Saturday, October 8, 2022
In Connection With
Last week, the Second Circuit issued an interesting decision on the scope of Section 10(b) standing in Menora Mivtachem Insurance v. Furtarom, 2022 WL 4587488 (2d Cir. Sept. 30, 2022). IFF is a U.S. publicly traded company that purchased Frutarom, which also traded publicly but outside the U.S.. Frutarom lied about its business, and these lies were incorporated into IFF’s S-4 issued in connection with the merger. The truth came out, and IFF’s stock price fell. Stockholders of IFF tried to sue Frutarom, now a wholly-owned IFF subsidiary, for making false statements in connection with IFF’s stock. The Second Circuit held that under Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), the plaintiffs had no standing because they did not buy stock in the precise company being lied about. As the Second Circuit put it:
Under Plaintiffs’ “direct relationship” test, standing would be a “shifting and highly fact-oriented” inquiry, requiring courts to determine whether there was a sufficiently direct link…Section 10(b) standing does not depend on the significance or directness of the relationship between two companies.
Rather, the question is whether the plaintiff bought or sold shares of the company about which the misstatements were made…The fact that this case involved a merger instead of the sale of a business unit and that IFF incorporated some of Frutarom’s misstatements in its SEC filings and investor presentations does not change the analysis here. Plaintiffs did not purchase securities of the issuer about which misstatements were made….
So, first thing to note is why this matters. Normally, if plaintiffs bought stock in the parent, they’d sue the parent. But here, at least some of the false statements issued before the merger, when the parent is not responsible for the subsidiary’s misconduct. Post-merger, through a combination of agency and scienter theories, it’s tough to show that the parent company is liable for the false statements of a subsidiary. See my blog post about Plumbers & Steamfitters Local v. Danske Bank; see also Pugh v. Tribune Co., 521 F.3d 686 (7th Cir. 2008), and in fact, those kinds of allegations were dismissed in this very case. And despite the Second Circuit’s reservation that state law may permit claims here, the only likely remedy under state law would be a derivative action by parent company stockholders – which of course wouldn’t benefit anyone who had sold their shares since the truth was revealed, and, again, would not work without a showing of scienter at the parent level, to excuse demand.
Which leaves the subsidiary as the only viable defendant. But, as above, the Second Circuit narrowly construed the subsidiary’s statements to be about the subsidiary, and not about the parent – even when the subsidiary’s statements (presumably with the subsidiary’s permission) were included in merger documents associated with the parent.
So, first, let’s just point out the incongruence of treating statements in a prospectus for the sale of the acquirer’s stock as not being about the acquirer.
Leaving that aside, though, this issue comes up repeatedly. In Ontario Public Service Employees Union Pension Trust Fund v. Nortel Networks Inc., 369 F.3d 27 (2d Cir. 2004), for example, Nortel was JDS Uniphase’s largest customer, and issued stock to JDS in exchange for a business unit. When Nortel collapsed in fraud, JDS shareholders tried to sue Nortel on the grounds that the false statements had affected JDS Uniphase’s price. They were rebuffed because Nortel’s statements were about Nortel, not JDS Uniphase. Not long ago, though, a district court held that Juul might be liable to Altria’s shareholders for misstatements about its own business, seeing as how Altria was a 35% shareholder of Juul at the time. See Klein v Altria Group, 2021 WL 955992 (E.D. Va. Mar. 12, 2021). And in Semerenko v. Cendant Corp., 223 F.3d 165 (3d Cir. 2000), the Third Circuit held that shareholders of a target company in a proposed, but unconsummated, stock-for-stock merger might be able to sue the acquirer and its auditor for a fraud discovered before the deal closed, on the ground that the acquiring company’s inflated performance affected the stock price of the target.
The Second Circuit’s decision here may – or may not – be at odds with Semerenko. Formally, the Third Circuit’s decision was not based on “standing” but on construction of Section 10(b)’s language prohibiting fraud “in connection with” the purchase or sale of a security, which the Second Circuit here took as permission to disregard its holding: “Nortel rejected Cendant as persuasive authority, so Plaintiffs’ attempt to invoke Cendant to argue that other courts have allowed plaintiffs in their circumstances to sue is unavailing. In any event, as we noted in Nortel, Cendant did not discuss standing.” That’s a little weird, because the standing requirement of Blue Chip is rooted in 10(b)’s “in connection with” language. More generally, Semerenko has often been understood as representing the general principle that if two companies are closely related, a false statement about one is actionable by shareholders of the other.
I’ve previously written about the artificiality of how the fraud on the market doctrine is applied in modern cases, because there are so many judicially-created rules that limit what is supposed to be a court’s empirical inquiry into how frauds affect securities trading, and this is (sort of) another addition to the pile. Leaving aside the fear that this allows, say, public companies to wink-wink-nudge-nudge induce related private companies to make false statements about their businesses, knowing that shareholders of the public company will be blocked from suing anyone at all, it’s fairly obvious that false statements by a target company about its business will affect the trading price of its acquirer. That’s why the statements go in the acquiring company’s SEC filings in the first place. Of course, when it comes to securities trading, everything affects everything else and certainly it’s reasonable to place limits on the connections one draws from one company to another – a point I made when discussing this issue in connection with “shadow” insider trading – but there’s a difference between requiring a close nexus, and creating a bright line rule that bars lawsuits of this kind. Let alone a bright line rule that somehow excludes statements made in a prospectus for the sale of stock purchased by the plaintiff.
That said, even a “nexus” rule may be applied strangely; in this case, Judge Pérez in concurrence would have applied a nexus rule, but she still found a nexus was lacking because the plaintiffs had not shown a direct relationship between the false statements of Furtarom and IFF’s stock price. If required disclosures in an SEC registration statement are not enough to show that kind of relationship on a motion to dismiss, I’m really confused about what we’re all doing here.
It's also worth pointing out some sparring between the majority opinion and the concurrence that does not bear on the direct holding. The majority justified its refusal to permit standing here on the grounds that judicially created private rights of action, such as the right under Section 10(b), should be narrowly construed. The concurrence, however, appeared to be concerned that the majority’s broad language could be taken to apply outside the 10(b) context, and warned that the opinion should not be taken to mean that all implied private rights of action should be read narrowly.