These days, most public company mergers continue to attract one or more boilerplate complaints, usually filed by the same roster of plaintiffs’ law firms, asserting that the target company’s proxy statement contains materially false or misleading statements. These complaints usually also assert that the stockholder meeting to approve the merger should be enjoined unless and until the company “corrects” the false or misleading statements by making supplemental disclosures. While not too long ago cases like this tended to be filed in the Delaware Court of Chancery and other state courts asserting breaches of state-law fiduciary duties, including the duty of disclosure, after Trulia the vast majority of these cases today are filed in federal court under Section 14 of the Securities Exchange Act of 1934.
Almost none of these cases, however, are actually litigated. Instead, they usually follow a by-now-familiar pattern: After one or more complaints are filed, defendants (usually the target company and its board of directors) offer to make supplemental disclosures to “moot” the plaintiffs’ claims (even though defendants rarely believe there is any merit to the claims); perhaps after some back-and-forth negotiation (sometimes not), the plaintiffs agree to withdraw their claims in light of the supplemental disclosures; the plaintiffs’ lawyers then seek a “mootness fee,” supposedly in compensation for the “benefit” provided in the form of the supplemental disclosures; and the defendants (usually after some negotiation) agree to pay such fees, which ends the case. (Because no class-wide release is obtained, the courts typically never get involved.) This practice has been widely criticized as imposing a “merger tax” without providing any benefits to companies or stockholders. But, given the strong incentives to avoid delaying the overall transaction, as well as to minimize litigation costs and risk, most defendants elect not to litigate these cases (despite their weaknesses on the merits), and so the practice continues.
In Karp v. SI Financial Group, Inc., No. 3:19-cv-001099 (MPS), 2020 WL 1891629 (D. Conn. Apr. 16, 2020), however, the defendants chose not to follow the usual playbook and actually litigated the plaintiff’s Section 14 claim. And on April 16, 2020, the district court granted the defendants’ motion to dismiss, ruling that the plaintiff had failed to plead that any statement in the proxy was rendered false or misleading by the omissions of facts the plaintiff alleged were material and not disclosed.
In so ruling, the court highlighted a fundamental difficulty plaintiffs in such strike suit merger cases often have in successfully pleading a Section 14 claim: Unless a plaintiff can show that the proxy statement omitted a fact required to be disclosed by SEC regulations (which is often a tall task), the plaintiff must plead that some omitted fact renders a statement in the proxy materially misleading. Importantly, unlike Delaware duty-of-disclosure claims, the omission of a material fact alone is not enough to state a Section 14 claim. Instead, the plaintiff must plead – with particularity, not merely with conclusory allegations – how the allegedly omitted fact renders the proxy statement disclosures materially misleading. But without knowing the facts that have been omitted – and because of the discovery stay imposed by the Private Securities Litigation Reform Act (“PSLRA”) – plaintiffs will have difficulty obtaining such facts at the pleading stage, particularly since there is no equivalent tool to a Section 220 books and records claim under the federal proxy rules.
As SI Financial shows, in the typical strike suit merger case, it will be challenging for plaintiffs to plead a viable Section 14 claim. But the question remains: Will this decision lead to less Section 14 claims being filed in public company merger transactions, or more defendants choosing to litigate rather than settle? Given the current incentives at play, we expect many parties will continue to settle these cases. But that is not inevitably the best course, and parties to public company merger transactions should seriously consider whether the usual playbook is still the best approach in light of the SI Financial decision and other potential legal developments discussed below.
The SI Financial case initially followed the familiar pattern described above. On December 11, 2018, SI Financial Group, Inc. (“SI FI”), a “community oriented” financial services company operating in New England, publicly announced that it had agreed to merge with Berkshire Hills Bancorp (“Berkshire”) in an all stock merger at a 0.48 exchange ratio. SI FI filed its preliminary proxy statement on February 4, 2019, followed by a nearly identical definitive proxy statement on February 26, 2019.
Just four days after the preliminary proxy was filed, the plaintiff filed a complaint in federal district court in Connecticut, alleging that information material to the stockholders’ decision whether to approve the merger was omitted from the preliminary proxy statement, thereby making the proxy statement misleading. The allegedly omitted information included: (i) information about an alternative bid that the SI FI board had rejected in favor of the Berkshire bid; (ii) information related to SI FI’s financial advisor’s fairness opinion and analysis, including the rationale for the financial advisor’s discount rate assumptions, the free cash flow projections used in the discounted cash flow analysis, the individual multiples and financial metrics for companies included in the selected company analysis, and any benchmarking analyses for SI FI in relation to comparable companies analyzed; and (iii) details about SI FI insiders’ interests in the merger. That same day, plaintiff made a demand for supplemental disclosures to be made in the definitive proxy statement. Shortly after, other substantially similar suits were filed by other purported shareholders who made similar disclosure-based claims.
From there, however, this case veered off the usual course. The defendants refused to make the demanded (or any) supplemental disclosures. Notwithstanding their threats to seek a preliminary injunction, the plaintiffs failed to do so, and the merger between SI FI and Berkshire closed on May 17, 2019. Following the merger, the litigation continued, now in the form of a suit for money damages purportedly resulting from the alleged disclosure violations. SI FI and Berkshire filed a motion to dismiss, arguing the plaintiff failed to state a claim under Section 14.
The District Court’s Decision
On April 16, 2020, the court agreed with the defendants and granted the motion to dismiss. As the court explained, omitting information from the proxy statement violates Section 14 (and SEC Rule 14a-9) only if “the SEC regulations specifically require disclosure of the omitted information in a proxy statement, or the omission makes other statements in the proxy statement materially false or misleading.” SI Financial, 2020 WL 1891629 at *10 (citing Resnik v. Swartz, 303 F.3d 147, 151 (2d Cir. 2002)). Notably, the court contrasted this stricter pleading standard with the duty of disclosure under Delaware law, which “includes a general prohibition on the omission of material facts” when a director is seeking or recommending stockholder action Id. at *13. Accordingly, while it may suffice under Delaware law to plead the omission of a material fact, that is not enough to plead a claim under Section 14. Id.
Applying the Section 14 standard, the court found that plaintiff’s allegations that the omitted information would have been helpful were not enough to state a claim. “As helpful as this information might have been to investors, Plaintiff fails to allege any facts suggesting that its absence made any statement in the Proxy misleading. And he certainly does not ‘specify [any] statement’ that was made misleading as a result of these omissions, let alone provide ‘the reason or reasons why the statement is misleading.’” Id. at *11 (citing 15 U.S.C. § 78u-4(b)(1)). The court further held that plaintiff did not allege “except in conclusory fashion how the disclosure of the omitted information would have changed the overall picture of the transaction presented by the Proxy, i.e., whether it would have made that picture more or less rosy, let alone how the omission of the information rendered any particular statement in the Proxy misleading.” Id. at *14. The court therefore dismissed the plaintiff’s Section 14 claim. It is worth noting that, although the court drew a distinction between federal law and Delaware law, had the case been brought in the Delaware Court of Chancery on the basis that the director defendants breached their duty of disclosure, it is likely the plaintiff’s disclosure claims in this case would have also been dismissed under the Delaware law standard.
Will SI Financial Change Anything?
If nothing else, the decision in SI Financial demonstrates that it is very difficult for stockholder plaintiffs to plead a viable Section 14 claim in a strike suit merger case. The typical Section 14 complaint challenging a public company merger proxy statement on the grounds that it omits details regarding the sale process, management projections, and financial advisor analyses (which often very closely resembles the complaint in SI Financial) does not come close to meeting the pleading standard articulated in SI Financial. That is unsurprising, since in most of these cases the plaintiffs have no idea what the allegedly omitted facts are, and so have no way to plead – except in bare conclusions and speculations, which is not enough – that the alleged omissions would have “changed the overall picture of the transaction presented by the [p]roxy.”
Unfortunately, this does not necessarily mean plaintiffs will stop bringing these cases or that defendants will stop settling them. For starters, it is relatively straightforward and costless to issue supplemental disclosures, and the mootness fees that are typically paid are relatively modest (usually less than either the anticipated costs of litigating a motion to dismiss or a motion for an award of a mootness fee). Transaction participants are also reluctant to expose transactions to delay or hypothetical execution risk, and the systemic costs imposed by these suits (i.e., the “merger tax”), while disturbing, do not change the overall value proposition of the transaction. And another recent Section 14 decision shows that, if they do not settle, defendants may still face litigation risk: In Karp v. First Connecticut Bancorp, Inc., No. RDB-18-2496, 2019 WL 4643799 (D. Md. Sept. 24, 2019), the District of Maryland denied a motion to dismiss similar claims brought by the same plaintiff in connection with the acquisition of First Connecticut Bancorp by People’s United Financial, even though it appears the plaintiff’s claims in that case were subject to dismissal for the same reasons as in the SI Financial case.
So is the proliferation of Section 14 cases challenging public company mergers inevitable (and permanent)? We think not. There are several ways the current pace of these cases could be slowed, or could even come to an end.
- First, while perhaps unlikely for the reasons discussed above, if more defendants refused to make supplemental disclosures, these cases would at once become less lucrative for the plaintiffs’ lawyers who file them (as the steady stream of agreed mootness fees would dry up) and more expensive (as the cases would actually have to be litigated, at least through the motion to dismiss stage). That, in turn, would likely discourage such cases from being filed in the first place.
- Second, even if most companies that are not repeat players in public mergers will likely continue to make supplemental disclosures and pay mootness fees, given the incentives at play, others that repeatedly acquire public companies may want to pursue a public strategy of refusing to settle these cases as a way of discouraging the plaintiffs’ bar from filing complaints in cases in which they are involved.
- Third, a pending decision in the Seventh Circuit may have a substantial impact on these cases. In the district court’s decision that is currently on appeal, the Northern District of Illinois in House v. Akorn, Inc., No. 17 C 5018, 2018 WL 4579781, at *1 (N.D. Ill. Sept. 25, 2018), ordered the plaintiff’s counsel to disgorge the mootness fee that the defendants had agreed to pay based on the court’s finding that the supplemental disclosures defendants agreed to make in response to the complaint did not provide any substantial benefit to the stockholders, and the mootness fee was thus unwarranted. Notably, the court reached that result even though the mootness fee was not subject to court approval (because no class claims were released). The Seventh Circuit’s decision on appeal is pending. If it affirms, the incentive for plaintiffs’ lawyers to file Section 14 cases would practically disappear (at least in courts within the Seventh Circuit).
- Fourth, some courts have ruled that the PSLRA bars attorneys’ fees when plaintiffs only achieve a non-monetary recovery (such as supplemental disclosures) on behalf of a class. For example, in Mostaed v. Crawford, No. 3:11-cv-00079-JAG, 2012 WL 3947978, at *7 (E.D. Va. Sept. 10, 2012), the court noted that plaintiffs only achieved supplemental disclosures and “[did] not receive a monetary judgment, so [the PSLRA] clearly precludes them from seeking attorneys’ fees based on alleged Securities and Exchange Act violations.” Similarly, in Masters v. Wilhelmina Model Agency, Inc., 473 F.3d 423, 438 (2d Cir. 2007), the Second Circuit noted that “[t]he PSLRA would not allow for the computation of fees on the basis of  non-damage items” because “the statute speaks in terms of a percentage ‘actually paid to the class.’” While these cases have not widely caught on (and some plaintiffs have sought to get around the issue by only filing an individual, and not class, action), they provide another potential avenue for combating the proliferation of Section 14 complaints in public merger cases.
- Fifth, courts could remove one of the sources of leverage plaintiffs have in these Section 14 cases by ruling that the PSLRA prohibits plaintiffs from seeking a class-wide injunction before a lead plaintiff is appointed or a class is certified (which would usually effectively mean no injunction could be issued in time before the stockholder vote). See Rosenfeld v. Time Inc., No. 17cv9886 (DLC), 2018 WL 4177938, at *4 (S.D.N.Y. Aug. 30, 2018) (noting that this is “an open question in this Circuit”).
- Sixth, in light of the fact that most Section 14 complaints challenging public company mergers have little or no chance of surviving a motion to dismiss, courts could enforce the PSLRA’s “mandatory sanctions” provisions for violations of Rule 11 of the Federal Rules of Civil Procedure. See 15 U.S.C. § 78u-4(c)(1) (“In any private action arising under [the Exchange Act], upon final adjudication of the action, the court shall include in the record specific findings regarding compliance by each party and each attorney representing any party with each requirement of Rule 11(b) of the Federal Rules of Civil Procedure as to any complaint, responsive pleading, or dispositive motion.”).
- Seventh, the argument was raised before the United States Supreme Court in Varjabedian v. Emulex Corporation that there is no private right of action under Section 14(e), which governs recommendation statements made by companies on Schedule 14D-9 in connection with a tender offer, but the Supreme Court dismissed the writ of certiorari in that case before deciding the issue. Were courts to adopt that argument, it would likely bring to an end strike suits in tender offers or two-step mergers, but it would likely not have an immediate impact on cases involving traditional mergers, in which the company issues a proxy statement governed by Section 14(a).
Although it will remain tempting for plaintiffs to bring Section 14 merger claims and for defendants to settle them, we think the recent SI Financial decision highlights that defendants have options and should give ammunition to companies and boards that want to consider the strategies proposed above as an alternative to the status quo.
 In 2015 – the year before the Delaware Court of Chancery’s watershed decision in In re Trulia, Inc. Stockholder Litigation, which we discussed on this blog (here) – just 34 M&A-related cases were filed in federal court. In 2016, that number more than doubled to 85; in 2017, it more than doubled again to 198; and in 2018 and 2019, it remained relatively high at 182 and 160, respectively. Cornerstone Research, Securities Class Action Filings: 2019 Year in Review at 5, available at https://www.cornerstone.com/Publications/Reports/Securities-Class-Action-Filings-2019-Year-in-Review. We also note that, although we generally refer in this post to “Section 14 claims,” there are actually two distinct types of claims that are asserted in these cases depending on the type of merger: Section 14(a) claims challenge a proxy statement issued in advance of a stockholder meeting, whereas Section 14(e) claims challenge statements made in a company’s Recommendation Statement on Schedule 14D-9 in the tender offer context (e.g., in a two-step merger).
 In addition, the Delaware Court of Chancery has held that a stockholder plaintiff cannot use Section 220 as a means to obtain documents for use in securities litigation where discovery is stayed under the PSLRA, at least where that is the sole purpose for the stockholder plaintiff’s books-and-records request. See Beiser v. PMC-Sierra, Inc., 2009 WL 483321, at *3 (Del. Ch. Feb. 6, 2009).