Can an individual sue for inaccurate or missing disclosure statements in a firm’s tender offer under Section 14(e) of the Securities Exchange Act of 1934; and, is an alleged violation of Section 14(e) subject to a negligence or scienter standard of proof?
This case asks the Supreme Court to define the private right of action under Section 14(e) of the Securities Exchange Act of 1934. Gary Varjabedian and other Emulex Corporation shareholders contend that they have a right to file a private action against Emulex under Section 14(e). Emulex Corporation and Avago Technologies Wireless Manufacturing, Inc. counter that Section 14(e) does not allow a private cause of action based on negligence, and that a higher scienter standard should apply instead. The Supreme Court’s ruling will have significant implications for shareholders’ interests in the event of a merger.
Questions as Framed for the Court by the Parties
Whether the U.S. Court of Appeals for the Ninth Circuit correctly held, in express disagreement with five other courts of appeals, that Section 14(e) of the Securities Exchange Act of 1934 supports an inferred private right of action based on the negligent misstatement or omission made in connection with a tender offer.
In February 2015, the technology companies Emulex Corporation (“Emulex”) and Avago Technologies Wireless Manufacturing, Inc. (“Avago”) announced that they would be merging. In accordance with the merger agreement, the companies agreed that an Avago subsidiary would make a tender offer of $8 per share for all of Emulex’s outstanding shares. Emulex subsequently filed a recommendation statement with the U.S. Securities and Exchange Commission (“SEC”), where—with the expertise of the bank Goldman Sachs—it notified its shareholders that it believed the Avago subsidiary’s offer was fair and that the shareholders should agree to sell their stock. Goldman Sachs prepared a “Premium Analysis” in which it examined comparable transactions and the premiums that shareholders received. Goldman Sachs determined that the 26.4% premium Emulex’s shareholders were due to receive was below average, but still within the normal range of premiums that shareholders earned in similar transactions. Emulex did not include or summarize the “Premium Analysis” in its recommendation statement.
Although enough shareholders ultimately sold their shares to complete the merger, others believed that the tender offer was inadequate. These shareholders refused to sell, and later sued Emulex in the United States District Court for the Central District of California for violating Section 14(e) of the Securities Exchange Act of 1934 (“1934 Act”). Section 14(e) makes it illegal for any person to “make any untrue statement of a material fact or omit to state any material fact” with respect to a tender offer. The plaintiff shareholders alleged that Emulex and Avago violated Section 14(e) by claiming that the deal was worth more than it actually was and by omitting Goldman Sachs’ “Premium Analysis” from the recommendation statement. The district court held that a violation under Section 14(e) required a showing of scienter—the defendant’s intent or knowledge of wrongdoing—and that the plaintiff shareholders failed to make this showing. The district court therefore dismissed the suit. The shareholders appealed to the United States Court of Appeals for the Ninth Circuit.
On appeal, the Ninth Circuit considered whether Section 14(e) required a showing of scienter or negligence. The Ninth Circuit noted that other appellate courts had ruled that Section 14(e) required a showing of scienter based on Rule 10b-5 of the 1934 Act. The Ninth Circuit then stated that when determining whether to use a negligence or scienter standard for Rule 10b-5, the Supreme Court has acknowledged that the rule’s language could be interpreted in favor of either standard. This language is identical to that used in Section 14(e). The Ninth Circuit then pointed out, however, that the Supreme Court has held a showing of scienter was necessary for Rule 10b-5 because of its close connection to Section 10(b) of the 1934 Act and because of its focus on deception. The Ninth Circuit then determined that the link other appellate courts had drawn between Rule 10b-5 and Section 14(e) was improper because the Supreme Court’s reasoning as to Rule 10b-5’s scienter requirement was inapplicable to Section 14(e).
Additionally, the Ninth Circuit cited the Supreme Court’s prior decision that Section 17(a)(2) of the 1934 Act did not require a showing of scienter. The Ninth Circuit claimed that because Section 17(a)(2) serves a similar purpose to Section 14(e) by setting standards for corporate disclosures during initial public offerings, the Supreme Court’s interpretation of Section 17(a)(2) should also be controlling for Section 14(e). Thus, the Ninth Circuit held that Section 14(e) does not require a showing of scienter. Emulex appealed this ruling to the Supreme Court, which granted Emulex’s petition for writ of certiorari.
DOES SECTION 14(e) SUPPORT A PRIVATE RIGHT OF ACTION?
Emulex argues that Section 14(e) of the 1934 Act does not support a private right of action. According to Emulex, only Congress has the constitutional power to determine whether Section 14(e) allows private parties to sue. Emulex contends the Ninth Circuit’s decision that Section 14(e) implies a private right of action effectively creates a new law, and therefore oversteps the constitutional boundaries of judicial power. Emulex argues that the Supreme Court has consistently refused to infer new private causes of action or expand previously recognized private causes of action.
Moreover, Emulex asserts that Section 14(e) does not meet the Supreme Court’s established test for identifying when a law grants an implied private right of action. Emulex explains that under this test, Section 14(e) must demonstrate Congress’ intent to create a private right of action through “rights-creating language” and that it must belong to a statutory scheme allowing enforcement through a private remedy. Emulex states that Section 14(e) does not contain “rights-creating language” because it imposes a broad ban on certain conduct instead of singling out a class of plaintiffs for special protection. Furthermore, Emulex observes that Section 14(e) instructs federal agencies rather than private plaintiffs to enforce violations of its provisions.
Varjabedian and the other Emulex shareholders (“Shareholders”) counter that Emulex did not argue the issue of whether Section 14(e) supports a private right of action before the Ninth Circuit. In fact, according to the Shareholders, Emulex’s brief to the Ninth Circuit expressly conceded that Section 14(e) supports a private right of action.
Alternatively, the Shareholders argue that Section 14(e) does support a private right of action. The Shareholders contend that by adopting language from the privately enforceable Section 14(a) of the 1934 Act, Congress demonstrated its intent to create a private remedy. The Shareholders explain Section 14(e) was meant to instill a system of regulation for tender offers that would mirror Section 14(a)’s governance of proxy solicitations. According to the Shareholders, the intentional similarities between the two regimes strongly suggest that Congress wanted both to be privately enforceable.
The Shareholders also claim that both Congress and the circuit courts of appeals have affirmed that Section 14(e) supports a private right of action. More specifically, the Shareholders point to fifty years of case law inferring a private right of action under Section 14(e). Given that Congress has never rejected this jurisprudence, the Shareholders contend that the Supreme Court should not call it into question either.Finally, the Shareholders dispute Emulex’s assertion that Section 14(e) lacks “rights-creating language” by arguing that the 1934 Acts’ overriding purpose was to generate rights. In light of this broader purpose, the Shareholders maintain that Section 14(e)’s failure to explicitly address a protected class of plaintiffs is irrelevant.
DOES SECTION 14(e)’S TEXT REQUIRE SCIENTER OR NEGLIGENCE?
Emulex argues that even if Section 14(e) supports a private cause of action, the Shareholders still have to show that Emulex was not merely negligent, but rather that it intended to commit or had knowledge of wrongdoing. Emulex contends that if Congress had intended for negligence to be the standard of care in Section 14(e), it would have used different language such as “reasonableness.” Instead, Emulex points out that Section 14(e) uses terms such as “fraudulent,” “deceptive,” and “manipulative,” all of which the Supreme Court has previously associated with scienter. Although the Ninth Circuit found that the words “untrue” and “misleading” indicate a negligence standard, Emulex asserts that these terms can also denote a scienter standard because they mean “dishonest” and “deceptive.”
In addition to this lack of textual support for a negligence standard, Emulex maintains that the Ninth Circuit’s reading of Section 14(e) violates both “whole-text canon” and the “associated-words canon” of statutory construction by conceding that a scienter standard applies only to the second clause of Section 14(e)’s first sentence. Emulex explains that the “whole-text canon” asks judges to focus on the entire text of a statute, while the “associated-words canon” directs them to define words by looking at the related terms in a statute. According to Emulex, the “whole-text canon” means that the Ninth Circuit should have read the first sentence of Section 14(e) as a whole and interpreted the first clause in light of the second clause. Emulex also argues that the Ninth Circuit should have adhered to the “associated-words canon,” when interpreting the first sentence of Section 14(e). Emulex contends that neither the commas nor the word “or” in this sentence qualify as structural divisions, and that the words “untrue” and “misleading” in the first clause should be read in light of their associated words in the second clause.
The Shareholders counter that the plain text of Section 14(e) makes it clear that its two clauses cover different categories of conduct. The Shareholders contend that the first clause, as opposed to the second clause, does not expressly or implicitly require scienter. According to the Shareholders, associating the first clause with scienter runs contrary to the objective of protecting shareholders by requiring disclosure of necessary information. The Shareholders argue that Section 14(e) must apply to negligent misstatements and omissions because, regardless of scienter, these actions still withhold necessary information from shareholders. The Shareholders point out that Congress could have limited the scope of the first clause by using modifiers other than the word “any.” Moreover, the Shareholders assert that Section 14(e) becomes redundant under Emulex’s reading because if both clauses require scienter, they would cover the same type of conduct. As an example, the Shareholders note that if the first clause requires scienter, then the phrase “untrue statement” counts as a “fraudulent, deceptive, or manipulative act” in the second clause.
The Shareholders also point to the Supreme Court’s prior ruling that courts need not read separate clauses together. Here, the Shareholders posit that it would be proper to treat the two clauses as separate entities because Congress inserted the word “or” between them and used an infinitive to start each clause. The Shareholders claim that Congress selected this disjunctive structure because it viewed the two clauses as independent prohibitions on different types of conduct. The Shareholders therefore argue that it would be unreasonable for Congress to apply a scienter standard to the first clause just because the second clause requires one.
DID CONGRESS INTEND TO CREATE A SCIENTER REQUIREMENT IN SECTION 14(e)?
Emulex argues that Congress drafted Section 14(e) based on Rule 10b-5. Because the Supreme Court has interpreted the language in Rule 10b-5 to apply only to conduct with scienter, Emulex asserts that Section 14(e) should also require scienter. According to Emulex, Congress would not use similar language to cover different types of conduct. Emulex further explains that the SEC promulgated Rule 10b-5 under Section 10(b) of the 1934 Act, and Section 10(b) only allows the SEC to regulate only conduct with scienter. According to Emulex, the fact that Congress used a rule that applies only to conduct with scienter as a model for Section 14(e) demonstrates that this provision was only intended to regulate conduct with scienter.
Emulex also cites other relevant securities laws to support its argument that Section 14(e) demands a showing of scienter. Emulex contends that in these surrounding statutes, Congress explicitly stated when a private right action could proceed on negligence grounds. Moreover, Emulex notes that Congress subjected each of these negligence actions to several procedural limitations, including a requirement that prospective plaintiffs advance a bond to cover litigation costs. Because Section 14(e) does not contain either an express mention of negligence or any procedural constraints, Emulex concludes that it does not belong within the group of actions that are subject to a mere negligence standard.
The Shareholders counter by citing the Supreme Court’s decision that the same language in Section 17(a) of the 1934 Act does not require scienter. The Shareholders argue that there is no logical reason for the same language to have different meanings. According to the Shareholders, Section 14(e)’s clauses should be read separately like the Section 17(a)’s subparagraphs, despite the fact that Section 17(a) is not privately enforceable and involves injunctive relief. The Shareholders argue, however, that the issue at hand does not involve either of these differences, and that Section 17(a) should still dictate how Section 14(e) is defined.
Finally, the Shareholders also challenge Emulex’s analogy to the Supreme Court’s prior interpretation of Rule 10b-5. The Shareholders argue that in determining this rule’s scope, the Supreme Court had to consider that it was an SEC regulation rather than a statute, and that the SEC’s rulemaking authority is restricted to conduct with scienter. In contrast, the Shareholders claim that in this case the Supreme Court only needs to account for how Congress drafted Section 14(e). Moreover, the Shareholders contend that although Congress used Rule 10b-5’s language in Section 14(e), that does not necessarily mean that the scienter requirement from the former transfers to the latter. According to the Shareholders, Rule 10b-5 is actually based on Section 17(a)(2) of the 1934 Act, which requires negligence, and the Supreme Court would have applied this lower standard to the rule were it not for Section 10(b)’s narrow scope.
AVOIDING FRIVOLOUS LAWSUITS
The Chamber of Commerce of the United States of America and Business Roundtable argue (collectively “the Chamber of Commerce”), in support of Emulex, that reading a negligence standard into Section 14(e) of the 1934 Act will increase frivolous litigation concerning disclosures during tender offers. The Chamber of Commerce claims that most mergers and acquisitions valued at over 100 million dollars become subject to lawsuits immediately after they are announced. The Chamber of Commerce explains that the plaintiffs in these suits can then use the threat of an injunction to block the transaction. The Chamber of Commerce contends that although these lawsuits are frequently resolved through the defendants’ disclosure of nonmaterial information, shareholders usually are not any more informed than before the lawsuit began. Instead, the Chamber of Commerce assert that the only beneficiaries are the plaintiff’s attorneys who can extract a “litigation tax” from the transaction for their efforts.
A group of institutional investors (“Institutional Investors”), in support of the Shareholders, argue that there are already adequate safeguards in place through the Private Securities Litigation Reform Act (“PSLRA”) to ensure that defendants are not overburdened by frivolous lawsuits. The Institutional Investors assert that the PSLRA’s enhanced pleading requirements and constraints on party discovery ensure that only valid lawsuits move forward. Furthermore, the Institutional Investors claim that these measures ensure defendants are not pressured into settling so as to avoid litigation costs. The Institutional Investors also contend that lawyers will not be incentivized to engage in overzealous litigation because there are federal statutes that cap attorney’s fees in securities cases. Additionally, the Institutional Investors note that a judge can always impose sanctions on attorneys who bring frivolous suits.
DEVELOPING THE PROPER INCENTIVES
Former Commissioners of the Securities and Exchange Commission (“Former SEC Commissioners”), in support of Emulex, argue that eliminating private rights of action under Section 14(e) and making the SEC the 1934 Act’s sole enforcement authority for misleading disclosures would lead to greater market efficiency. The Former SEC Commissioners contend that although securities fraud can increase the cost of capital, over-enforcement can also drive up the cost of doing business. The Former SEC Commissioners assert that private plaintiffs may be incentivized to bring claims with a low probability of success due to the propensity of many firms to settle because of the possibility that a court will rule in the plaintiffs’ favor. According to the Former SEC Commissioners, the SEC would be less-inclined to bring these low-probability suits if they were the only means of enforcement. Moreover, the Former SEC Commissioners assert that the SEC would be more likely than private parties to sue “judgment-proof” defendants as a means of deterring this behavior in the future. Therefore, the Former SEC Commissioners argue that placing Section 14(e) actions solely within the SEC’s authority would optimally deter securities fraud.
The North American Security Administrators Association (“NASAA”), in support of the Shareholders, responds that private actions under Section 14(e) critically supplement SEC enforcement in order to effectively deter securities fraud. To support this assertion, NASAA cites to the current SEC Commissioner’s public statement that the agency relies on private actions to curb corporate misdeeds. The United States adds that in addition to tender offer disclosure claims, the SEC also brings actions for other disclosure and regulation violations. The United States, in support of neither party, therefore suggests that if the SEC were the only authority capable of enforcing Section 14(e), it would need to substantially increase its enforcement efforts, and that this additional load would strain the agency’s limited resources. Furthermore, the United States contends that a higher scienter standard would only make this burden heavier if the Court were to determine that the SEC is the only party that can initiate enforcement litigation under Section 14(e).
- Joseph M. McLaughlin and Shannon K. McGovern, ‘Varjabedian v. Emulex’: Supreme Court Set to Decide Whether §14(e) of the Exchange Act Requires Scienter, New York Law Journal (Feb. 13, 2019).
- Brian Croce, Supreme Court Will Hear Case to Determine M&A Negligence Standard, Pensions and Investments (Jan. 7, 2019).
- Judy Greenwald, High Court Set to Rule in Case That Could Weaken D&O Defenses, Business Insurance (Jan. 15, 2019).