The Ninth Circuit Eases Section 14(e) Pleading Standards: The Chilling Effect on Tender Offers

By: Eli Sulkin

The Ninth Circuit’s 2018 decision in Varjabedian v. Emulex Corp.^[1] split with five circuits and bolstered plaintiffs’ ability to file class action lawsuits against companies engaged in tender offers.^[2] The court’s decision permits plaintiffs to file lawsuits in response to a company’s negligent omission or misstatement of a material fact in a proxy statement that influences the outcome of a tender offer.^[3] As a result, companies may hesitate when considering a tender offer, fearing that a mistake on a proxy statement may result in adverse consequences. This paper argues that the Ninth Circuit incorrectly analyzed Section 14(e) of the Securities Exchange Act of 1934 (“Exchange Act”) and reasons that Section 14(e) requires plaintiffs allege that defendants acted with scienter.

After granting certiorari, the Supreme Court dismissed Emulex Corp. v. Varjabedian,^[4] determining that it improvidently granted certiorari to decide a secondary issue in the case, the question of whether Section 14(e) grants a private right of action. The Court found that the parties did not properly litigate the private right of action issue in the lower courts, and as a result, dismissed the case.^[5] While the Ninth Circuit’s negligence standard stands, it is likely the Supreme Court will overrule the Ninth Circuit and side with the five circuits that require plaintiffs to plead scienter for all Section 14(e) claims.

Section 14(e) reads as follows:

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,orto 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 Ninth Circuit reads the first sentence of Section 14(e) as two separate and distinct clauses requiring different pleading standards; holding that the clause before the emphasized “or” only requires pleading negligence, and the clause after the “or” requires pleading scienter.^[7]

The Ninth Circuit criticized the reasoning of the five circuit courts that require plaintiffs to allege scienter under Section 14(e).^[8] The five circuits determined that since the section’s language is nearly identical to the language of Rule 10b-5 of the Exchange Act, and Rule 10b-5 requires pleading scienter, Congress must have intended the same pleading requirement for Section 14(e).^[9] The Ninth Circuit correctly highlighted that Rule 10b-5’s scienter requirement is unrelated to the language in the rule itself.^[10] Rather, Rule 10b-5 adopts the pleading requirement of its authorizing legislation, Section 10(b).^[11] Section 10(b) covers “[m]anipulative and deceptive devices.”^[12] Since the acts proscribed in Section 10(b) require intent, all rules authorized under the section adopt its scienter pleading standard.^[13] Of course, as the Ninth Circuit identifies, Section 14(e) does not have such authorizing language.^[14]

Rather than apply the flawed 10b-5 reasoning to Section 14(e), the Ninth Circuit reasoned that courts should look to Section 17(a) of the Securities Act of 1933 (“Securities Act”).^[15] Congress wrote Section 17(a) as three separately enumerated subparagraphs, each requiring its own pleading standard.^[16] The Ninth Circuit equated the placement of the comma and the word “or” in Section 14(e) with the three separately enumerated subparagraphs in Section 17(a).^[17] The Varjabedian court held that the language in the second clause of 14(e) tracks the language in Section 17(a)(1), which covers an intent to “employ any device…to defraud,” indicating a scienter pleading standard.^[18] The Varjabediancourt further reasoned that the language in the first clause of Section 14(e) tracks the language in Sections 17(a)(2) and 17(a)(3) which do not indicate specific intent and only require pleading negligence.^[19] Thus, the Ninth Circuit held that claims arising under Section 14(e)’s first clause require the less stringent negligence standard.^[20] In addition to comparing Section 14(e) to Section 17(a), the Ninth Circuit supported its decision by citing the Supreme Court’s holding in United States v. O’Hagan.^[21] In O’Hagan, the SupremeCourt ruled that under Section 14(e), the Securities Exchange Commission (“SEC”) is authorized to prohibit non-fraudulent acts that are committed in the commission of a fraud.^[22] Citing O’Hagan, the Ninth Circuit reasoned that if the SEC can prohibit non-fraudulent acts under Section 14(e), and non-fraudulent acts do not require intent, Section 14(e) must apply to negligence as well.^{^[23]}

Finally, the Ninth Circuit relied on the Senate Report accompanying the passage of Section 14(e) which states: “[t]his provision would affirm the fact that persons engaged in making or opposing tender offers or otherwise seeking to influence the decision of investors or the outcome of the tender offer are under an obligation to make full disclosure of material information to those with whom they deal.”^{^[24]} From this, the Ninth Circuit reasoned that Congress was more concerned about the quality of the information provided to shareholders rather than the state of mind of those issuing the tender offers.^[25]

At first glance, the Ninth Circuit’s argument is compelling. The five circuits inaccurately base Section 14(e)’s scienter standard on its similar language to Rule 10b-5 without regard to the fact that Rule 10b-5 derives its scienter standard from the language of the its authorizing legislation, Section 10(b), not the language of the rule itself.^[26] Further, the Ninth Circuit argues that Supreme Court precedent and Section 14(e)’s legislative history establish that the negligence pleading standard applies to Section 14(e) claims.^[27] However, upon further analysis, the Ninth Circuit’s reasoning breaks down.

The Ninth Circuit’s comparison of Section 14(e) to Section 17(a) is misguided. By structuring Section 17(a) into three separately enumerated subparagraphs, Congress indicated its intent to require different pleading standards for each subparagraph.^[28] No such indication exists in the structure Section 14(e). Moreover, in Schreiber v. Northern Burlington Inc.,^[29]the Supreme Court emphatically rejected the Ninth Circuit’s theory that the placement of the word “or” in the middle of Section 14(e) indicated congressional intent.

In Schreiber, Burlington Northern submitted a tender offer to purchase shares of El Paso Gas Co in pursuit of a hostile takeover.^[30] After shareholders responded favorably, Burlington Northern revoked the offer, entered into negotiations with El Paso’s management, and submitted a second offer.^[31] In its second offer, Burlington Northern substantially reduced the number of shares it offered to purchase, thus reducing the value of the shares owned by the petitioner, Schreiber.^[32] In response, Schreiber sued, arguing that under Section 14(e), Burlington Northern unlawfully manipulated the tender offer.^[33] In support of her argument, Schreiber claimed the disjunctive “or” preceding the word “manipulative” implies that acts need not be deceptive or fraudulent to be manipulative.^[34] In short, Schreiber’s claim rested on the argument that Congress intended Section 14(e) to apply to a variety of issues, not strictly disclosure, and Congress expressed its intent by placing “or” before the word “manipulative.”^[35]

The Supreme Court rejected Schreiber’s argument, noting that the statute’s core concern relates to issues of disclosure, not every type of manipulation that influences the outcome of a tender offer.^[36] The disjunctive “or” before “manipulative” does not broaden the scope of Section 14(e). Rather, it clarifies the types of acts reached by the section.^[37] The Schreiber Court reasoned that if Congress intended a broader scope for Section 14(e), it would have done more than “express it only through the use of a single word placed in the middle of a provision otherwise devoted to disclosure.”^[38] While the Ninth Circuit attached significant weight to the use and placement of “or” as a signal of congressional intent, the Schreiberdecision exposes the Ninth Circuit’s flawed reasoning.

Additionally, the Ninth Circuit’s rationale – that because the SEC can make non-fraudulent acts in the commission of fraud actionable, 14(e) must cover acts of negligence, is incorrect. The SEC is only authorized to prohibit non-fraudulent acts when the ultimate goal of engaging in those acts is fraudulent. Of course, people who take non-fraudulent steps in the pursuit of fraud act with intent, i.e., scienter. The Supreme Court’s O’Hagan decisiongrants the SEC narrow enforcement authority related to non-fraudulent acts taken in pursuit of a fraudulent goal.^[39] O’Haganneither grants the SEC enforcement authority over unintentional acts that influence the outcome of a tender, nor does it broaden the scope of Section 14(e) to encompass unintentional manipulation.^[40]

The Ninth Circuit also overlooks an essential phrase in its analysis of the Senate Report relating to the enactment of Section 14(e) (quoted above). Specifically, the phrase “seeking to influence” provides guidance to determine congressional intent. A person who seeks to influence the outcome of a tender offer must intend a specific outcome. In short, that person acts with scienter. On the other hand, negligence does not require a person to seek a desired outcome. While the Ninth Circuit interprets the Senate Report to imply Congress intended to require a negligence standard, the stronger indication is the application of scienter.

The Ninth Circuit’s 14(e) negligence standard causes a circuit split that will likely be resolved by the Supreme Court because it disregards Schreiber, misreads O’Hagan, and ignores crucial language in the Senate Report. However, until the Supreme Court resolves the circuit split, companies must be wary of proposing tender offers in the Ninth Circuit’s jurisdiction.

^[1]888 F.3d 399, 410 (9th Cir. 2018).

^[2]See generally, SEC v. Ginsburg, 362 F.3d 1292, 1297 (11th Cir. 2004) (holding that establishing scienter is necessary for claims arising under both 14(e) and 10b-5); In re Digital Island Sec. Litig., 357 F.3d 322, 328 (3d Cir. 2004) (holding that the similarity in language between 10b-5 and 14(e) leads the court to construe the claims arising under both consistently); Adams v. Standard Knitting Mills, Inc., 623 F.2d 422, 431 (6th Cir. 1980) (holding that the language of 14(e) demonstrates scienter as a necessary element); Smallwood v. Pearl Brewing Co., 489 F.2d 579, 605 (5th Cir. 1974) (holding that the similarity of language between 14(e) and 10b-5 indicates that Congress intended on the same pleading standards); Chris-Craft Indus. Inc. v. Piper Aircraft Corp., 480 F.2d 341, 362 (2d Cir. 1973).

^[3]See generally Varjabedian, 888 F.3d at 410 (determining that plaintiffs may file lawsuits under Section 14(e) claiming defendants acted negligently).

^[4]139 S. Ct. 782, 782 (2019).

^[5]See Varjabedian, 888 F.3d at 409 (“it is undisputed that §14(e), 15 U.S.C.S. §78n(e), provides for a private right of action to challenge alleged misrepresentations or omissions in connection with a tender offer.”).

^[6]15 U.S.C. § 78n(e) (2018) (emphasis added).

^[7]SeeVarjabedian, 888 F.3d 399 at 408 (holding that due to the difference in language within the two clauses, each clause requires different pleading standards).

^[8]Id. at 407.

^[9]See generally SEC v. Ginsburg, 362 F.3d 1292, 1297 (11th Cir. 2004)(holding that establishing scienter is necessary for claims arising under both 14(e) and 10b-5); In re Digital Island Sec. Litig., 357 F.3d 322, 328 (3d Cir. 2004) (holding that the similarity in language between 10b-5 and 14(e) leads the court to construe the claims arising under both consistently); Adams v. Standard Knitting Mills, Inc., 623 F.2d 422, 428 (6th Cir. 1980) (holding that the language of 14(e) demonstrates scienter as a necessary element); Smallwood v. Pearl Brewing Co., 489 F.2d 579, 605 (5th Cir. 1974) (holding that the similarity of language between 14(e) and 10b-5 indicates that Congress intended on the same pleading standards); Chris-Craft Indus. Inc. v. Piper Aircraft Corp., 480 F.2d 341, 362 (2d Cir. 1973).

^[10]Varjabedian, 888 F.3d at 405.

^[11]See id. at 410 (reasoning that Rule 10b-5’s scienter requirement relies on the relationship between the rule and its authorizing legislation); see also15 U.S.C. § 78j (2018).

^[12]15 U.S.C. § 78j (2018).

^[13]Varjabedian, 888 F.3d at 406.

^[14]15 U.S.C. § 78n (2018).

^[15]Varjabedian, 888 F.3d at 406; see also15 U.S.C. § 77q (2018).

^[16]See Aaron v. SEC 446 U.S. 680, 696–97 (1980) (holding that Congress intended to require different pleading standards for each subsection 17(a)).

^[17]Varjabedian, 888 F.3d at 406.

^[18]See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 197 (1976) (reasoning that the language of Section 10(b) strongly indicates intentional misconduct); Varjabedian, see also888 F.3d at 406; 15 U.S.C. §78j (2018).

^[19]Varjabedian, 888 F.3d at 406.

^[20]Id.

^[21]521 U.S. 642, 673 (1997).

^[22]Id. at 673.

^[23]Varjabedian, 888 F.3d at 407.

^[24]S. Rep. No. 90-510 (1968) (detailing that the purpose of Section 14(e) is to require full disclosure of material information by individuals engaged or opposed to a tender offer); see also Varjabedian888 F.3d at 407.

^[25]Varjabedian, 888 F.3d at 408.

^[26]Id. at 406.

^[27]Id. at 408.

^[28]Aaron v. SEC, 446 U.S. 680, 696–97.

^[29]Schreiber v. N. Burlington Inc., 472 U.S. 1, 10 (1985).

^[30]Id. at 2–3.

^[31]See id. at 3 (allowing Burlington Northern to terminate or amend the offer if specified events occurred).

^[32]Id.

^[33]Id.

^[34]Id. at 6.

^[35]Id. at 3

^[36]See id. at 10; see also S. Rep. No. 90-510 (1968) (requiring full disclosure of information by people seeking to influence the outcome of a tender offer).

^[37]Schreiber, 472 U.S. at 7.

^[38]Id. at 12.

^[39]U.S. v. O’Hagan, 521 U.S. 642, 673 (1997).

^[40]Id. at 673.