Corporate Dualism: Applying a Dual-Standard of Liability Under Section 14(e)'s Tender Offer Antifraud Provisions.

• Date: 22 September 2019
• Author: Bay, Katlyn M.

1. Introduction 205 II. Background 206 A. Tender Offers and Ambiguity Surrounding Section 14(e) 206 B. Cases Applying a Scienter Standard to 14(e) Claims 207 C. Cases Applying a Negligence Standard to 14(e) Claims 209 III. Analysis 211 A. Application of Liability Standards to Tender Offer Antifraud Violations 211 B. Benefits and Disadvantages of Applying a Scienter Standard 212 1. Benefits of Applying a Scienter Standard of Liability 212 2. Disadvantages of Applying a Scienter Standard 212 3. Application of Scienter Standard to Hypothetical Tender Offer 213 C. Benefits and Disadvantages of Applying a Negligence Standard 213 1. Benefits of Applying a Negligence Standard 213 2. Disadvantages of Applying a Negligence Standard 213 3. Application of a Negligence Standard to Tender Offer Hypothetical 214 D. Application of a Negligence Standard in Varjabedian 215 1. Rule-Making Power of Section 10(b) and Section 14(e) 215 2. Possible Interpretation of Section 14(e) to Allow a Negligence Standard 215 IV. Recommendation 216 A. Public Policy Favors a Dual-Standard of Liability 216 B. Statutory Interpretation Favors a Dual-Standard of Liability 218 C. Implications of a Dual-Standard Approach to Section 14(e) 219 V. Conclusion 220 I. INTRODUCTION

   The Ninth Circuit Court of Appeals recently diverged from the decisions of five other federal circuit courts in Varjabedian v. Emulex Corp., when the court applied a negligence standard in assessing a claim for material misstatements or omissions in a tender offer under Section 14(e) of the Securities Exchange Act of 1934 (1934 SEA). (1) This Note will begin by addressing the purpose of Section 14(e) and by providing a brief overview of the federal circuits' statutory interpretations of the Securities and Exchange Commission (SEC) Rule 10b-5. It will end with a brief discussion of Varjabedian, and the Ninth Circuit's rationale for applying a negligence standard.

   Part III will discuss the statutes and rules that provide support for the federal circuits' interpretations of Section 14(e) to include, or not include, a scienter requirement. The final portion of Part III will focus on the implications of applying a negligence standard as opposed to a scienter standard.

   Finally, Part IV will focus on why the application of a dual-standard of liability is more favorable than a scienter standard. Part IV.A will discuss the policy arguments promoting the interests of shareholders, offerors, and directors, which supports a dualstandard of liability under Section 14(e). Part IV.B will focus on the statutory interpretation of similar language in Rule 10b-5 and Section 17(a) compared to Section 14(e) in support of a dual-liability standard. Part IV will end by briefly discussing the implications of the Supreme Court establishing a dual-standard of liability for Section 14(e) claims in terms of legal precedent.

2. BACKGROUND

   This Part provides a general background on tender offers and Section 14(e)'s antifraud provisions, focusing on the ambiguity surrounding the mental state requirement (i.e., standard of liability) for material misstatements or omissions committed in connection with a tender offer. Additionally, this Part summarizes the cases applying a scienter standard to Section 14(e) claims, as well as the Ninth Circuit's decision to apply a negligence standard in Varjabedian.

   1. Tender Offers and Ambiguity Surrounding Section 14(e)

      Tender offers are a form of public offer that corporations or individuals use to acquire a specific amount of corporate security and, with that, a substantial or entire stake in a company. (2) The SEC defines a tender offer as "a broad solicitation by a company or a third party to purchase a substantial percentage of a company's Section 12 registered equity shares or units for a limited period of time." (3) Tender offers are one way a corporation or a third party can obtain corporate securities. (4) Tender offers are regulated by the SEC and are subject to the antifraud provisions set out in Section 14(e) of the 1934 SEA. (5) Section 14(e) states:

      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, in the light of the circumstances under which they are made, not misleading, or to engage in any fraudulent, deceptive, or manipulative acts or practices, in connection with any tender offer or request or invitation for tenders, or any solicitation of security holders in opposition to or in favor of any such offer, request, or invitation. The Commission shall, for the purposes of this subsection, by rules and regulations define, and prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive, or manipulative. (6) The crux of Section 14(e) focuses on an offeror or director's use of material misstatements or omissions, or fraudulent acts in connection with a tender offer. (7) Though Section 14(e) is comprised of antifraud provisions, it does not assign a specific standard of liability to cases involving Section 14(e) antifraud violations. (8)

      Until recently, federal courts have consistently applied a scienter standard of liability to Section 14(e) claims because they have generally applied the same scienter standard to violations of SEC Rule 10b-5. (9) Rule 10b-5 states:

      It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) to employ any device, scheme, or artifice to defraud, (b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. (10) Similarly, Rule 10b-5 does not assign a standard of liability for antifraud violations in connection with the purchase or sale of any security. (11) However, the Supreme Court held in Ernst & Ernst v. Hochfelder that a scienter standard is the proper standard of liability for Rule 10b-5 violations. (12)

   2. Cases Applying a Scienter Standard to 14(e) Claims

      In Ernst, the Supreme Court noted that the scienter requirement is satisfied when an individual, in connection with a tender offer, exhibits the "mental state embracing intent to deceive, manipulate, or defraud." (13) Further, the Supreme Court decided the scienter mental state is required for Rule 10b-5 claims because the Rule incorporates language prohibiting manipulative and deceptive activity. (14) The Court reasoned that the extent to which the SEC can regulate "manipulative or deceptive device[s]" under the rule-making power of Section 10(b) limits Rule 10b-5 to fraudulent acts entailing an intent to defraud. (15)

      Since 1973, five federal circuits have held that a Section 14(e) antifraud violation in connection with a tender offer requires proof of scienter, as opposed to mere proof of negligence. (16) In addressing the 14(e) claims, each circuit focused on the similar language in Rule 10b-5 and the Rule's accepted scienter standard. (17)

      In 1973, the Second Circuit applied a scienter standard of liability to a Section 14(e) claim in Chris-Craft Indus. Inc. v. Piper Aircraft Corp. (18) In Chris-Craft, the court determined the liability standard under Section 14(e) for a person or corporate officer soliciting a misleading tender offer is "whether ... [the] defendant either (1) knew the material facts that were misstated or omitted, or (2) failed or refused to ascertain such facts when they were available to him or could have been discovered by him with reasonable effort." (19) The Second Circuit also noted a negligence standard was not appropriate in claims arising under Sections 17(a) or 10(b) of the 1934 SEA. (20) In making its decision to require scienter, the court focused on Congress' intent in enacting Section 14(e), which was to promote and ensure informed shareholder voting in the case of tender offers. (21)

      In that case, in response to Chris-Craft issuing a tender offer to purchase Piper stock, Piper sent a letter to its shareholders discouraging the offer because it was not in the company's best interest. (22) Piper then agreed to an exchange offer with Bangor Punta Corp. before issuing a press release outlining the exchange offer. (23) Accordingly, Chris-Craft brought a private right of action against Piper and Bangor Punta Corp. under Section 14(e) and Rule 10b-5, claiming the letter to Piper stockholders and the press release contained material misstatements. (24) The court held that both Piper and Bangor Punta Corp. violated Section 14(e) because the shareholders were entitled to accurate information adequate to make an informed decision regarding the Piper family's personal recommendations. (25)

      In the following year, the Fifth Circuit also applied a scienter standard to a Section 14(e) claim in Smallwood v. Pearl Brewing Co. (26) In that case, the court stated a degree of culpability that exceeds mere negligence is required in cases alleging violations of Rule 10b-5. The evidence was not sufficient to find that the defendant knew or acted with culpability when they sent a letter to shareholders containing omissions of material facts. (27)

      The trend continued in Adams v. Standard Knitting Mills, Inc., where the Sixth Circuit applied a scienter standard of liability for a Section 14(a) claim. (28) In Adams, the court found for the defendant proxy statement issuers, stating, "[w]e find nothing in the record indicating an intent to deceive or a motive for deception ... here we find no evidence of anything other than a negligent error." (29)

      Similarly, in SEC v. Ginsburg, the Eleventh Circuit relied on similar language...