Rare Federal Court Decision Casts Doubt On Merger Disclosure Claims, But Will It Change Anything?

• Published date: 01 July 2020
• Subject Matter: Corporate/Commercial Law, Litigation, Mediation & Arbitration, M&A/Private Equity, Corporate and Company Law, Trials & Appeals & Compensation, Securities, Shareholders
• Law Firm: Cleary Gottlieb Steen & Hamilton LLP
• Author: Mr Roger A. Cooper, James E. Langston, Mark E. McDonald and Charity Lee

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 1934.¹

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.²

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...