Second Circuit Affirms Dismissal Of Exchange Act Claims Against Acquired Public Company, Holding That Shareholders Of An M&A Acquiror Do Not Have Standing To Pursue Claims Based On Acquired Company’s Alleged Pre-Transaction Misstatements
On September 30, 2022, a panel of the United States Court of Appeals for the Second Circuit affirmed a decision of the United States District Court for the Southern District of New York dismissing a putative securities fraud class action asserting claims under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 promulgated thereunder against a flavoring and fragrance products company (the “Company”) and several of its executives. Menora Mivtachim Ins. Ltd., et al. v. Frutarom Indus. Ltd., et al., No 21-1076 (2d Cir. Sept. 30, 2022). Plaintiffs alleged that, from 2002 to 2018, the Company engaged in a “long-running bribery scheme,” and that defendants made materially misleading statements about the Company’s compliance with anti-bribery laws and its business growth in public documents filed when the Company was acquired in 2018. The district court granted the motion to dismiss as against the Company and its officers, holding that plaintiffs failed to sufficiently allege statutory standing to pursue their securities fraud claims. The Second Circuit affirmed.
According to the complaint, when the merger closed in October of 2018, the Company became a wholly-owned subsidiary of the purchasing company (the “Parent Company”). Plaintiffs alleged that on October 5, 2019, the Parent Company disclosed that the Company had made improper bribes in Russia and Ukraine, and the following day, the Parent Company’s share price dropped approximately 16%. Plaintiffs—purchasers of shares of the Parent Company—brought suit against the Parent Company, the Company, and officers of both companies. Defendants moved to dismiss, and the district court granted the motion, finding that (1) plaintiffs failed to plead with the requisite particularity that the alleged misconduct continued into the class period; (2) the allegedly false statements and omissions were not actionable or material; and (3) plaintiffs lacked statutory standing to sue the Company and its officers because plaintiffs were shareholders only of the Parent Company and never bought or sold shares of the Company. Plaintiffs appealed the decision only as it related to the Company and its officers.
Plaintiffs contended that they had standing because there was a “direct relationship” between the Company’s alleged misstatements and the price of the Parent Company’s shares. The Second Circuit rejected this argument. The Court stated that “judicially created private rights of action should be construed narrowly” and noted that this had been emphasized by the Supreme Court in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). In Blue Chip Stamps, the Supreme Court adopted the “purchaser-seller rule,” which “limited the class of plaintiffs who could sue under Rule 10b-5 to those who purchased or sold the securities of an issuer about which a material misstatement was made.” The Court noted that adopting plaintiffs’ “direct relationship” test would erode the Supreme Court’s precedent by “adding further uncertainty to Section 10(b)’s ‘rule of liability imposed on the conduct of business transactions.’” Further, the Court found that plaintiffs improperly relied on dicta from an earlier case in which the Second Circuit contemplated whether “a merger creates a far more significant relationship between two companies than does the sale of a business unit” in ultimately holding that plaintiffs lacked standing to sue under the latter scenario. Ontario Public Service Employees Union Pension Trust Fund v. Nortel Networks Corp., 369 F.3d 27 (2d Cir. 2004) (“Nortel”). While acknowledging that the Nortel decision left that issue open, the Second Circuit stated that it “now answer[s] that question by holding that purchasers of a security of an acquiring company do not have standing under Section 10(b) to sue the target company for alleged misstatements the target company made about itself prior to the merger between the two companies.” The Court further held that “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.”
Judge Pérez agreed with the holding but authored a concurrence stating that the reasoning in Nortel was sufficient to find that “the relationship between one company’s material misstatements about itself and another company’s stock price was ‘too remote to sustain an action’ under Section 10(b) and Rule 10b-5,” and that the Court did not need to create new law on the issue to reach the same result.