United States: The Rise Of Federal Merger-Challenge Lawsuits And The Hurdles Plaintiffs Face

The pattern is familiar: A proposed merger or acquisition involving a publicly traded company is announced and almost immediately law firms issue press releases announcing "investigations" into whether the target company and its board of directors breached their fiduciary duties. The press releases encourage shareholders who would like to know more about their rights to contact the law firm. Then — sometimes as soon as within 24 hours of the announcement of a transaction — merger-challenge lawsuits begin to be filed in the state courts of the target company's state of incorporation and the state in which it is headquartered. They allege breaches of state-law fiduciary duties based on allegations that the purchase price is too low and the result of a flawed process, that the deal protection devices in the merger agreement are preventing the target from obtaining higher offers, and — after the preliminary proxy statement is filed with the Securities and Exchange Commission (SEC) — that the disclosures made to the target's shareholders are insufficient. Increasingly now, however, another set of lawsuits is being filed: federal securities-fraud lawsuits alleging disclosure violations under Section 14(a) of the Securities Exchange Act.

A recent analysis of securities class-action filings found that almost one-fourth of all securities class-action lawsuits filed in the first half of 2011 challenged the disclosures made to a company's shareholders in connection with a proposed merger or sale of the company.¹ This continues a trend that began last year² and is likely an outgrowth of the recent large increase in the number of public-company mergers that are challenged in state-court lawsuits.³ Despite this increase in Section 14(a) suits, however, it is not clear that federal merger-challenge lawsuits will, in the long term, provide a viable alternative to state-law fiduciary-duty claims.

As we explain, plaintiffs face a number of strategic and tactical problems in bringing what are essentially state-law fiduciary-duty causes of action as federal securities-law claims. The usual form that merger-challenge lawsuits take and the manner in which they typically are prosecuted in state courts simply are not compatible with federal law, especially the Private Securities Litigation Reform Act (PSLRA). Therefore, while the current increase in federal-court merger-challenge lawsuits is likely to continue for now, such cases may decline as the case law catches up with the plaintiffs' bar's ingenuity.

Increased Competition for State-Law Merger-Challenge Work Is Leading Law Firms to File Federal Actions.

Probably the most significant factor leading to the increase in federal merger-challenge lawsuits is that the market for law firms that file these lawsuits appears to be oversaturated.

A meritorious merger-challenge lawsuit can generate tens of millions of dollars in fees. But even a meritless merger-challenge lawsuit can generate tens of thousands, if not hundreds of thousands, of dollars in fees, as companies frequently settle groundless lawsuits simply to gain deal certainty and because often such lawsuits can be settled for significantly less than the cost of defending them.⁴

Moreover, the barriers to entry are relatively low for a plaintiff's attorney who wants to do merger-challenge work. All an attorney needs is a shareholder who is willing to serve as a plaintiff. Even if that shareholder owns just one share, that is sufficient to allow the attorney to file a lawsuit and have a chance of getting some portion of any fees generated. If that lawsuit is also the first filed, then the lawyer has a significant chance of controlling the subsequent lawsuits that normally are filed and consolidated in a particular jurisdiction.⁵ An attorney can attempt to find a shareholder willing to serve as a plaintiff simply by issuing a press release posted to the internet announcing an "investigation" of the proposed transaction that insinuates that it is unfair and that encourages shareholders who want to know more about their rights to call the law firm.

A good illustration of this is the proposed acquisition of El Paso Corporation by Kinder Morgan, Inc., which was announced on October 16, 2011. That same day, law firms began announcing "investigations," and within a couple of days of the announcement, at least 11 law firms had issued press releases announcing "investigations." Within nine days of the announcement, at least seven lawsuits challenging the proposed transaction had been filed in Texas state courts, with nine more being filed in Delaware state courts. These cases likely will be consolidated in each of those two forums. After an initial proxy statement is filed with the SEC, one can expect another round of law-firm press releases with a new law firm — or one of the firms that failed to gain a significant stake in the consolidated state-court lawsuits — then filing a federal lawsuit alleging violations of Section 14(a) of the Securities Exchange Act and Rule 14a-9 in Texas or Delaware.

Federal Merger-Challenge Lawsuits Are Usually State- Law Fiduciary Duty Claims Stretched Thin to Fit a Section 14(a) Mold.⁶

A plaintiff in a state-court merger-challenge lawsuit typically seeks to enjoin the merger based on allegations that it is the product of breaches of fiduciary duty by the target company's board of directors. The plaintiff will usually allege that: (1) the disclosures related to the proposed transaction are inadequate; (2) the deal protection mechanisms agreed to by the parties unfairly prejudice the target company's ability to receive or consider a better offer; and (3) the sales process was flawed and led to an unfair transaction price. The plaintiff usually will seek to have a preliminary injunction hearing set before any shareholder vote on the proposed transaction, and he will move for expedited discovery prior to that hearing. If the plaintiff can get both expedited discovery and a quick hearing on a motion for temporary injunction, then he can maximize his ability to threaten the proposed transaction and, therefore, his leverage in settlement negotiations.

Federal merger-challenge plaintiffs have typically followed the same pattern. They make similar allegations regarding transaction price and process, and they allege that shareholders are not being provided sufficient information to allow them to cast an informed vote for or against the proposed transaction. There is no federal-law cause of action, however, that covers the transaction price or process. And, as discussed below, the disclosure obligations under federal law are narrower than the obligations under state law. Many federal merger-challenge lawsuits still try to shoehorn state-law disclosure claims into federal-law claims, though, by focusing on the fact that Delaware courts employ the definition of materiality used under federal law.⁷ This does not, however, mean that Rule 14a-9 is coextensive with the state law duty to disclose all material information.

Section 14(a) proscribes soliciting a proxy in contravention of SEC rules and regulations.⁸ Section 14(a) and Rule 14a-9 provide a claim for relief only where a proxy statement either: (1) does not include information required by the SEC's rules, or (2) contains a materially false or misleading statement.⁹ Rule 14a-9 provides that no proxy statement shall contain "any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading . . . ."¹⁰ Thus, federal law does not require disclosure of all information a shareholder might like.

It Is Impossible for Most Plaintiffs to State Disclosure Claims That Satisfy the PSLRA.

The PSLRA requires a plaintiff bringing claims under the Securities Exchange Act to "specify each statement alleged to have been misleading [and] the reason or reasons why the statement is misleading" and to state with particularity all facts on which a belief is based when pleading on information and belief.¹¹ This means that a plaintiff must make particularized allegations demonstrating that any allegedly omitted information is material and necessary to make some statement made in a proxy statement not misleading. An omitted fact is material only "if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote . . . . Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."¹²

In a typical Section 14(a) that is not a merger-challenge lawsuit, either shareholders have discovered after the fact that some statement made in proxy-soliciting materials was false or misleading, or communications sent to shareholders are alleged to be proxy solicitations that do not meet the SEC's explicit requirements or were not filed with the SEC. Federal merger-challenge cases are different.

In federal merger-challenge cases, the plaintiff is seeking additional information, for example, details regarding fairness opinions, other opportunities available to a target company, or the process by which the agreement to enter into the proposed transactions was reached. The plaintiff does not know the allegedly omitted information; in fact, the crux of the complaint is that he is asking for that information so that he can cast an informed vote. Without knowing the allegedly omitted information, however, a plaintiff cannot have a plausible belief that there is a substantial likelihood that a reasonable investor would think it significantly alters the total mix of information presented in a proxy statement — the test for materiality. Similarly, a plaintiff cannot have a plausible belief that the omission of information makes some statement in a proxy statement misleading.¹³ Therefore, the plaintiff should not be able to meet the PSLRA's enhanced pleading requirements.

It Is Difficult for Federal Securities Plaintiffs to Gain Quick Leverage.

In addition to pleading burdens imposed by the PSLRA, there are also timing difficulties inherent in federal securities litigation under Section 14(a) that make it difficult to employ the same tactics one would in state court merger challenges. Namely, the PSLRA's mandatory stay of discovery during the pendency of a motion to dismiss and the fact that Section 14(a) claims are not ripe until proxies are actually solicited make it difficult for a plaintiff to put the proposed transaction in immediate jeopardy.

The PSLRA Erects Significant Hurdles to Expedited Discovery.

Plaintiffs often try to create pressure to settle by threatening expedited discovery. Not only can such discovery be expensive, but it can also cause directors and senior management to have to prepare for and attend a deposition instead of focusing on the proposed transaction and it can provide the plaintiffs with discovery that they can use to try to find a more viable claim for relief. That, however, is what the PSLRA was in part meant to prevent.

The PSLRA was enacted "to restrict abuses in securities class-action litigation, including . . . (2) [the] targeting of 'deep pocket' defendants; (3) the abuse of the discovery process to coerce settlement; and (4) manipulation of clients by class action attorneys."¹⁴ To prevent these abuses, the PSLRA incorporates the heightened pleading standard discussed above.¹⁵ It also stays discovery and other proceedings in all securities actions while a motion to dismiss is pending.¹⁶

This mandatory stay protects defendants from the burden of discovery prior to a ruling on a motion to dismiss. It also "avoid[s] the situation in which a plaintiff sues without possessing the requisite information to satisfy the PSLRA's heightened pleading requirements, then uses discovery to acquire that information and resuscitate a complaint that would otherwise be dismissed."¹⁷ Accordingly, "[u]nless exceptional circumstances are present, discovery in securities actions is permitted only after the court has sustained the legal sufficiency of the complaint."¹⁸

Federal merger-challenge lawsuits often present exactly the abuses that the PSLRA was meant to control. They are filed quickly, often without any regard to merit, and they are used to extract settlements by threatening a company's business (the proposed transaction) and forcing it into expensive discovery. While mergers often occur in relatively short order, the PSLRA affects all federal merger-challenge litigation in the same way; therefore, unless courts decide to adopt a categorical exception to the PSLRA stay (which no court has done), there generally will not be any exceptional circumstances that would allow a plaintiff to circumvent the PSLRA stay. Indeed, two courts recently applied the PSLRA discovery stay to deny discovery to plaintiffs seeking to enjoin mergers based on claims under Section 14(a).¹⁹

Plaintiffs Typically File Their Lawsuits Before Any Proxies Are Solicited.

Federal merger-challenge lawsuits are generally filed when a preliminary proxy statement is filed with the SEC. State-court breach of fiduciary duty claims, however, are usually filed even before the preliminary proxy is filed, and the claims can be amended to include disclosure claims after the preliminary proxy is filed. Thus, the state-court plaintiffs usually have a head start in prosecuting their claims. Section 14(a) claims likely are not ripe until a definitive proxy statement is sent to shareholders.

Section 14(a) and Rule 14a-9 prohibit "solicitation . . . by means of a proxy."²⁰ Rule 14a-1(1) defines "solicit" and "solicitation" to include only requests for proxies that are reasonably calculated to result in the giving or withholding of a proxy.²¹ It includes: "(i) any request for a proxy whether or not accompanied by or included in a form of proxy; (ii) any request to execute or not to execute, or to revoke, a proxy; or (iii) the furnishing of a form of proxy or other communication to security holders under circumstances reasonably calculated to result in the procurement, withholding, or revocation of a proxy."²² Accordingly, to state a claim under Section 14(a) and Rule 14a-9, the defendants must have "actually solicited proxies," i.e., they must have requested proxies or furnished a proxy statement to shareholders.²³

This puts law firms filing federal merger-challenge lawsuits in the position of choosing between: (1) filing unripe claims at a time when the state-court lawsuits may not have progressed too far, or (2) waiting until their claims are ripe, at which time state-court lawsuits may very well be settled already, which means these law firms risk missing out on any piece of the fees paid. So far, law firms that file federal merger challenges generally have decided to file unripe claims, but as the case law on this issue catches up with the current trend, it may become easier to get premature claims summarily dismissed on this basis.

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These problems with federal merger-challenge lawsuits should lead to the development of case law favorable for companies that chose to litigate the merger-challenge lawsuits, and they may reduce the proliferation of these suits. They are not, however, likely to prevent plaintiffs firms from filing these cases or to keep them — in some instances — from being able to use the federal forum to gain some portion of any settlement a company may choose to enter into.

Footnotes

1 Cornerstone Research, Securities Class Action Filings Report: 2011 Mid-Year Assessment, available at: www.cornerstone.com/files/Publication/ef3dc0f2-d0a2-478a-b8bc-363297b27252/Presentation/PublicationAttachment/f7d9395c-faa7-44a3-a807-37f8eac5e1c7/Cornerstone_Research_Filings_2011_Mid_Year_Assessment.pdf.

2 Id. at 14 (citation omitted).

3 Tom Hals and Jonathan Stempel, Analysis: Merger Lawsuits Increase — as Do the Legal Fees, ("Lawsuits challenging mergers tripled to 335 in 2010 from 107 just three years earlier even as deal volume dropped, according to Advisen, a provider of research to insurers"), available at: http://www.reuters.com/article/2011/02/11/us-shareholder-lawsuits-idUSTRE71A4HI20110211.

4 A quick settlement of a weak merger-challenge lawsuit usually involves the company making additional disclosures in its merger-related SEC filings, and then, after agreeing on those disclosures, it will agree to pay attorneys fees to the law firm or firms that brought the merger-challenge lawsuit. Because such suits are typically brought as class actions on behalf of all shareholders, these settlements usually are subject to court approval.

5 The typical forums for these cases are the state and federal courts of the state in which a company is incorporated and headquartered.

6 See, e.g., Suez Equity Investors, L.P. v. Toronto-Dominion Bank, 250 F.3d 87, 99 (2d Cir. 2001). ("[F]ederal security laws were not intended to 'bootstrap' garden-variety state law claims of breach of fiduciary duty into federal securities claims for failure to disclose.")

7 See Rosenblatt v. Getty Oil Co., 493 A.2d 929, 945 (Del. 1985) (adopting materiality test from TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438 (1976)).

8 15 U.S.C. § 78n(a).

9 Id.

10 17 C.F.R. § 240.14a-9(a).

11 15 U.S.C. § 78u-4(b)(1).

12 TSC Indus., Inc., 426 U.S. at 449.

13 Hysong v. Encore Energy Partners, LP, C.A. No. 11-781 (D. Del. Oct. 18, 2011) (rejecting Plaintiffs' counsel's motion to lift the PSLRA based on claim that discovery was needed to enjoin a merger based on Section 14(a) claims).

14 In re Advanta Corp. Sec. Litig., 180 F.3d 525, 531 (3d Cir. 1999) (citing H.R. Conf. Rep. No. 104-369, at 28 (1995), reprinted in 1995 U.S.C.C.A.N. 679, 748).

15 In re Alpharma Inc. Sec. Litig., 372 F.3d 137, 147 (3d Cir. 2004).

16 15 U.S.C. § 78u-4(b)(3)(B) (emphasis added).

17 Sarantakis v. Gruttaduaria, No. 02 C 1609, 2002 WL 1803750, at *1 (N.D. Ill. Aug. 5, 2002); see also In re NAHC, Inc. Sec. Litig., 306 F.3d 1314, 1332 (3d Cir. 2002) ("The PSLRA's stay of discovery procedure was intended by Congress to protect innocent defendants from having to pay nuisance settlements in securities fraud actions in which a foundation for the suit cannot be pleaded.").

18 In re Vivendi Universal, S.A., Sec. Litig., 381 F. Supp. 2d 129, 130 (S.D.N.Y. 2003) (emphasis added) (citation and internal quotation marks omitted).

19 Davis v. Duncan Energy Partners L.P., Civil Action No. H-11-2486, 2011 WL 3518263, at *5 (S.D. Tex. Aug. 10, 2011); Hysong, No. 11- 781 (D. Del.).

20 Ferro v. Blankenship, No. EP-95-CA-004-DB, 1999 WL 35125518, at *3 (W.D. Tex. Mar. 17, 1999).

21 17 C.F.R. § 240.14a-1(1).

22 Id.

23 Ferro, 1999 WL 35125518, at *3; see also Flannery v. Tesoro Petroleum Corp., No. Civ. SA-95-CA-1298, 1999 WL 35125519, at *1 (W.D. Tex. Feb. 2, 1999) ("[A]n actual solicitation must be made before plaintiffs can be accused of making an improper solicitation.").

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