Open the Floodgates: Ninth Circuit's Decision in Varjabedian Departs from Precedent and Gives Shareholders Free Reign.

AuthorStratton, Margaret

"Each of the provisions of the 1934 Act that expressly create civil liability ... contains a state-of-mind condition requiring something more than negligence. " (1)

  1. INTRODUCTION

    In 1968, Congress enacted the Williams Act, a series of amendments to the Securities Exchange Act of 1934 (1934 Act), to regulate the tender-offer process. (2) Tender offers are public takeover bids made to a company's shareholders to purchase stock at a fixed price--usually a premium above the shares' current market value. (3) The Williams Act's regulatory amendments sought to create fairness in the marketplace by requiring full disclosure of certain information to the Securities and Exchange Commission (SEC) to protect targeted companies' shareholders during these takeover attempts. (4) Specifically, Congress revised the 1934 Act to include a broad antifraud provision regulating tender offers, codified as section 14(e) (Section 14(e)). (5) Section 14(e) imposes restrictions on tender offers by prohibiting untrue statements of material facts, omissions of material facts, and fraudulent or deceptive acts. (6) Section 14(e) applies to tender offers of any security type and provides defrauded shareholders--including nonsellers and nonpurchasers--a cause of action. (7)

    The first ruling to address the proper standard for pleading a Section 14(e) claim came out of Chris-Craft Industries v. Piper Aircraft Corp., (8) a 1973 decision from the Second Circuit. (9) The Chris-Craft court analogized claims brought under Section 14(e) with antifraud claims brought under section 10(b) of the 1934 Act (Section 10(b)), as well as SEC Rule 10b-5 (Rule 10b-5), and held that scienter constituted the appropriate standard for both Rule 10b-5 and Section 14(e). (10) One year after Chris-Craft, the Fifth Circuit followed the Second Circuit's holding without question. (11) Then, in 1976, the Supreme Court firmly established in Ernst & Ernst v. Hochfelder (12) that a claim under Section 10(b) and Rule 10b-5 must allege scienter. (13) In the years following Ernst & Ernst, three other circuits continued to equate Rule 10b-5 with Section 14(e), and accordingly interpreted Ernst & Ernst as extending the scienter standard to claims asserted under Section 14(e), falling in line with the Second and Fifth Circuits' position. (14)

    In 2018, however, forty-five years after the Chris-Craft decision, the Ninth Circuit reversed the lower court ruling in Varjabedian v. Emulex Corp. (15) and held that Section 14(e) claims only require negligence. (16) In this California shareholder suit, the Ninth Circuit held that plaintiffs only need to plead, and ultimately prove, that defendants acted negligently in making material misstatements or omissions in tender-offer disclosures. (17) This holding deviated significantly from other circuits' understanding of Section 14(e). (18) The Ninth Circuit relied on both a plain text and statutory purpose interpretation to support diverging from the scienter standard. (19) Moreover, the Ninth Circuit also observed that any reliance on Ernst & Ernst to analogize Rule 10b-5 with Section 14(e) was unfounded because the legislative intent for a scienter standard only applies to "fraudulent" or "deceptive" practices, not merely untrue statements. (20) The Ninth Circuit declined to rely on the Rule 10b-5 language, and used a section of the Securities Act of 1933 (1933 Act) to address the intended lower standard. (21)

    This Note first briefly examines and discusses the general history of the 1933 Act and the 1934 Act, and the legislative intent behind creating the Williams Act and Section 14(e). (22) Next, this Note introduces the scienter standard under Rule 10b-5 claims through a discussion of the Ernst & Ernst holding. (23) This Note then shifts the focus specifically to the scienter standard under Section 14(e) and provides a deeper understanding of the forty-five years of circuit court precedent. (24) Thereafter, this Note analyzes the Varjabedian opinion, asserts a statutory construction and interpretation method for reading ambiguous securities statutes, proposes that the SEC promulgate a rule to clearly restrict Section 14(e) to a scienter standard, and addresses the implications of a lower negligence standard in the shareholder merger-litigation world. (25) Finally, this Note revisits the argument for a scienter standard under Section 14(e), expands on policy reasons for maintaining this element for tender offers, and ultimately concludes that the Ninth Circuit incorrectly interpreted that Section 14(e) imposes a lower negligence standard. (26)

  2. HISTORY

    1. Federal Legislation Governing Securities

      1. The 1933 Act and the 1934 Act

        In response to the Great Depression, Congress enacted two major federal securities statutes. (27) The first, the 1933 Act, was created to regulate the initial sale and distribution of securities to the public. (28) The 1933 Act required a company to file a registration statement containing information to help prospective purchasers make informed investment decisions. (29) The second, the 1934 Act, was designed to regulate ongoing transactions in the secondary market and to identify, prohibit, and discipline fraudulent activities in connection with the offer, purchase, or sale of securities. (30) The 1934 Act also established the SEC and gave it broad agency authority to both enforce federal securities laws and issue rules to further regulate the securities industry. (31)

        Together, the federal statutes govern the securities industry, protect investors, and provide the framework for the SEC to maintain fair and efficient markets through a mandated flow of information. (32) Additionally, the SEC may create and implement rules to help govern the securities industry. (33) For example, Section 10(b) was adopted under the 1934 Act as a "catch-all" antifraud provision, and provided the SEC with the power to create "rules and regulations ... as necessary ... for the protection of investors." (34) Under this statutory power, the SEC promulgated Rule 10b-5 to complement Section 10(b) and prohibit any possible deception or fraud when selling or purchasing securities. (35) As a result, the SEC's rulemaking authority preserved Congress's intent under the federal securities laws while defining the scope of Section (10)(b)'s statutory language. (36)

      2. The Williams Act

        In 1968, Congress amended the 1934 Act to also regulate the cash tender-offer process. (37) A tender offer is an effective technique for an entity to initiate a corporate takeover. (38) Before the Williams Act, a cash tender offer consisted of an offeror placing an anonymous, public bid to purchase a certain number of a target company's stock, and requesting that the shareholders "tender" their shares at a fixed price--typically a premium above the shares' current market value--over a short period of time. (39) The purpose behind a tender offer was to allow an entity to quickly acquire enough target company shares in order to take control of it. (40) Although effective, tender offers were coercive in nature and left the careful, hesitant shareholder stuck with an investment subject to a new, unknown entity. (41)

        Congress enacted the Williams Act to ensure shareholders received extensive information to intelligently consider a tender offer and make an informed decision about the future of their shares. (42) Specifically, the Williams Act requires adequate disclosure of the offerors' funds source, plans relating to the takeover company, and agreements relating to the securities, as well as providing shareholders with ample time to digest the disclosed information. (43) The amendments closed a large gap in disclosure requirements under the federal securities laws. (44)

        Before the Williams Act, the majority of cash, tender-offer suits were brought under Section 10(b) and Rule 10b-5. (45) At the time, courts generally took the position that offerors had no duty to disclose certain information, and thus were not liable for any failure to disclose. (46) In response, the Williams Act added Section 14(e) to the 1934 Act, which functions as an additional antifraud device by increasing the disclosure of material information between tender-offer participants. (47) Although Section 14(e)'s legislative history is not robust, the

        Senate's report describes the overall provision as regulating "[f]raudulent transactions." (48) Section 14(e)'s first sentence focuses on prohibiting fraudulent acts in connection with a tender offer, while its second sentence provides the SEC with room to promulgate rules that are reasonably calculated to prevent such fraudulent acts. (49)

    2. Examining the Scienter Standard through Ernst & Ernst v. Hochfelder

      Courts have observed that some of the Williams Act's sections "largely track[] the substantive provisions of Rule 10b-5." (50) As a result, many courts require an allegedly-injured plaintiff to show something more than negligence to prove liability under Section 14(e). (51)

      1. What is Scienter?

        The scienter standard is something more than negligence. (52) To satisfy scienter, the plaintiff must identify that the defendant's mental state was an extreme departure from ordinary care. (53) The standard implies that a defendant must intend to misrepresent or omit material information, or knowingly use some practice to defraud. (54) Applying this higher standard, as opposed to negligence, serves as a gatekeeper, preventing frivolous litigation after merger and acquisition announcements. (55)

        Congress similarly enacted the Private Securities Litigation Reform Act (PSLRA) in 1995 to limit frivolous federal securities lawsuits by private parties. (56) The PSLRA strengthens the pleading barriers for plaintiffs to initiate federal securities actions, including imposing the scienter standard. (57) Under the (discussing strong inference of scienter not established using mere knowledge of problem). PSLRA, plaintiffs need to "state with particularity...

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