govern a much broader range of conduct than under section 10b-5. The Securities Exchange Act emphasized “the quality of information shareholders receive in a tender offer (rather) than on the state of mind harbored by those issuing a tender offer.”

Three of the adverse circuit decisions were before Aaron v. SEC, which held that section 17(a)(2) of the Securities Act of 1933, in language identical to Section 14(e), 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” does not require a showing of scienter. In short, the Ninth Circuit wrote: “The plain language of Section 17(a)(2) of the Securities Act of 1933 (sic) largely identical to the first clause of Section 14(e), requires a showing of negligence not scienter, and 'statutes dealing with similar subjects should be interpreted harmoniously.'”

Based on questioning at oral argument, it has been suggested that the case was dismissed because some justices believe there is no private right of action at all under section 14(e)—an issue that was not raised below—and wanted to defer tackling that broader issue until a case in which it was squarely presented. Until then, of course, the circuit split created by Vabjabedian will continue.