Second Circuit Makes New Law by Establishing a Bright-Line Test for Standing to Bring Rule 10b-5 Claims Challenging a Target’s False or Misleading Pre-Merger Disclosure—Menora v. Frutarom

In Menora Mivtachim Insurance Ltd. v. Frutarom Industries Ltd. (Sept. 30, 2022), a panel of the United States Court of Appeals for the Second Circuit, affirming a decision of the United States District Court for the Southern District of New York, determined that purchasers of a security of an acquiring company do not have standing under Section 10(b) under the Exchange Act of 1934 (or SEC Rule 10b-5 promulgated thereunder) to sue the target company for alleged misstatements the target made about itself prior to the merger of the two companies. The court stated that, in so holding, it was answering a question that had been left open in its 2004 decision in Ontario Public Service Employees Union Pension Trust Fund v. Nortel Networks Corp.

Key Point

• The decision establishes a bright-line test for bringing Rule 10b-5 disclosure claims, limiting standing to plaintiffs who “bought or sold shares” of the company about which the alleged misstatements were made. Because the alleged misstatements in this case had been made by the target company about itself prior to the merger, investors who, after announcement of the planned merger had purchased shares of the acquiror (but not shares of the target company), did not have standing to bring Rule 10b-5 disclosure claims against the target. The court rejected the plaintiffs’ argument that, based on precedent, it had standing given the “significant” and “direct” relationship between the acquiror and the target (including the acquiror’s incorporation of the misstatements into its press releases and registration statement relating to the merger, as well as the direct impact of the misstatements on the acquiror’s stock price).
• We note that, as claims for a target’s pre-merger statements about itself generally cannot be brought against the acquiror, investors in the acquiror may be left without a route to making federal disclosure claims relating to a target’s pre-merger misstatements, even when they affected the acquiror’s stock price.

Background

On May 7, 2018, International Flavors & Fragrances Inc. (“IFF”) and Frutarom Industries Ltd. announced a planned merger pursuant to which Frutarom would be become a wholly-owned subsidiary of IFF. The merger closed in October 2018. In early August 2019, IFF discovered and publicly acknowledged that, prior to the merger, Flutarom had made improper payments (bribes) to representatives of a number of the company’s customers in Russia and Ukraine. The following day, IFF’s stock price dropped almost 16%. The plaintiffs, a putative class of investors who bought IFF shares during a period from May 7, 2018 through August 12, 2019, brought suit against IFF, Frutarom (now a subsidiary of IFF) and certain of their respective officers. The plaintiffs alleged that, from 2002 through 2018, Frutarom had been making illegal bribes to representatives of its customers, and to customs and other officials, in Russia and Ukraine to facilitate the sale of its products into those countries. They alleged that Frutaron’s pre-merger statements that it had complied with law (including anti-bribery laws) and that its growth was attributable to organic growth, acquisitions and favorable exchange rates—much of which information had been incorporated by IFF into its press releases about the merger and its registration statement on Form S-4—were materially misleading and constituted violations of Sections 10(b) and 20(a) of the Exchange Act and SEC Rule 10b-5.

The District Court granted the defendants’ motion to dismiss the case, finding that the plaintiffs (who had purchased IFF shares, but not Frutarom shares) lacked standing under Section 10(b) to bring claims (i) against the IFF defendants for pre-merger statements made by Frutarom and, notably, (ii) against the Frutarom defendants for statements made about Frutarom. The plaintiffs appealed to the Second Circuit with respect to their claims against Frutarom and its officers. The Second Circuit upheld the dismissal of the case based on lack of standing under Section 10(b).

Discussion

The private right of action for Rule 10b-5 disclosure violations is limited to purchasers and sellers of securities of the company about which the alleged material misstatements were made. In Menora, the Second Circuit noted that the U.S. Supreme Court has long emphasized that the judicially-created implied private right of action under Rule 10b-5 is a limited right and to be “narrowly construed.” The Second Circuit explained that it has generally followed the rule it first articulated in 1952 in Birnbaum v. Newport Steel—namely, that the class of plaintiffs who can sue under Rule 10b-5 is limited to those who purchased or sold the securities of an issuer about which a material misstatement was made. The Second Circuit noted that the U.S. Supreme Court adopted the Birnbaum rule in 1974 in Blue Chip Stamps. In Blue Chip Stamps, the Supreme Court, expressing concern about “the danger of vexatious litigation which could result from a widely expanded class of plaintiffs under Rule 10b-5,” stated that the “virtue” of Birnbaum’s “purchaser-seller rule” was that “it limits the class of plaintiffs [in Rule 10b-5 cases] to those who have at least dealt in the security to which the prospectus, representation, or omission relates.”

The court rejected the plaintiffs’ argument that they had standing based on the “significant and direct relationship” between the IFF and Frutarom. The plaintiffs pointed to dicta in the Second Circuit’s 2004 Nortel decision to support their argument. Nortel involved a sale by JDS Uniphase Corporation of one of its business units to its largest customer, Nortel Networks Corporation, in exchange for Nortel stock. Certain JDS stockholders sued Nortel for allegedly misleading statements that Nortel had made about itself leading up to the transaction. The Nortel court, holding that the plaintiffs did not have standing under Rule 10b-5, stated that standing is not conferred when a “company whose stock [the plaintiffs] purchased is negatively impacted by the material misstatement of another company [about itself], whose stock they did not purchase.” The court reasoned 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.” However, in dicta in Nortel, the court stated that the outcome might be different in the context of a merger, as “a merger creates a far more significant relationship between two companies than does the sale of a business unit.” In Menora, the court emphasized that, notwithstanding the dicta raising the question about the merger context, the Nortel court had expressly left “for another day” and “expressed no opinion” as to whether the outcome would be different in the context of a merger. That question was being answered in Menora, the court stated—“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.”

The court clarified that it would follow the Birnbaum rule, even in the context of a merger. The court explained that, under the “direct relationship” test advocated by the plaintiffs, the issue of standing would require a “shifting and highly fact-oriented” inquiry, requiring courts to determine whether there was a sufficiently direct link between the companies involved. The court concluded: “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…. Plaintiffs did not purchase securities of the issuer about which misstatements were made, so they did not have standing to sue under Section 10(b) or Rule 10b-5.”

Circuit Judge Myrna Pérez issued a concurring opinion, agreeing with the court’s holding that the plaintiffs lacked standing but positing that it could have been decided without “creating new law.” Judge Pérez suggested that the court could have reached the same result (finding a lack of standing) by applying the reasoning in Nortel rather than creating new law with a bright-line test. Under Nortel, the relationship between alleged material misstatements made about one company and the stock price of another company was “too remote” to sustain an action under Rule 10b-5. In Judge Pérez’s view, as the plaintiffs in Menora had “failed to persuasively explain…how the IFF-Frutarom merger itself created a more ‘direct relationship’ between Frutarom's misstatements and IFF's stock price than the sale of a business unit in Nortel,” the finding of lack of standing could have been reached without dispensing with the Nortel approach. Reaching a decision based on Nortel would have “[left] open the question Nortel raised [relating to standing in the context of a merger] and allow[ed] for future consideration of other fact patterns by the Court and the trial court,” she wrote.

The decision likely leaves post-merger-announcement investors in an acquiror without the ability to bring disclosure claims relating to the target’s pre-merger material misstatements about itself. It is not uncommon that, leading up to a merger, a target may make statements that it later turns out may have been materially false or misleading. Under these circumstances, the stock price of the acquiror typically falls. The plaintiffs’ claims in Menora relating to the target’s pre-merger statements about itself initially were brought against both the target and the acquiror, as the statements were incorporated into the acquiror’s press releases and registration statement. The claims against the acquiror defendants were dismissed as an acquiror is not responsible for a target’s pre-merger misconduct; and, post-merger, it is difficult to establish liability of an acquiror under agency and scienter theories. The Second Circuit noted in Menora that state law may permit claims by plaintiffs under these circumstances; however, we would observe that the only likely remedy under state law would be a derivative action by the acquiror’s stockholders—which would not benefit investors who sold their acquiror shares after it became known that the statements were false or misleading and, in any event, could be sustained only with a showing of scienter by the acquiror (or demand would not be excused).

Practice Points

• Acquirors should take steps to minimize any remaining risk of being held liable to their stockholders for pre-merger misstatements made by the target company about itself. While Menora establishes a bright-line test that limits standing under Rule10b-5 to holders of shares in the company about which the misstatements were made, conceivably, at some point, an acquiror’s incorporation of the target’s misstatements into the acquiror’s own materials might lead a court to view the statements as about the acquiror—particularly if the use of the statements is extensive and/or the acquiror may have had a particular reason to suspect that the statements were false or misleading. Specifically, acquirors should (i) conduct careful due diligence to confirm a target’s statements about itself, certainly with respect to critical issues such as the target’s compliance with law, reasons for its growth, and key trends in its business; (ii) consider adding disclaimer language with respect to statements about a target that were made by the target pre-merger and are incorporated in the acquiror’s disclosure material; and (iii) correct any such statements once the acquiror learns that they were materially false or misleading.
• Defendant companies should take into consideration the emphasis in the Menora opinion relating to judicially-created private rights of action being “narrowly construed.” It remains to be seen whether the court’s emphasis on “construing narrowly” judicially created private rights of action may be applied to rights outside the Rule 10(b)-5 context. Notably, the concurring opinion in Menora urged that the majority opinion not be taken to imply that all private rights of action should be narrowly construed.