Justices Could Trigger Sea Change For Tender Offer Suits

This article by partners Martin Crisp, Douglas Hallward-Driemeier, David Hennes, and Gregg Weiner, with contributions from associate Logan Pettigrew, was published by Law360 on April 18, 2019.

On April 15, 2019, the U.S. Supreme Court heard oral argument in Emulex Corp. v. Varjabedian,¹ a case that could significantly alter the landscape of tender offer litigation under Section 14(e) of the Securities Exchange Act of 1934.² Emulex offers an opportunity for the court to take up key questions left unresolved by the court’s prior precedent — first, the predicate question of whether Section 14(e) permits an inferred private right of action (an issue left unresolved in Piper v. Chris–Craft Industries Inc.³); and second, whether negligent misstatements and omissions, as opposed to those made with scienter, are sufficient to establish a violation of Section 14(e).

Oral arguments confirmed the potentially significant nature of the forthcoming Emulex decision, as well as the justices’ sharp divide on these issues.

Section 14(e) regulates actions and statements made “in connection with any tender offer.” In language similar to clause (b) of U.S. Securities and Exchange Commission Rule 10b-5, the first clause of Section 14(e) makes it “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.” The second clause of Section 14(e) makes it unlawful for any person “to engage in any fraudulent, deceptive, or manipulative acts or practices” in connection with any tender offer, using language similar to clause (a) of Rule 10b-5.

In the case below, the U.S. District Court for the Central District of California rejected a stockholder plaintiff’s claim that Emulex Corporation violated federal securities law by issuing a false and misleading Schedule 14D-9 recommendation statement in support of Avago’s 2015 tender offer, applying a scienter standard. In the proposed transaction, Avago offered to pay $8 per share for Emulex’s stock, reflecting a premium of 26.4% over Emulex’s preannouncement stock price.

As the company considered the offer, Emulex’s financial adviser prepared a premiums paid analysis for the Emulex board of directors, which showed that, while Emulex’s 26.4% premium fell within the range of the semiconductor merger premiums for similar companies, it was below average. Nevertheless, Emulex’s financial adviser found the proposed consideration fair to the company, and Emulex elected not to summarize the analysis in the Schedule 14D-9 filed with the SEC. The tender offer ultimately succeeded, but with close margins: only 60.58% of outstanding shares were tendered.

Stockholder plaintiffs sued Emulex, its board and Avago, claiming that the omission of the premiums paid analysis rendered Emulex’s Scheduled 14D-9 false and misleading. The district court dismissed the action, finding that the “simple omission” of the premiums paid analysis alone failed to raise “an inference of scienter.” The U.S. Court of Appeals for the Ninth Circuit reversed that decision, concluding that claims premised on Section 14(e)’s first clause require “a showing of negligence, not scienter.” The Ninth Circuit’s decision broke with the uniform holdings of five other courts of appeals, all of which applied the scienter standard. The Supreme Court granted certiorari on whether Section 14(e) “supports an inferred private right of action based on a negligent misstatement or omission made in connection with a tender offer.”

In Emulex’s briefing before the Supreme Court, Emulex also raised the predicate issue of whether the Ninth Circuit erred in inferring a private right of action because Section 14(e) lacks any of the necessary “rights-creating language,” and because the Exchange Act’s express creation of certain private causes of action creates a presumption against any implied right under Section 14(e). In addition, Emulex took on the Ninth Circuit’s central holding, arguing that, by finding that Section 14(e) encompassed negligent conduct, the Ninth Circuit misread the statutory language.

On that latter issue, the stockholders’ briefing emphasized Section 14(e)’s two separate and distinct clauses, and the court’s decision in Aaron v. Securities and Exchange Commission,⁴ which held that negligence would violate the prohibition on material misstatements in Section 17(a) of the Exchange Act. Because Aaron predated Congress’ enactment of the similar language in Section 14(a) (applicable to proxy statements), the stockholders argued that Congress intended Section 14(a), like Section 17(a), to extend to negligent acts.

On the question of an inferred private right of action, the stockholders argued both that Emulex waived the issue by failing to raise it below and that the issue had already been resolved in J.I. Case Co. v. Borak,⁵ where the court decided that the substantively identical Section 14(a) creates an inferred right of action.

Oral arguments in Emulex focused primarily on the predicate issue of whether Section 14(e) created an implied right of action. Certain justices, particularly Justices Sonia Sotomayor and Samuel Alito, questioned Emulex’s counsel on the propriety of entertaining that argument, given that it had not been raised before the Central District of California or the Ninth Circuit. In response, counsel for Emulex cited Central Bank of Denver v. First Interstate Bank of Denver,⁶ a decision in which the court resolved the appeal on an issue first raised by the court itself, rather than the parties.

Emulex argued that it had presented the question in the petition for certiorari, and part of the court’s grant of certiorari expressly included whether Section 14(e) “supports an inferred private right of action.” By contrast, counsel for the stockholders argued that Emulex impliedly conceded an inferred right of action by not raising the issue below, making Central Bank distinguishable. Chief Justice John Roberts and Justice Neil Gorsuch pushed back against this argument, reminding stockholders’ counsel that Ninth Circuit precedent recognizes a private right of action, rendering any argument Emulex could have raised against that right in the prior proceedings futile.

Justice Elena Kagan then raised the court’s decision in Cannon v. University of Chicago,⁷ as applicable to Section 14(e). There, the court held that congressional silence in the face of earlier interpretations inferring a private right of action could provide a basis for the implication of one involving similar language. Justice Kagan stated that, under Cannon, if Congress repeats language that the court has already held to create an implied private right of action, “then that counts as a pretty strong indicator that Congress has meant for the same result to obtain.”

Stockholders’ counsel also relied on the court’s decision in J.I. Case Co. v. Borak,⁸ which recognized an implied private right of action in Section 14(a) cases. Counsel for Emulex responded by emphasizing the court’s subsequent holding in Alexander v. Sandoval,⁹ which cast doubt on Borak and similar decisions that have inferred private rights of action in the absence of supportive statutory language.

Chief Justice Roberts echoed this argument and quoted the late Justice Antonin Scalia who characterized Borak as an “ancient regime.” Stockholders’ counsel agreed that Borak might have been decided differently today, but argued that Congress enacted Section 14(e) with knowledge of the inferred right under Section 14(a)’s closely matched language. However, certain justices expressed discomfort with the entire notion of an implied right of action, including Justice Brett Kavanaugh, who focused on Section 14(e)’s plain text.

On the issue of the appropriate state of mind, to which the parties and the court gave far less attention during oral arguments, counsel for Emulex restated the importance of Rule 10b-5’s scienter requirement, and warned that enlarging Section 14(e) to encompass negligence would cause tender offer litigation to proliferate, and prompt a counterproductive “document dump” on stockholders. Counsel for the stockholders, by contrast, rested his argument on Section 14(e)’s plain language, which does not impose any scienter requirement.

As the justices’ commentary at oral argument indicated, Emulex presents a clear opportunity for the court to answer an issue left unresolved in the court’s prior precedent: whether Section 14(e) creates an inferred right of action. That gating issue gained unexpected preeminence in the parties’ merits briefing and at oral arguments, but the tenor of the justices’ questioning left the tea leaves difficult to decipher.

On the one hand, the court often looks to resolve cases on the narrowest possible ground, and finding no inferred private right of action would obviate the court’s need to determine the complicated culpability questions. In order to reach that result, the justices would have to address Section 14(e)’s similarities to Section 14(a), and harmonize the court’s holdings in Cannon, Borak and Sandoval.

Likewise, Emulex never raised this issue below, and the court generally avoids reaching issues not presented below. Justices Sotomayor and Alito expressly addressed the preservation issue, but Chief Justice Roberts and Justice Gorsuch appeared less concerned. Nevertheless, because courts of appeals have uniformly concluded that Section 14(e) creates an inferred private right of action, a decision in Emulex’s favor on this issue seems unlikely, given the seemingly settled nature of the law.

Interestingly, the justices’ questioning focused far less on the culpability question, the more closely watched question by practitioners. The court’s recent decision in Lorenzo v. Securities and Exchange Commission,¹⁰ may provide some indication of where the majority of justices stand on the scope of liability under the federal securities laws. In Lorenzo, a 6-2 majority of the court expanded the scope of liability under Rule 10b-5, by concluding that the dissemination of false or misleading statements could trigger liability for fraudulent schemes and practices under Rule 10b-5(a) and (c), even if the disseminator of that information could not be liable for making the statements under Rule 10b-5(b).

Justices Gorsuch and Clarence Thomas dissented from that decision, and although Justice Kavanaugh took no part in the court’s consideration, he dissented in the underlying decision as a then-judge of the U.S. Court of Appeals for the D.C. Circuit. The Lorenzo decision makes clear that the court will not reflexively reject expanded liability in the securities context. The question will be whether the court believes negligence-based liability is consistent with the statutory scheme.

As with nearly all oral arguments, the ultimate outcome remains unknown. The tenor of the justices questioning certainly suggests that the court may be prepared to address the threshold issue of whether a private right of action may be inferred under Section 14(e).

As for the issue of the proper standard for assessing culpability under Section 14(e), a decision reversing the Ninth Circuit’s decision on the merits would preserve the status quo across on this issue as it had been understood for decades by the courts of appeals. By contrast, an affirmance on that issue could result in a dramatic increase in the number of class action suits involving disclosure claims under Section 14(e) in federal district courts, as we have already seen under Section 14(a), given certain developments in the Delaware Court of Chancery.