On The Case

Bucking precedent, 9th Circuit opens door to more M&A challenges

(Reuters) - The single biggest development in securities class action litigation in the past two years is the rise of federal court suits by investors challenging M&A transactions. According to reports by both Cornerstone and NERA Economic Consulting, there were nearly 200 class actions by investors claiming to have been misled by corporate deal disclosures – more than double the 85 M&A challenges filed in 2016 and more than five times as many cases as investors filed in 2015. (You know why this has happened: Delaware Chancery Court cracked down on fee awards for plaintiffs' lawyers who obtained only additional proxy disclosures so filings quickly shifted out of Delaware and into federal court.)

Cornerstone’s report breaks down M&A challenges by federal circuit. Courts in the 9th Circuit saw a disproportionate share: 41 new M&A class actions were filed in the circuit in 2017, more than in any other circuit.

The 9th Circuit’s percentage of all M&A class action filings did decrease between 2016 and 2017. In 2016, nearly 30 percent (25 of 85) of all of the M&A class action filings were in the 9th Circuit; in 2017, the percentage fell to about 21 percent. The 3rd Circuit was close behind, with nearly 20 percent, or 39 cases.

I would not be at all surprised if the 9th Circuit widens the gap in filings this year. If investors have the option of suing over an M&A deal in California, Nevada or other West Coast states, I suspect they will after a decision Friday by the 9th U.S. Circuit Court of Appeals in Varjabedian v. Emulex Corporation, a shareholder challenge to Avago Technologies’ $610 million acquisition of Emulex in 2015.

9th Circuit Judges Susan Graber, Mary Murguia and Morgan Christen split with five (five!) other federal circuits to hold that shareholders need not allege a corporation intended to deceive investors in issuing supposedly inadequate disclosures about a prospective deal.

The 9th Circuit said the statute on deal disclosures, Section 14 of the Securities and Exchange Act of 1934, requires a showing only of negligence, not fraudulent intent (or scienter, if you want to get technical). “We are aware that our holding today parts ways from our colleagues in five other circuits,” wrote Judge Murguia for the panel. “However … we are persuaded that intervening guidance from the Supreme Court compels the conclusion that Section 14 of the Exchange Act imposes a negligence standard.”

The first decision to address the proper standard for Section 14 claims was the 2nd Circuit’s ruling in Chris-Craft Industries v. Piper Aircraft back in 1973. The Chris-Craft ruling analogized claims under Section 14 to claims of securities fraud under Rule 10b-5. Since courts have held that investors suing under Rule 10b-5 must show a corporation’s intent to deceive, the 2nd Circuit said, the same standard should apply to claims under the newer-vintage law prohibiting misleading deal disclosures.

In the decades since the Chris-Craft decision, the 3rd, 5th, 6th and 11th Circuits have all agreed with the 2nd Circuit that investors have to allege scienter to sue under Section 14.

The 9th Circuit, however, looked at the language of the statute and two U.S. Supreme Court rulings – 1976’s Ernst & Ernst v. Hochfelder and 1980’s Aaron v. Securities and Exchange Commission – to conclude those other circuits were wrong. The statute, the court observed, says it is illegal for a person to make untrue statements or omit material information about a tender offer or to engage in any fraudulent or deceptive acts related to a tender offer. The word “or” is crucial, according to the 9th Circuit. It shows that Congress intended to proscribe two different offenses – and only the second offense mentions deception.

It’s true that Rule 10b-5 contains the same text, the 9th Circuit said, and the Supreme Court held in the Ernst & Ernst decision that 10b-5 claims require allegations of fraudulent intent. But according to the 9th Circuit in Emulex, the Supreme Court reached that conclusion by looking back at the statute the SEC interpreted to draft Rule 10b-5, Section 10 of the Securities and Exchange Act. (Going into the weeds a bit here but for that you can blame the 9th Circuit.) That section allows the Securities and Exchange Commission to regulate “manipulative or deceptive” statements.

“Put simply, Rule 10b-5 requires a showing of scienter because it is a regulation promulgated under Section 10(b) of the Exchange Act,” the 9th Circuit said in Emulex. “This rationale regarding Rule 10b-5 does not apply to Section 14(e), which is a statute, not an SEC rule.”

The 9th Circuit said the Supreme Court’s interpretation of yet another securities provision, Section 17 of the Securities Act of 1933, confirms its analysis. In the Aaron case, the justices found that Section 17, which regulates fraud in securities offerings, requires only a showing of negligence, not intent to deceive. Section 14 of the 1934 Act contains almost the same language as Section 17 of the 1933 Act, the 9th Circuit said, so it makes sense to apply the Aaron reasoning – despite contrary conclusions from all of the other federal circuits.

I should point out that in the surge of recent M&A challenges in federal court, motions to dismiss are seldom actually litigated. The vast majority of Section 14 class actions are voluntarily dismissed by shareholders, sometimes after negotiations in which defendants agree to additional proxy disclosures, but almost always without much litigation. Still, if the Emulex decision holds up, plaintiffs’ lawyers will have additional leverage.

I emailed Emulex counsel Eric Landau of Jones Day and Avago Technologies Matthew Rawlinson of Latham & Watkins to see if there are plans to ask the entire 9th Circuit or the Supreme Court to take a look at the case, considering both the circuit split and the increasing incidence of Section 14 class actions. I didn’t immediately hear back.

Shareholder lawyer Juan Monteverde of Monteverde & Associates presented the winning argument to the 9th Circuit in Emulex. He didn’t respond to my email.