Robert L. Hickok, Jay A. Dubow and Erica Hall Dressler of Pepper Hamilton.

On Jan. 4, 2019, the U.S. Supreme Court granted certiorari in the matter, Emulex v. Varjabedian. A ruling by the Supreme Court will likely resolve a circuit split regarding the pleading standard for claims brought under Section 14(e) of the Securities Exchange Act of 1934 that was created by the U.S. Court of Appeals for the Ninth Circuit's decision in April 2018. In that decision, the Ninth Circuit departed from five other circuits, including the Third Circuit, and held that plaintiffs seeking to recover under Section 14(e) of the Exchange Act for alleged material misstatements or omissions in tender-offer filings must only prove negligence and not scienter.

Additionally, the Supreme Court could determine as a threshold matter whether a private right of action even exists under Section 14(e). If the Supreme Court decides that there is no private right of action under Section 14(e), then the issue regarding the state of mind required for Section 14(e) claims will become irrelevant.

Section 14(e) prohibits false statements and material omissions made in connection with a tender offer. Emulex arose from the merger of two technology companies—Emulex and Avago Technologies. On Feb. 25, 2015, the two companies issued a joint press release announcing that they had entered into a merger agreement. A subsidiary of Avago initiated a tender offer for Emulex's outstanding stock on April 7, 2015, pursuant to the merger agreement and offered to pay $8 per share. This price represented a 26.4 percent premium on Emulex's stock price one day before the merger had been announced. On the same day that the tender offer was initiated, Emulex filed a 48-page recommendation statement with the SEC that listed reasons for approving the merger and included a fairness opinion that Emulex had received from its financial adviser.

A putative federal securities class action was filed the day after Emulex filed its recommendation statement with the SEC in the U.S. District Court for the Central District of California seeking to enjoin the merger. Emulex produced to plaintiff a one-page chart titled “Selected Semiconductor Transactions,” also known as the “premium analysis.” The premium analysis, which had not been part of or summarized in the recommendation statement that was filed with the SEC, displayed 17 transactions involving similar companies between 2010 and 2014. The chart revealed that Emulex's 26.4 percent premium was below average, even though it fell within the normal range of similar merger premiums. The district court denied the plaintiff's motion to enjoin the merger. However, the lead plaintiff amended the complaint to allege that the failure of Emulex and its individual directors violated Section 14(e) because their omission of the premium analysis misled Emulex's shareholders into believing that the merger was better than it was.

The district court dismissed the amended complaint with prejudice and rejected the plaintiff's argument that only negligence was required to state a claim under Section 14(e). The district court first observed that no federal court had held that Section 14(e) requires a showing of only negligence and relied on persuasive case law from the other circuits holding that similarities between Rule 10b-5 and Section 14(e) require the element of scienter for Section 14(e) claims. It then concluded that the plaintiff failed to establish a strong inference of scienter because: nothing in the premium analysis contradicted the recommendation statement; and the substance of the premium analysis was insignificant compared to the information in the recommendation statement and fairness opinion.

As noted by the district court in Emulex, the Second, Third, Fifth, Sixth, and Eleventh circuits have all previously considered and rejected a negligence-based standard for Section 14(e) claims. The Third Circuit held that scienter is an element of a Section 14(e) claim in In re Digital Island Securities Litigation, 357 F.3d 322 (3d Cir. 2004). That lawsuit was brought by stockholders after the announcement of two business deals immediately following the expiration of a tender offer. The tender offer period expired on June 18, 2001, and two days later, Digital Island announced a major business deal with Bloomberg. Then, on July 2, 2001, Digital Island announced another major business deal with Major League Baseball. Plaintiffs brought claims under Section 14(e) and Section 14(d)(7), as well as Section 20(a) of the 1934 Act. The plaintiffs alleged that the defendants knew of the two business deals before the expiration of the tender offer but deliberately or recklessly failed to disclose the deals until the expiration of the tender offer. According to the plaintiffs, the two business deals had substantial value to Digital Island and disclosure of the deals would have substantially influenced their decision to tender their shares.

The district court dismissed the complaint for failure to state a claim and held that the plaintiffs' Section 14(e) claim failed to identify with specificity the statements that were misleading; and plead facts giving rise to a strong inference of scienter. The district court subsequently denied the plaintiffs' motion for leave to file an amended complaint. On appeal, the Third Circuit agreed with the district court's conclusion that scienter is an element of a Section 14(e) claim and observed that such a position was consistent with precedent construing Section 14(e) and Rule 10b-5 in a similar manner. It then concluded that the proposed amended complaint failed to allege facts giving rise to a strong inference that Digital Island's board of directors acted with scienter in not disclosing the deals in their statements regarding the tender offer.

In Emulex, the Ninth Circuit rejected an approach similar to the one taken by the Third Circuit in In re Digital Island Securities Litigation. In rejecting such an approach, the Ninth Circuit first noted that the two clauses in Section 14(e) are separated by the word “or,” meaning that the statute proscribes two different offenses—making any false statements or material omission, or engaging in any fraudulent, deceptive, or manipulative acts or practices. According to the Ninth Circuit, the text of the first clause did not suggest that scienter is required. It further concluded that distinctions between Rule 10b-5 and Section 14(e) weigh against applying the scienter requirement to Section 14(e) claims. The Ninth Circuit also interpreted the legislative history and purpose of the Williams Act as placing greater emphasis on the quality of information given to shareholders in a tender offer rather than the state of mind of those issuing a tender offer.

The Supreme Court's decision will likely have a significant impact on M&A litigation. As the Securities Industry and Financial Markets Association noted in its amicus brief, the number of “merger objection” lawsuits in federal court based on Section 14(e) claims has doubled since 2016, likely as a result of the Delaware Court of Chancery's landmark decision in In re Trulia Stockholder Litigation, 129 A.3d 885 (Del. Ch. 2016). Prior to Trulia, litigation was filed in over 90 percent of public company mergers. For companies incorporated in Delaware, the cases were usually filed in Delaware Chancery Court. Most of these cases were settled with the defendants making some additional disclosures, getting broad releases and paying the plaintiff's attorney fees. In Trulia, however, the court refused to approve such a settlement, and plaintiffs thereafter began filing more cases in federal court.

If the Supreme Court rules that there is no private right of action for a Section 14(e) claim, then federal M&A litigation alleging proxy violations under Section 14(e) will end. However, if the Supreme Court rules that a private right of action exists under Section 14(e) and that a negligence standard is appropriate for Section 14(e) claims, then even more companies and their directors will be exposed to increased litigation following any announcement of a merger or similar transaction. Moreover, with a relaxed pleading standard, fewer Section 14(e) claims will be dismissed at the pleading stage. Oral argument is set for April 15, 2019. Robert L. Hickok is a partner and former co-chair of the litigation and dispute resolution department of Pepper Hamilton. He is a past member of the firm's executive committee. He can be reached at 215-981-4583 or [email protected].

Jay A. Dubow is a partner with the firm, resident in the Philadelphia office. He is a member of the firm's white collar litigation and investigations practice group and is co-chair of the securities and financial services enforcement group. He can be reached at 215-981-4713 or [email protected].

Erica Hall Dressler is an associate in the firm's trial and dispute resolution practice group, where she helps clients analyze and solve their most emergent and complex problems through negotiation, arbitration and litigation. She can be reached at 215-981-4691 or [email protected].