Ninth Circuit Holds that Shareholders Must Only Show Negligence to Bring Claims in Tender Offer Cases Under the Exchange Act

On April 20, 2018, the Ninth Circuit ruled in Gary Varjabedian v. Emulex Corp., et al. that claims brought under Section 14(e) of the Securities Exchange Act of 1934 (the “Exchange Act”) require a showing of negligence rather than scienter.  In its decision, the court expressly rejected holdings by the Second, Third, Fifth, Sixth and Eleventh Circuits that Section 14(e) requires a showing of scienter similar to fraud claims brought under Section 10(b).  The Ninth Circuit’s ruling is a significant win for shareholders.

In the case, shareholders sued Emulex Corporation, a network connectivity company, and its board of directors for issuing misleading solicitation material with respect to the company’s proposed merger with Avago Technologies valued at $8.00 per share.  Defendants moved to dismiss on grounds that the plaintiff had failed to adequately plead scienter, a more exacting standard that applies to fraud claims under Section 10(b) of the Exchange Act. The district court agreed with the defendants and granted the dismissal.

On appeal, plaintiff—represented by Faruqi & Faruqi, LLP and Monteverde & Associates—walked the court through the history, purpose, and statutory construction of Section 14(e) to argue that the pleading standard should be the same as that for claims under Section 14(a).   The court agreed, and in so ruling, rejected holdings to the contrary from the five other circuits on the same issue.  The Ninth Circuit agreed with the plaintiff that the other circuits had incorrectly premised their analyses on the shared text between SEC Rule 10b-5 promulgated under Section 10(b), and Section 14(e).  Despite these similarities in text, the court explained:

                                          Yet important distinctions exist between Rule 10b-5 and Section 14(e)—distinctions that
                                          strongly militate against importing the scienter requirement from the context of Rule 10
                                          b-5 to Section 14(e).

The court explained that in two of those prior cases, the Second Circuit in Chris-Craft Indus. Inc., v. Piper Aircraft Corp. and the Fifth Circuit in Smallwood v. Pearl Brewing Co. held that both Rule 10b-5 and Section 14(e) require a showing of scienter. Two years after those decisions, the U.S. Supreme Court in Ernst & Ernst v. Hochfelder distinguished Rule 10b-5 on its relation to its authorizing statute, and compared the similar statutory language of another Exchange Act provision with a negligence standard in Aaron v. SEC, which the court found significant:

                                            Accordingly, both Ernst & Ernst and Aaron cast doubt on the underlying rationale of Chris-
and Smallwood. Ernst & Ernst provides that the scienter requirement is rooted not in
                                            the text of Rule 10b-5, but rather in the relationship between Rule 10b-5 and its authorizing
                                            legislation. Ernst & Ernst, 425 U.S. at 212–14. Aaron took a further step by holding that the
                                            plain language of Section 17(a)(2), which is largely identical to the first clause of Section 14(e),
                                            requires a showing of negligence, not scienter. Aaron, 446 U.S. at 696–97. In so doing, Aaron
                                            rejected the Second Circuit’s rationale for holding that a negligence standard does not apply
                                            to claims under Section 17(a).

In a concurring opinion, Judge Morgan B. Christen emphasized that “Ernst & Ernst and Aaron are both critical” in understanding that a negligence standard is most appropriate under Section 14(e).  In doing so, Judge Christen explained that the circuits that held otherwise relied upon pre-Ernst & Ernst and Aaron authority:

                                            We cannot be sure how other circuits would rule were they to revisit § 14(e) in light of Ernst
                                            & Ernst
and Aaron, but I question the continuing viability of the foundation for Chris-Craft
                                            and the cases that followed it. I am persuaded that the decision we issue today is most
                                            consistent with the Supreme Court’s decisions in Ernst & Ernst and Aaron.

The Court remanded the case to the district court for further proceedings consistent with its opinion.

Faruqi & Faruqi, LLP and Monteverde & Associates represent shareholders in this action.

About Faruqi & Faruqi, LLP

Faruqi & Faruqi focuses on complex civil litigation, including securities, antitrust, consumer and wage and hour class actions, as well as shareholder derivative suits.  The firm is headquartered in New York, and maintains offices in California, Delaware, Pennsylvania and Georgia.

Since its founding in 1995, Faruqi & Faruqi has served as lead or co-lead counsel in numerous high-profile cases which ultimately provided significant recoveries to investors, consumers, and employees.

To contact the author of this blog or the offices of Faruqi & Faruqi, please call us at (877) 476-7797.

About James Madison Kim

James Kim’s practice is focused on securities litigation.  James is a law clerk in the firm’s New York office.

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