One of the more intriguing rulings of this Supreme Court Term is the Court's one-sentence order yesterday dismissing as improvidently granted the writ of certiorari issued in Emulex Corp. v. Varjabedian (No. 18-459). The Court had taken the case to review a Circuit split on the liability standard under § 14(e) of the Securities Exchange Act, which regulates tender offers. Along the way, however, the petitioner argued that a private right of action does not exist at all under § 14(e) – an issue that had not been raised in the lower courts. That issue occupied a large portion of the oral argument held on April 15, 2019, with the parties and the Justices exploring whether the Court should entertain the previously unraised issue and, if so, what the outcome should be.
One week later, the Court dismissed the writ of certiorari as improvidently granted, even though a Circuit split remains on the substantive liability issue. The dismissal virtually ensures that both the liability standard and the existence of a private right of action under § 14(e) will reach the Court in the future. But, perhaps more important, the tenor of the oral argument could lead litigants to ask the Court to overrule longstanding precedent holding that a private right of action exists under § 14(a), which governs proxy litigation.
A ruling that no private right of action exists under § 14(a) could have dramatic implications for merger litigation, which has recently been migrating from state to federal courts in light of the Delaware courts' crack-down on disclosure-only settlements of suits challenging mergers. Some members of the plaintiffs' bar have sought to avoid the Delaware courts' antipathy to those cases by bringing them in federal court and pleading subject-matter jurisdiction under § 14(a) for allegedly false or misleading disclosures in proxy solicitations. If a private right of action does not exist for those claims, a federal forum might be foreclosed, and plaintiffs would have to resort to state courts again.
The Emulex case involves § 14(e) of the Exchange Act, which concerns statements made in connection with tender offers. Section 14(e) forbids "any person [i] 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 [ii] to engage in any fraudulent, deceptive, or manipulative acts or practices, in connection with any tender offer" (brackets and emphasis added). Starting in 1973, five federal appellate courts – the Second, Fifth, Third, Sixth, and Eleventh Circuits – held that § 14(e) requires a showing of scienter (knowing or reckless misconduct), not mere negligence.
The appellate courts had reached that conclusion by analogizing § 14(e) to Exchange Act § 10(b) and SEC Rule 10b-5. Section 10(b) prohibits the use or employment of "any manipulative device or contrivance" in contravention of SEC rules in connection with the purchase or sale of a security. And Rule 10b-5, promulgated under § 10(b), forbids any person (a) "[t]o employ any device, scheme, or artifice to defraud," (b) "[t]o make any untrue statement of a material fact," or any material omission, in connection with the purchase or sale of a security, or (c) "[t]o engage in any act, practice, or course of business which operates or would operate as a fraud or deceit."
The Supreme Court held in Ernst & Ernst v. Hochfelder (1976) that claims under § 10(b) and Rule 10b-5 require proof of scienter, not mere negligence. Accordingly, courts viewing § 14(e) as analogous to § 10(b) have applied the scienter standard to § 14(e) claims.
The Emulex Case
The Ninth Circuit panel unanimously concluded in Emulex that those five Circuits were wrong in light of Ernst & Ernst and the Supreme Court's subsequent decision in Aaron v. SEC (1980).
According to the Ninth Circuit, Ernst & Ernst had held that misrepresentation claims under § 10(b) and Rule 10b-5 require proof of scienter because § 10(b) itself applies only to "manipulative devices and contrivances" – a concept that involves intent to deceive. The Supreme Court had acknowledged that Rule 10b-5's second prong – which prohibits "any untrue statement of a material fact" or any material omission – could be read in isolation as proscribing any type of material misrepresentation or omission, whether intentional or not. But unless a statute otherwise provides, a regulation cannot exceed the scope of the authorizing statute, and § 10(b) itself prohibits only intent-based "manipulative devices and contrivances." Accordingly, all prongs of Rule 10b-5 require proof of scienter.
The Ninth Circuit noted that, in contrast to § 10(b), § 14(e) contains two prongs: one prohibiting materially "untrue statements" or omissions, and another prohibiting "fraudulent, deceptive, or manipulative acts or practices." The latter clearly requires scienter; however, as the Supreme Court had observed regarding Rule 10b-5, the former – viewed in isolation – does not necessarily do so. The Ninth Circuit also noted that the first prong of § 14(e) is almost identical to § 17(a)(2) of the Securities Act, which the Supreme Court had held in Aaron does not require a showing of scienter. Accordingly, the Ninth Circuit held that § 14(e) misrepresentation or omission claims can be predicated on simple negligence.
Emulex sought and obtained certiorari based on the Circuit split on the liability standard. Its merits brief, however, also argued that courts should not imply a private right of action under § 14(e) – a point that Emulex had not litigated in the lower courts.
The United States filed an amicus brief in support of neither party. The United States agreed with the Ninth Circuit that § 14(e)'s first prong does not contain a scienter requirement and can be satisfied by mere negligence. However, the Government argued that the case should have been dismissed because § 14(e) does not provide a private right of action for damages – a position contrary to the SEC's stance in earlier litigation before the Supreme Court.
Supreme Court's Decision
The Supreme Court argument on April 15, 2019 focused on three issues: (i) whether the Court should consider a challenge to the private right of action, inasmuch as the issue had not been raised below; (ii) whether a private right of action exists, if the issue had not been waived; and (iii) what the liability standard should be (negligence or scienter). On April 23, 2019, the Court issued a one-sentence order dismissing the writ of certiorari as having been improvidently granted – probably because the Court concluded that this case was not the best vehicle to consider the § 14(e) issues in light of Emulex's not having challenged the private right of action in the lower courts.
During oral argument, however, certain Justices made comments that could go beyond the § 14(e) context and implicate § 14(a), which, in conjunction with implementing regulations promulgated by the SEC, prohibits false and misleading statements in proxy solicitations. The Supreme Court had held in J.I. Case Co. v. Borak (1964) that a private right of action exists under § 14(a), and litigants have frequently exercised that right to attack proxy solicitations for mergers and other corporate actions. But the Emulex argument seems to have revealed doubts about Borak among at least some Justices.
Chief Justice Roberts appeared expressly to question Borak's validity in light of the significant change in the Court's jurisprudence on implied rights of action in the 55 years since Borak was decided. Chief Justice Roberts observed that "we now know that that was not the right approach [in Borak]," that "Borak would not be decided the same way today," and that, "from today's perspective, what we did back then was a mistake." In response, the plaintiff's counsel conceded that "Borak may not be decided the same way today" and that "maybe Borak was wrongly decided," although he sought to differentiate § 14(e) from the Borak rationale.
Several other Justices also wondered whether any difference should exist as to the availability of a private right of action under § 14(a) versus under § 14(e), inasmuch as corporate transactions can be accomplished either through mergers (implicating § 14(a)) or through tender offers (implicating § 14(e)). These comments collectively suggest that attacks on private rights of action under § 14(e) could cause litigants to raise the same questions about § 14(a) and ask the Court to overrule Borak.
The Emulex punt will undoubtedly lead to efforts to present the § 14(e) issues to the Supreme Court in future cases. Defendants will attack the existence of a private right of action, and the Circuit split on the liability standard must be resolved in any event, because the SEC can bring enforcement actions under § 14(e) even if private litigants cannot sue. The Government took the position at oral argument that § 14(e) covers negligent misrepresentations regardless of whether a private right of action exists.
The more important ramifications, however, could involve any spillover into § 14(a) jurisprudence, because § 14(a) cases are more common than are § 14(e) actions. Section 14(a) has provided a means to attack proxy solicitations for mergers, election of corporate directors, and other significant corporate transactions. If shareholders cannot invoke that section to establish federal jurisdiction and assert a cause of action, large swaths of securities litigation could be affected.
The impact on merger litigation could be particularly important. When the Delaware Court of Chancery began to crack down on what it viewed as meritless lawsuits leading to settlements providing only additional proxy disclosures of questionable significance (plus attorneys' fees for plaintiffs' counsel), a number of those cases moved to federal courts. Those lawsuits have asserted § 14(a) claims attacking the proxy solicitations in addition to the standard state-law fiduciary-duty claims that would otherwise have been pled in state-court litigation. A decision overruling Borak could close the federal courts to at least some of those cases.
For now, everyone will await the next round of cases teeing up § 14(a) and § 14(e) issues.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.