In Re Digital Island Securities Litigation , 357 F.3d 322 ( 2004 )

Opinions of the United
2004 Decisions States Court of Appeals
for the Third Circuit
2-6-2004
In Re:Digital Island
Precedential or Non-Precedential: Precedential
Docket No. 03-1055
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PRECEDENTIAL One Rodney Square
P.O. Box 1035, Suite 500
UNITED STATES COURT OF APPEALS Wilmington, DE 19899
FOR THE THIRD CIRCUIT
__________ Counsel for Appellants
Case No: 03-1055 Jerrold J. Ganzfried [Argued]
Mark D. Wegener
IN RE: DIGITAL ISLAND Howrey, Simon, Arnold & White
SECURITIES LITIGATION 1299 Pennsylvania Avenue, N.W.
Washington, DC 20004
WILLIAM BLAIR MASSEY, Lead Philip A. Rovner
Plaintiff Potter, Anderson & Corroon
as representative of a class consisting 1313 North Market Street
of all holders of the common stock of 6th Floor, P.O. Box 951
Digital Island, Inc., Wilmington, DE 19801
Appellant Counsel for Appellees
__________
On Appeal From The _________
United States District Court For The
District of Delaware OPINION
(Civil Action No. 02-cv-00057) ____________
The Honorable Gregory M. Sleet,
District Judge SMITH, Circuit Judge
__________
This securities class action lawsuit
Argued November 4, 2003 arises out of the acquisition of Digital
__________ Island, Inc. by Cable & Wireless, PLC
(“C&W”). Pursuant to a May 14, 2001
Before: MCKEE, SMITH, and WEIS,
Merger Agreement between Digital Island
Circuit Judges
and C&W , Dali Acquisition Corp.
(Opinion Filed February 6, 2004) (“Dali”), a wholly-owned subsidiary of
C&W, made a cash tender offer to
Jeffrey G. Smith shareholders of Digital Island under which
Robert Abrams [Argued] it acquired 80 percent of the shares of
Wolf, Haldenstein, Adler, Freeman & Herz Digital Island. Dali was thereafter merged
270 Madison Avenue into Digital Island, which survived as a
New York, NY 10016 wholly-owned subsidiary of C&W.
Pamela S. Tikellis Plaintiffs filed a Consolidated
Chimicles & Tikellis
Amended Class Action Complaint (the
“Complaint”) on May 15, 2002. Plaintiffs received “extra consideration” for their
in this case represent a class comprised of shares in violation of Section 14(d)(7) of
all persons, other than the named the ‘34 Act, 15 U.S.C. § 78n(d)(7), and
defendants and certain related parties, who Securities and Exchange Commission
owned Digital Island common stock (“SEC”) Rule 14d-10, the so-called “Best
during the relevant period and who Price Rule,” 17 C.F.R. § 240.14d-10(a).
received the tender offer. 1 Defendants are Plaintiffs allege both individual violations
Digital Island, members of Digital Island’s by Defendants of these provisions, as well
Board of Directors during the relevant as “control person liability” under Section
time period, including Digital Island’s 20(a) of the ‘34 Act. 15 U.S.C. § 78t(a).
CEO, Ruann Ernst (the “Directors”),2
C&W, C&W ’s CEO, Graham Wallace,3 The District Court dismissed
and Dali. Plaintiffs allege that, in Plaintif f s’ c o n s o l id a t e d a m e n d ed
connection with the tender offer, complaint, with prejudice, for failure to
Defendants made misleading statements state a claim pursuant to Fed. R. Civ. P.
and failed to disclose material information 12(b)(6) and the Private Securities
in violation of Section 14(e) of the Litigation Reform Act of 1995 (the
Securities and Exchange Act of 1934 (the “PSLRA”), 15 U.S.C. § 78u-4. In re
“‘34 Act”), as amended by the W illiams Digital Island Sec. Litig., 223 F. Supp. 2d
Act of 1968. 15 U.S.C. § 78n(e). 546 (D. Del. 2002). By a subsequent
Plaintiffs further allege that the Directors order, the District Court denied Plaintiffs’
motion, pursuant to Fed. R. Civ. P. 59(e),
which sought to alter the court’s judgment
1
Individual complaints were filed by and to permit Plaintiffs to file an amended
shareholders of Digital Island in late complaint under Fed. R. Civ. P. 15(a).
January and early February of 2002. On Because we conclude that Plaintiffs’
April 16, 2002, the District Court granted proposed Second Consolidated Amended
Plaintiffs’ Joint Motion for Consolidation, Class Action Complaint (the “proposed
Appointment of Lead Plaintiff and amended Complaint”) does not articulate
Appointment of Lead Counsel. a viable theory of fraud, we will affirm
both orders of the District Court.
2
The other Directors are: Charlie Bass,
Christos Cotsakos, Mary Cirillo-Goldberg, I.
G. Bradford Jones, Robert Marbut, Shahan
Soghikian, Don Reed, Mike McTighe, The following facts are drawn from
Robert Drolet, Avery Duff, and Marc the proposed amended Complaint and
Lefar. from Digital Island’s Securities and
3
Exchange Commission (“SEC”) Form
Defendant Wallace also served as a
14D-9, which is referenced in the proposed
member of Digital Island’s board
amended Complaint and included in the
beginning on July 16, 2001.
Joint Appendix. See Oran v. Stafford, 226 $3.40 per share.4 Digital Island made a
F.3d 275, 289 (3d Cir. 2000) (taking counter-proposal of $4.10 per share, which
judicial notice of documents required by was rejected by C&W . On May 13, 2001,
law to be filed with the SEC). Digital the Digital Island board met and voted
Island provides a global e-business unanimously to approve the execution of
delivery network and suite of services for the Merger Agreement with a per share
enterprises that use the internet to deploy tender offer price of $3.40 and to
business applications and conduct e- recommend to the shareholders that they
commerce. Digital Island began searching accept the tender offer.
for a potential acquirer in August of 2000,
at which time representatives of Digital On May 14, 2001, Digital Island
Island contacted representatives of C&W and C&W executed the Merger
to gauge C& W’s interest in a strategic Agreement, which contemplated a first
partnership with Digital Island. In March step tender offer followed by a second step
of 2001, C&W indicated that it was merger. Under the tender offer,
interested in a potential business shareholders who tendered their shares
combination with Digital Island. In April were to receive $3.40 per share. Under the
of 2001, C&W delivered an initial draft of merger, all remaining shares of Digital
the Merger Agreement and made an initial I sland would be c a nc e le d , a nd
offer to purchase Digital Island for $2.25 shareholders would receive $3.40 per
a share. After considering the offer and share. The tender offer period expired on
meeting with its financial advisors, Digital June 18, 2001, and on June 19, 2001,
Island advised C&W that it was prepared D i g i t a l Isla n d a n n o u n c e d t h at
to begin negotiations, provided that the appro xima tely 80 percent of it s
offer price was increased to at least $3.25. outstanding stock had been tendered.
Negotiations between Digital Island Plaintiffs’ Section 14(e) claim is
and C&W continued through April and based on two significant business deals
into May, but C&W would not agree to that were announced immediately after the
raise its offer to $3.25 per share. On May expiration of the tender offer. On June 20,
10, 2001, Digital Island announced an 2001, Digital Island announced a major
agreement to provide certain business business agreement with Bloomberg LP,
services to Microsoft Corporation. The and on July 2, 2001, Digital Island
price of Digital Island’s stock rose that day announced anoth er major business
from $2.00 per share to $3.69 per share. agreement with Major League Baseball
On May 11, 2001, representatives of C&W
indicated that C&W’s board of directors 4
According to information submitted in
had preliminarily approved an offer of
the Joint Appendix, Digital Island’s stock
dropped to $3.13 at the close of trading on
May 11.
(“MLB”). According to Plaintiffs, both MLB deals because the success of the
the Bloomberg and MLB deals had tender offer and resulting merger created a
substantial value to Digital Island, and, if windfall for Defendants that was not
disclosed, would have substantially enjoyed by Digital Island’s other
influenced the shareholders’ decision to shareholders. Specifically, Plaintiffs
tender their shares.5 allege that, pursuant to the merger, the
Directors received substantial cash
Plaintiffs allege that Defendants payments for outstanding options to
knew of the Bloomberg and MLB deals purchase Digital Island common stock, as
prior to expiration of the tender offer, but well as for their shares of restricted
deliberately or recklessly failed to disclose common stock. Additionally, Plaintiffs
the deals until after the expiration of the allege that CEO Ernst had executed a
tender offer. Plaintiffs argue that lucrative contract for employment to serve
Defendants had an affirmative duty to as President and CEO of the surviving
disclose the Bloomberg and MLB deals, entity. 6
or, alternatively, that Defendants’ failure
to mention those deals in the tender offer Such extra consideration was given
and the Schedule 14D-9 rendered those to Digital Island officers and
docu men ts mate rially m islea ding. directors in order to induce them to
Plaintiffs allege that Defendants were support the Offer to Purchase at the
motivated to suppress the Bloomberg and $3.40 price per share and to
withhold the announcement of the
5
Bloomberg and Major League
Plaintiffs’ prediction is based on the
Baseball deals until after the
increase in value of Digital Island stock
expiration of the Offer to Purchase
that occurred after announcement of the
in order to preclude the need for
Microsoft deal. The actual disclosure of
C&W to increase the consideration
the Bloomberg and MLB deals does not
in the Offer to Purchase.
appear to have affected the price of Digital
Island stock. Plaintiffs explain that the
6
success of the tender offer on June 19 The proposed amended Complaint
effectively froze Digital Island’s share alleges that “five of the officers of Digital
price at $3.40 per share because, under the Island, including Ms. Ernst, received
merger agreement, all outstanding shares lucrative employment contracts in
of Digital Island were to be automatically connection with the merger which entitled
cashed out at that price. Nevertheless, them to generous salary and option
Plaintiffs allege very few facts from which packages.” Defendants point out that,
any meaningful comparison can be drawn according to the Schedule 14D-9
between the Microsoft deal on the one referenced in the Complaint, only one
hand, and the Bloomberg and MLB deals named Defendant, CEO Ernst, received
on the other. such a contract. Plaintiffs did not respond.
App. at 338. According to Plaintiffs, The District Court dismissed the
disclosure of the Bloomberg and MLB Complaint on September 10, 2002, for
deals threatened to derail the merger with failure to state a claim. The District Court
C&W: held that Plaintiffs’ Section 14(e) claim
failed to meet the heightened pleading
If the announcement induced more requirements of the PSLRA in two
than 50 percent of Digital Island respects: (1) the Complaint did not
stockholders not to tender their identify with specificity the statements that
shares, the Merger would not be were allegedly misleading, and (2) the
consummated and the Digital Island Complaint did not plead facts giving rise
officers would lose their lucrative to a strong inference of scienter. 15
employment agreements, as well as U.S.C. § 78u-4(b). The District Court
the extra consideration for their further held that Plaintiffs failed to state a
shares. Thus, any announcement claim for violation of the Best Price Rule
concerning the Bloomberg or because that provision applies only to
Major League Baseball Deals payments made during a tender offer, and
carried with it the threat of the extra consideration alleged by
undermining the M erger Plaintiffs was received pursuant to
Agreement. agreements executed prior to the tender
offer. Finally, the District Court dismissed
App. at 352. Plaintiffs’ “control person liability” claim
because (1) the predicate violations on
In addition to their Section 14(e) which that claim was based (i.e., the
claim, Plaintiffs allege that, by virtue of Section 14(e) and Best Price Rule claims)
these cash payments and the Ernst were dismissed, and (2) because Plaintiffs
employment agreement, the Directors failed to allege facts sufficient to establish
received “extra consideration” for their control and/or culpable participation.
shares in violation of Section 14(d)(7) of
the ‘34 Act and the SEC’s Best Price Rule. Plaintiffs filed a Motion to Alter
Plaintiffs allege individual violations by Judgment and For Leave to File An
Defendants of Sections 14(e) and the Best Amended Complaint under Fed. R. Civ. P.
Price Rule, as well as “control person 59(e) and 15(a). The District Court denied
liability” under Section 20(a) of the ‘34 Plaintiffs’ motion on November 25, 2002.
Act.7 The District Court concluded that
P l a in t i f fs h a d d e l i b e r a t e l y a n d
7
unreasonably delayed seeking leave to
The Complaint also alleges that
amend until after judgment had been
Defendants issued a false and misleading
entered on the motion to dismiss.
proxy statement in violation of Section
14(a) of the ‘34 Act. Plaintiffs do not
appeal dismissal of this claim.
Plaintiffs timely appealed both Claim. Although the stay of proceedings
orders on December 23, 2002.8 The against Digital Island and Dali does not
District Court had subject matter affect our reasoning, it does mean that our
jurisdiction under 28 U.S.C. § 1331 and 15 decision today does not reach either entity.
U.S.C. § 78aa. This Court has jurisdiction
over the District Court’s order dismissing II.
Plaintiffs’ Complaint under 28 U.S.C. §
1291 because the Complaint was Section 14(e) of the ‘34 Act
dismissed with prejudice. Manze v. State provides, in pertinent part:
Farm Ins. Co., 817 F.2d 1062, 1064 (3d
Cir. 1987). This Court also has It shall be unlawful for any person
jurisdiction under section 1291 over the to make any untrue statement of a
District Court’s denial of Plaintiffs’ post- material fact or omit to state any
judgment motion for leave to amend. See material fact necessary in order to
Foman v. Davis, 371 U.S. 178 (1962); N. make the statements made, in the
River Ins. Co. v. CIGNA Reinsurance Co., light of the circumstances under
52 F.3d 1194, 1203 (3d Cir. 1995). We which they are made, not
review de novo a District Court’s misleading, or to engage in any
dismissal of a complaint for failure to state fraudulent, dec eptiv e, or
a claim under Fed. R. Civ. P. 12(b)(6). manipulative acts or practices, in
Ramsgate Court Townhome Ass’n v. West connection with any tender offer . .
Chester Borough, 313 F.3d 157, 158 (3d ..
Cir. 2002).
15 U.S.C. § 78n(e). The District Court
On December 8, 2003, after oral held that Section 14(e) requires proof of
argument in this case, the successor entity scienter, i.e., “a mental state embracing
to the merger of Digital Island and Dali intent to deceive, manipulate, or defraud.”
filed for Chapter 11 Bankruptcy in the Ernst & Ernst v. Hochfelder, 425 U.S. 185,
District of Delaware. Under 11 U.S.C. § 193 n.12 (1976). Both parties appear to
362(a), this filing operates to stay all agree.9
proceedings against Digital Island and
Dali. Digital Island is a defendant in Section 14(e) is “modeled on the
Plaintiffs’ Section 14(e) claim, and Dali is antifraud provisions of § 10(b) of the [‘34]
a defendant in Plaintiffs’ Best Price Rule Act and Rule 10b-5,” Schreiber v.
8 9
A timely Rule 59(e) motion suspends Plaintiffs cite Clearfield Bank & Trust
the time in which to appeal, which then Co. v. Omega Fin. Corp., 65 F. Supp. 2d
begins to run, pursuant to Fed. R. App. P. 325, 340, 342-43 (W.D. Pa. 1999), in
4(a)(4), upon the entry of an order granting support of the proposition that Section
or denying the motion. 14(e) requires proof of scienter.
Burlington Northern, Inc., 472 U.S. 1, 10 justified under a traditional Rule 12(b)(6)
(1985), which require proof of scienter, analysis.”); see also Greebel v. FTP
Ernst & Ernst, 425 U.S. at 193. Because Software, Inc., 194 F.3d 185, 196 (1st Cir.
of the similarity in the language and scope 1999) (“A mere reasonable inference is
of Section 14(e) and Rule 10b-5, we have insufficient to survive a motion to
in the past construed the two consistently. dismiss.”). For purposes of the PSLRA,
E.g., Flynn v. Bass Bros. Enters., Inc., 744 Plaintiffs may plead scienter by alleging
F.2d 978, 984-85 (3d Cir. 1984) (adopting facts that (1) establish a motive and an
the same test of materiality for both opportunity to commit fraud, or (2)
Section 14(e) and Rule 10b-5). We constitute circumstantial evidence of either
therefore join those circuits that hold that reckless or conscious behavior. In re
scienter is an element of a Section 14(e) Advanta Corp. Sec. Litig., 180 F.3d 525,
claim. See, e.g., Conn. Nat’l Bank v. Fluor 534-35 (3d Cir. 1999). Either way,
Corp., 808 F.2d 957, 961 (2d Cir. 1987); plaintiffs must plead f acts “w ith
Smallwood v. Pearl Brewing Co., 489 F.2d particularity,” and these facts must give
579, 605 (5th Cir. 1974) (“Congress rise to a “strong inference” of a knowing
adopted in Section 14(e) the substantive or reckless misstatement. Id. at 535.
language of the second paragraph of Rule
10b-5 and in so doing accepted the A.
precedential baggage those words have
carried over the years.”). Plaintiffs’ theory of the case is that
the Directors and CEO Wallace suppressed
The P S LR A establishes a the Bloomberg and MLB deals to ensure
heightened pleading requirement for the success of the tender offer and the
certain securities fraud cases. The PSLRA subsequent merger. 10 When the tender
requires plaintiffs to “state with
particularity facts giving rise to a strong 10
We agree with the District Court that,
inference that the defendant acted with the
absent a duty to correct or update
required state of mind.” 15 U.S.C. § 78u-
misleading statements, Plaintiffs failed to
4(b)(2). In requiring a “strong inference”
identify an affirmative duty to disclose the
of scienter, the PSLRA alters the normal
Bloomberg and MLB deals. Oran, 226
operation of inferences under Fed. R. Civ.
F.3d at 285-86 (“Such a duty to disclose
P. 12(b)(6). In re Rockefeller Ctr. Props.,
may arise when there is insider trading, a
Inc. Sec. Litig., 311 F.3d 198, 224 (3d Cir.
statute requiring disclosure, or an
2002) (“[U]nless plaintiffs in securities
inaccurate, incomplete or misleading prior
fraud actions allege facts . . . with the
disclosure.”); In re Burlington Coat
requisite particularity . . . they may not
Factory Sec. Litig., 114 F.3d 1410, 1432
benefit from inferences flowing from
(3d Cir. 1997) (“Except for specific
vague or unspecific allegations—
periodic reporting requirements . . . there
inferences that may arguably have been
is no general duty on the part of a company
offer succeeded, the merger cashed out various options to purchase shares of
common stock as well as shares of
restricted common stock held by the
to provide the public with all material
Directors. According to Plaintiffs, the
information.”). Because we conclude that
prospect of cashing out these holdings
Plaintiffs have failed to adequately plead
induced the Directors to suppress
scienter, we do not decide whether the
information that would have raised the
proposed amended Complaint adequately
value of Digital Island’s shares. Such an
specifies the statements alleged to be
increase, Plaintiffs allege, would have
misleading and the reason why those
jeopardized the Merger Agreement
statements are misleading, or whether the
because shareholders would not have
proposed amended Complaint properly
tendered at $3.40 and C&W would not
attributes those statements to any of the
have increased the consideration offered.
Defendants in this case. See Rockefeller,
CEO Ernst’s lucrative employment
311 F.3d at 217-18 (discussing the
contract with the surviving entity provided
pleading requirements of the PSLRA and
her with a further inducement.
Fed. R. Civ. P. 9(b)).
Setting aside the Ernst employment
The District Court further dismissed
agreement, the Directors stood to gain
the Section 14(e) claim as to C&W , Dali,
from any increase in Digital Island’s share
and Wallace, because those defendants
price in the same manner as any other
were not affiliated with Digital Island and
Digital Island shareholder, that is, by
therefore owed no duty to Digital Island’s
tendering their shares into the offer or by
shareholders to disclose the Bloomberg
having their shares cashed out in the
and IBM deals. Plaintiffs make no
merger. Moreover, our reading of the
argument in their briefs that dismissal was
proposed amended Complaint compels the
erroneous as to C&W and Dali and have
same conclusion reached by the District
therefore abandoned these issues. Kost v.
Court: “As a result of the tender offer and
Kozakiewicz, 1 F.3d 176, 182 (3d Cir.
merger, each [Director] was paid the face
1993). Plaintiffs do maintain that
value of the options, i.e., the difference, if
Defendant Wallace violated Section 14(e)
any between the option price and $3.40.”
by failing to disclose the two deals.
Digital Island, 223 F. Supp. 2d at 550.
Plaintiffs make no argum ent that
Nevertheless, Plaintiffs argue that the
Defendant Wallace owed a duty to correct
success of the tender offer created a
or update statements that he did not make
windfall for the Directors because it
and over which he had no control.
allowed them to unload their holdings all
Accordingly, we will affirm the District
Court’s dismissal of the Section 14(e)
claim as to Wallace on the grounds that he
was under no duty to disclose the
Bloomberg and MLB deals.
at once, at a guaranteed price of $3.40 a Granting that some value might
share.11 attach to the avoidance of future risk, or
that only so many shares can be unloaded
11
on the open market without depressing the
The allegations in the proposed
share price, Plaintiffs’ theory is
amended complaint emphasize the fact that
nevertheless a weak inference teetering on
the merger cashed out both vested and
an unfounded assumption. Kalnit v.
unvested options and restricted stock:
Eichler, 264 F.3d 131, 139-40 (2d Cir.
2001) (“Sufficient motive allegations
First, the Digital Island officers and
‘entail concrete benefits that could be
directors were to receive substantial
realized by one or more of the false
cash payments in connection with
statements and wrongful nondisclosures
the Merger for their in-the-money
alleged.’” (quoting Shields v. Citytrust
options to purchase Digital Island
Bancorp., Inc., 25 F.3d 1124, 1130 (2d
common stock. This applied to
Cir. 1994)). The inference is that the
both vested and unvested options.
Directors feared that C&W would abandon
In addition, the officers of Digital
its efforts to acquire Digital Island if the
Island were to receive cash in
share price increased. Plaintiffs argue that
connection with the Merger in
this fear can be inferred from C&W’s
return for certain re stricted
rejection of Digital Island’s $4.10 counter-
common stock which they had been
proposal, and from the fact that the merger
granted in April 2001, several
agreement was hastily executed within
weeks prior to the Merger
days of the disclosure of the Microsoft
announcement, in return for their
deal. Whether or not this inference is
out-of-the money options.
reasonable under Rule 12(b)(6), the
PSLRA requires a strong—as opposed to
App. at 351. Plaintiffs do not allege that
merely reasonable—inference to survive a
the Directors received any sort of
motion to dismiss. See Rockefeller, 311
accelerated payment for their holdings,
F.3d at 224. The inference urged by
i.e., that any payment was made prior to
Plaintiffs is not strong, because the far
their vesting. Nor are there any allegations
regarding the circumstances or purpose of
the April 2001 option exchange program. and restricted stock, whether vested or
Instead, our reading of the proposed unvested, was necessarily tied to the
amended Complaint leads us to the same market value of Digital Island’s common
conclusion as the District Court: the stock. While other eventualities might
Directors received the face value of their have decreased Digital Island’s share price
options and restricted stock pursuant to a before these holdings vested, such open-
merger in which all outstanding securities ended speculation is entirely insufficient to
of Digital Island were cancelled. More support a strong inference of motive under
fundamentally, the value of these options the PSLRA. Rockefeller, 311 F.3d at 222.
more compelling inference is that the Regardless of the strength of this
Directors bargained aggressively with inference, it rests on an assumption,
C&W, motivated solely by a desire to devo id of any fac tual alle gation
exploit the surge in Digital Island’s stock whatsoever, that the Directors would be
price that followed the announcement of worse off if C&W withdrew its offer. Yet
the Microsoft deal. If the Directors were Plaintiffs’ theory of the case necessarily
confident of the Bloomberg and MLB requires that disclosure of the MLB and
deals before the merger agreement was Bloomberg Deals would have increased
finalized, they would certainly have the market value of Digital Island stock
disclosed those deals to support their absent the merger. Accordingly, to
counter-offer. 12 If instead, the Bloomberg establish a strong inference of motive,
and MLB deals were finalized after Plaintiffs were obliged to allege some facts
execution of the merger agreement, tending to show how the Directors could
C&W’s rejection of the counter-offer have hoped to make out better by
could have no bearing on how C&W unloading their options and restricted stock
would react to the deals. Rather, C&W’s than by realizing the impact of the
decision to increase the tender offer price Bloomberg and MLB deals on their shares,
following the Microsoft deal would either in the market or in a merger with
indicate that C&W might respond another suitor. See Advanta, 180 F.3d at
favorably to the Bloomberg and MLB 540-41 (no strong inference of scienter
deals. where detailed allegations revealed that
allegedly improper profits were small in
comparison to defendants’ stock holdings);
Burlington Coat Factory, 114 F.3d at 1423
12
(noting that plaintiffs had failed to plead
Plaintiffs equivocate on when the
facts showing that allegedly improper
Bloomberg and MLB deals became
profits were substantial in comparison to
sufficiently certain to merit disclosure.
defendants’ overall stock holdings and
Plaintiffs generally allege that the deals
compensation). 13 Considering all the
were close to completion sometime during
allegations in Plaintiffs’ proposed
the tender offer period. Plaintiffs,
amended Complaint, we agree with the
however, imply that the deals were
District Court that “plaintiffs’ theory
sufficiently final sometime prior to
execution of the merger agreement, insofar
13
as Plaintiffs allege that the disclosure of The proposed amended Complaint
the Microsoft deal was misleading because further assumes, without the support of
it implied that no other deals were about to factual allegations, that other potential
be consummated. Plaintiffs also allege acquirers would not have emerged on
that C&W generally became aware of the terms comparable to those offered by
deals by virtue of the due diligence C&W, or at least that the Directors feared
process. that no other suitor would emerge.
makes little economic sense because the The rationale underlying these
directors’ own stock options would have holdings is straightforward. Similar
been devalued if they tried to sell the situations arise in every merger;
company for less than full price.” Digital thus, allowing a plaintiff to prove a
Island, 223 F. Supp. 2d at 555. The motive to defraud by simply
proposed amended Complaint therefore alleging a corporate defendant’s
does not allege facts giving rise to a strong desire to retain his position with its
inference that the Directors acted with attendant salary . . . would force the
scienter in not disclosing the Bloomberg directors of virtually every
and MLB deals in their statements company to defend securities fraud
regarding the tender offer. actions, every time that company
effected a merger or acquisition.
The Ernst employment agreement
does little to strengthen the inference of Accord Kalnit, 264 F.3d at 139-40 (“[A]n
motive that can be drawn from Plaintiffs’ allegation that defendants were motivated
allegations. As with the Directors’ stock by a desire to maintain or increase
holdings, Plaintiffs allege no facts from executive compensation is insufficient
which it can be inferred that the because such a desire can be imputed to all
employment agreement actually created a corporate officers.”). Because Plaintiffs’
windfall to Ernst beyond what she would a l l eg a t i o n s r e g a r d in g t h e E r n st
otherwise realize by an increase in the employment agreement do nothing to
value of her shares. More fundamentally, distinguish her motivations from those
the fact that CEO Ernst had executed an surrounding countless other mergers and
employment agreement with the acquirer acquisitions, the proposed amended
cannot, in and of itself, establish a strong Complaint fails to create a strong inference
inference of motive. As the Fourth Circuit of scienter as required by the PSLRA.
explained in Phillips v. LCI Int’l, Inc., 190
F.3d 609, 622-23 (4th Cir. 1999): B.
[A]ssertions that a corporate officer A reckless statement is one
or director committed fraud in “involving not merely simple, or even
order to retain an executive inexcusable negligence, but an extreme
position, or retain such a position departure from the standards of ordinary
with the merged company, simply care, and which presents a danger of
do not, in themselves, adequately misleading buyers or sellers that is either
plead motive. . . . known to defendant or is so obvious that
the actor must have been aware of it.”
Advanta, 180 F.3d at 535. Allowing
Plaintiffs to plead recklessness is intended
to “discourage[] deliberate ignorance and
prevent[] defendants from escaping Where any person varies the terms
liability solely because of the difficulty of of a tender offer . . . before the
proving conscious intent to commit fraud.” expiration thereof by increasing the
Id. Scienter therefore requires “a consideration offered to holders of
misrepresentation so recklessly made that such securities, such person shall
the culpability attaching to such reckless pay the increased consideration to
conduct closely approaches that which each security holder whose
attaches to conscious dec eptio n.’” securities are taken up and paid for
McLean v. Alexander, 599 F.2d 1190, pursuant to the tender offer . . . .
1197 (3d Cir. 1979) (quoting Coleco
Indus., Inc. v. Berman, 567 F.2d 569, 574 15 U.S.C. § 78n(d)(7). 14 SEC Rule
(3d Cir. 1977) (per curiam)). Recklessness 14d-10(a)(2), the “Best Price Rule,”
is not intended to encompass “claims implements Section 14(d)(7) and provides:
essen tially grounded on corporate “No bidder shall make a tender offer
mismanagement.” Advanta, 180 F.3d at unless . . . [t]he consideration paid to any
540. security holder pursuant to the tender offer
is the highest consideration paid to any
We agree with the District Court other security holder during such tender
that Plaintiffs’ allegations fail to create a offer.” 17 C.F.R. § 240.14d-10(a).
strong inference of recklessness. Because Plaintiffs allege that the Directors received
Plaintiffs’ allegations show that “extra consideration” for their shares when
Defendants’ interests were at all times tied their options and restricted stock were
to the value of their shares, we have no cashed out in the merger pursuant to the
basis to infer the sort of conscious
disregard and deliberate ignorance
required to plead scienter. At most,
Plaintiffs’ allegations show that the 14
Plaintiffs do not appeal dismissal of
Directors failed to exploit the potential that
this claim as to Digital Island or any of the
the Bloomberg and MLB deals had to
individual defendants other than Wallace.
increase the value of Digital Island shares,
As the District Court recognized, the Best
whether through the tender offer price paid
Price Rule, by its terms, only applies to
by C&W or on the open market. Such
bidders. Digital Island, 223 F. Supp. 2d at
alleged mismanagement does not fall
556. On appeal, Plaintiffs offer no
within the anti-fraud prohibitions of
explanation why Defendant Wallace
Section 14(e).
should be considered a bidder. We
therefore will affirm the District Court’s
IV.
dismissal of the Best Price Rule claim with
respect to Defendant Wallace on the
Section 14(d)(7) of the ‘34 Act
ground that Defendant W allace is not a
provides, in pertinent part:
bidder within the meaning of the rule.
Merger Agreement.15 In addition, C.F.R. § 240.14d-10(a). The District
Plaintiffs allege that the employment Court and Defendants rely heavily on
agreement between C&W and CEO Ernst Lerro v. Quaker Oats Co., 84 F.3d 239,
further constituted a premium for her 245 (7th Cir. 1996), in which the Seventh
shares. There is no dispute that both the Circuit held that “transactions before or
Merger Agreement and the Ernst after a tender offer are outside the scope of
Employment agreement were executed Rule 14d-10.” The plaintiff in Lerro
prior to the tender offer. alleged that a controlling shareholder had
received extra compensation for his shares
The District Court adopted, and in the form of an exclusive distribution
Defendants urge this Court to adopt, a agreement executed by the tender offeror
“bright-line rule” that payments arising out and the controlling shareholder prior to the
of an agreement executed prior to a tender tender offer. Id. at 240. The agreement
offer do not state a claim under the Best was to commence upon consummation of
Price Rule, which expressly applies only to the offer. Id. The court held that the value
payments made “during a tender offer.” 17 of the distribution agreement did not
constitute extra compensation in violation
15
of the Best Price Rule because the
The proposed amended Complaint
agreement was signed before the offer
alleges that this consideration exceeds that
began. Id. at 244. The court reasoned:
received by other Digital Island
shareholders, although Plaintiffs make no
Before the offer is not “during” the
allegation that Digital Island’s outstanding
offer. . . . The difference between
options and restricted stock were held
“during” and “before” (or “after”)
exclusively by the Directors.
is not just linguistic. It is essential
to permit everyone to participate in
Curiously, Plaintiffs argue in their
the markets near the time of a
brief that we should read the proposed
tender offer. Bidders are forbidden
amended Complaint to allege that the extra
to buy or sell on the open market or
payment was made when the Directors
via negotiated transactions during
tendered their shares. If that is the case,
an offer, but they are free to
we do not understand how the Directors
transact until an offer begins, or
could h a v e r e c e iv e d the ex tra
immediately after it ends.
consideration alleged by Plaintiffs, which
is premised on the allegation that those
Id. at 243; see also Katt v. Titan
options were partially unvested at the time
Acquisitions, Inc., 244 F. Supp. 2d 841,
of the merger. If the Directors did indeed
850 (M.D. Tenn. 2003) (stating that Rule
exercise their options, to the extent vested,
14d-10 “is, on its face, ‘aimed at conduct
they were simply paid the tender price for
during the pendency of the tender offer’”
each share tendered like every other
(quoting Walker v. Shield Acquisition
shareholder.
Corp., 145 F. Supp. 2d 1360, 1375 (N.D. after it accepted all of the tendered
Ga. 2001))). shares before paying the favored
shareholders.
Plaintiffs urge this Court to adopt a
more flexible rule that focuses on whether Id. at 655. Epstein held that the proper
the allegedly improper payment is an focus should be “whether the . . .
integral part of the tender offer. For their transaction was an integral part of [the]
part, Plaintiffs rely on Epstein v. MCA, tender offer.” Id.17
Inc., 50 F.3d 644 (9th Cir. 1995), in which
the Ninth Circuit rejected the argument We agree with the Seventh Circuit
that Rule 14d-10 turns on the timing of the and the District Court that the market
payment. Epstein did not involve an requires a bright-line rule “to demark
agreement executed prior to the tender
offer period.16 Instead, the issue in Epstein 17
We regard Epstein as persuasive,
was whether a payment made after the
despite the fact that it was reversed on
tender offer expired could violate the Best
other grounds by the Supreme Court.
Price Rule. The Ninth Circuit held that
Matsushita Elec. Indus. Co., Ltd. v.
such a payment could establish a violation,
Epstein, 516 U.S. 367 (1996). Epstein is
reasoning that to hold otherwise
apparently regarded as precedential within
the Ninth Circuit, e.g., Harris v. Intel
would drain Rule 14d-10 of all its
Corp., No. 00-CV-1528, 2002 WL
force [since] even the most
1759817, at *5 (N.D. Cal. July 8, 2002),
blatantly discriminatory tender
and has been adopted by district courts in
offer—in which large shareholders
other circuits, e.g., Katt v. Titan
were paid twice as much as small
Acquisitions, Inc., 133 F. Supp. 2d 632,
shareholders— would fall outside
644 (M.D. Tenn. 2000). Epstein was also
Rule 14d-10’s prohibition, so long
cited with approval by the Second Circuit
as the bidder waited a few seconds
in Gerber v. Computer Assocs. Int’l, Inc.,
303 F.3d 126 (2d Cir. 2002). Gerber
16
The agreements in Epstein were involved a non-compete agreement
executed the same day on which the tender between a bidder and a shareholder
offer was announced, thus occurring executed during a tender offer. Gerber
during the tender offer under Rule 14d- held that it was immaterial that payment
2(a), which provides that, for purposes of was not made under the non-compete
Section 14(d), a tender offer commences agreement until after the expiration of the
“at 12:01 a.m. on the date when the bidder tender offer. Quoting Epstein, the court
has first published, sent, or given the held that the Best Price Rule “cannot be so
means to tender to security holders.” 17 easily circumvented” by simply delaying
C.F.R. § 240.14d-2(a); see Epstein, 50 payment until after the expiration date. Id.
F.3d at 653, 655 & n.18, 657. at 135 (quoting Epstein, 50 F.3d at 655).
clearly the periods during which the will enter into a wide variety of
special Williams Act rules apply.” Lerro, agreements, including agreements with
84 F.3d at 243. W e also agree with shareholders, that are conditioned on the
Epstein that tender offerors cannot be success of the tender offer. The Ernst
permitted to evade the requirements of the employment agreement is a perfect
Williams Act simply by delaying the actual example: An offeror who intends to
payment, or by agreeing on the extra operate a company as a going concern
payment beforehand. Indeed, Lerro itself after the acquisition may reasonably
acknowledges that some payments made attempt to secure the services of
outside of the tender offer period may be incumbent management. Only where the
so transparently fraudulent as to require tender offeror deliberately inflates that
them to be treated as made “during the compensation to provide a premium for the
tender offer”: officer’s shares is there a violation of the
Best Price Rule. In such instances, the
Doubtless there are limits to the use tender offeror has attempted to defraud the
of a follow-up merger as a means to shareholders of the target company of the
d e liver extra com pensation. equal consideration to which they are
Suppose [the acquirer] had entitled under the Williams Act and the
promised [a shareholder] $14 for Best Price Rule.
each share he tendered during the
offer, plus another $6 for each of Accordingly, in order to base
these shares one month later. Just recovery under the Best Price Rule on a
as tax law requires “boot” to be transaction execute d prior to the
treated as a gain received from the commencement of a tender offer, Plaintiffs
sale of stock, securities law treats must comply with Fed. R. Civ. P. 9(b),
“boot” as a payment during the which requires that “[i]n all averments of
tender offer. fraud or mistake, the circumstances
constituting fraud or mistake shall be
Lerro, 84 F.3d at 245. Nevertheless, the stated with particularity.” See Shapiro v.
exception to the general rule is a narrow UJB Fin. Corp., 964 F.2d 272, 287-89 (3d
one, and Plaintiffs’ allegations do not fall Cir. 1992) (holding that Rule 9(b) applies
within it. to claims under Sections 11 and 12(2) of
the Securities and Exchange Act of 1933,
Where, as here, a plaintiff argues 15 U.S.C. §§ 77k, 77l, when those claims
that the Best Price Rule has been violated are grounded in fraud). Rule 9(b)’s
by a transaction executed prior to the particularity requirement, which “has been
tender offer, the plaintiff necessarily rigorously applied in securities fraud
alleges that the tender offeror has cases,” Burlington, 114 F.3d at 1417,
fraudulently devised a scheme to requires plaintiffs to “accompany their
circumvent the Rule. An offeror can and legal theory with factual allegations that
make their theoretically viable claim mergers as distinct from tender
plausible,” id. at 1418. Furthermore, offers. Statutory mergers are
under the PSLRA, Plaintiffs must allege authorized and regulated by state
facts giving rise to a strong inference that corporation codes, and federal
C&W acted with fraudulent intent; that is, regulation of such mergers is found
that C&W intended to provide a premium in federal regulations concerning
to the Directors for their shares through the the solicitation of proxies. Finally,
Merger Agreement and the Ernst the Williams Act contains, in
employment agreement. 15 U.S.C. § 78u- addition to the “best price”
4(b)(2); see also Burlington, 114 F.3d at provision, time limits, disclosure
1418 (requiring, prior to passage of the requirements, pro rata acceptance
PSLRA, allegations supporting a “‘strong r u l e s , a n d p r o v i s io n s f o r
inference’ that the defendant possessed the withdrawal of tendered shares that
requisite intent” to satisfy Rule 9(b)). make no sense whatsoever in the
merger context. 18
With respect to the Merger
Agreement, Plaintiffs allege that the Accord Lerro, 84 F.3d at 244 (“Kramer
Directors received “extra compensation” rejects, rightly we think, any argument that
to the extent that they were able to cash a follow-up merger should be integrated
out all of their options and restricted stock with a tender offer. They are different
at once. As a threshold matter, we transactions, under different bodies of law
question whether the Best Price Rule . . . .”); Epstein, 50 F.3d at 659 n.21
should ever apply to payments made (distinguishing Kramer on the grounds that
pursuant to a second-step merger. We find Kramer, unlike Epstein, involved a
persuasive the Second Circuit’s reasoning second-step statutory merger). 19
in Kramer v. Time Warner Inc., 937 F.2d
767, 779 (2d Cir. 1991):
18
In Kram er, the plaintiff claimed
[W]e perceive no basis in the that certain officers received payments for
language, structure or legislative their stock options in connection with a
history of the Act for viewing a merger that exceeded the price paid to
second-step statutory merger other shareholders pursuant to the merger.
following a successful tender offer Id. at 778-79 & n.5.
for 51 percent of a target’s shares 19
Plaintiffs allege that the payments
as a continuation of the tender
receiv ed by the Directors w e re
offer. Such a merger lacks the
consideration for options and restricted
most salient characteristics of a
stock that were held prior to the Merger
tender offer—an offer to purchase,
Ag reem ent. This gr ound f ur th er
tender and acceptance. Moreover,
distinguishes Epstein, where the options
state and federal law clearly treat
themselves were alleged to be conditioned
As discussed above, Plaintiffs fail allegation provides no basis on which to
to cobble together a coherent theory as to infer the payment of a share premium in
how these payments could have induced violation of the Best Price Rule.
the Directors to suppress the Bloomberg
and MLB deals and support the tender The facts alleged by Plaintiffs are
offer. Conversely, we have difficulty therefore a far cry from Epstein. In that
understanding how these payments could case, the tender offeror executed an
give rise to an inference that they were agreement with one of the shareholders,
intended by C&W as such an inducement. Sheinberg, under which Sheinberg would
More fundamentally, the fact that the receive a lump sum payment if the tender
merger cashed out certain unvested offer succeeded. Epstein, 50 F.3d at 657.
holdings of the Directors, without more, Immediately after the execution of the
cannot establish a strong inference of agreement—i.e., that same day—the tender
fraudulent intent. Plaintiffs do not allege offer was announced. Id. at 653, 657. The
that these holdings were anything but pre- defendant in Epstein claimed that the
existing, legitimate obligations of Digital payment was to induce Sheinberg to stay
Island. The only inference we can take on as an officer and to cash out his stock
from these allegations, then, is that C&W options under the merger. Id. at 657.
chose to honor Digital Island’s existing Plaintiffs argued, however, that the options
obligations. Plaintiffs provide no themselves were conditioned on the
explanation for why this behavior should success of the tender offer. Id. at 658.
raise suspicion, particularly where C&W With respect to Sheinberg’s “amended
intended to operate Digital Island as a employment agreement,” Plaintiffs pointed
going concern. out that the payment appeared to
correspond precisely to the value of his
Nor have Plaintiffs alleged any options, i.e., there was no compensation
facts that would render the Ernst for services. Id. at 658-59. Epstein thus
employment agreement suspect. Plaintiffs involved precisely the kind of allegations
do not allege that Ernst’s employment of fraud that a bright line rule would
agreement is a sham transaction designed exclude from Best Price Rule protection.
to insulate an improper tender offer Further proceedings were therefore
premium. They do not contend that the necessary to determine the purpose of the
compensation package was excessive, or Sheinberg agreement, i.e., whether the
that it was out of line with amounts that lump sum payment “constitutes incentive
similarly situated executives were paid. compensation that [the offeror] wanted to
Instead, Plaintiffs simply characterize the give Sheinberg independently of the . . .
agreement as “lucrative.” This conclusory deal, or a premium that [the offeror]
wanted to give Sheinberg as an
inducement to support the tender offer and
on the success of the tender offer. 50 F.3d
tender his own shares.” Id. at 659.
at 658.
To the extent that Epstein holds that Instead, when applying the Best
the proper inquiry in such cases is whether Price Rule to a transaction that is executed
the transaction “unconditionally obligated” outside of the tender offer period and that
the offeror, we respectfully reject that nominally does not involve the purchase of
holding. Id. at 656-57; see also id. at 656 securities, the “central issue” is whether a
(concluding that an agreement was “an given payment constitutes “a premium that
integral part of the offer and subject to [the offeror] wanted to give [the
Rule 14d-10’s requirements” because the shareholder] as an inducement to support
agreement was “conditioned on the tender the tender offer and tender his own
offer’s success”). Whether the offeror was shares.” Epstein, 50 F.3d at 659; see, e.g.,
unconditionally obligated would be Katt, 244 F. Supp. 2d at 857-58. This, of
important if we were dealing with an course, requires an intent to defraud the
outright purchase of securities. See 17 remaining shareholders of their entitlement
C.F.R. § 240.14e-5(b)(7) (allowing to equal consideration under the tender
purchases of securities during—but offer. Accordingly, when reviewing a
“outside”—of a tender offer where complaint alleging a violation of Rule 14d-
purchase is pursuant to an unconditional 10 based on a transaction executed prior to
and binding contract entered into before the commencement of a tender offer, the
public announcement of the tender offer); trial court should determine whether the
Epstein, 50 F.3d at 656 (“Thus a bidder plaintiff has met the heightened pleading
who purchases shares from a particular requirements of Rule 9(b) and the PSLRA.
shareholder before a tender offer begins
does not violate Rule 14d-10.”). But We conclude that Plaintiffs’
tender offerors routinely engage in allegations do not meet these heightened
transactions not involving the purchase of pleading standards. The proposed
securities that are conditioned on the amended Co mp laint allo ws no
success of the tender offer (e.g., if the reasonable—let alone strong—inference
offer fails, the prospective “employer” that the Merger Agreement or the Ernst
never comes into existence). Epstein’s employment agreement conceal a
“unconditionally obligated” test should not fraudulent share premium in violation of
subject all of these transactions to the Best Price Rule. We acknowledge that
challenge under the Best Price Rule. See we are applying for the first time the
also Lerro, 84 F.3d at 244-45 (warning pleading requirements of Rule 9(b) and the
against a construction of the Best Price PSLRA to a Best Price Rule claim.
Rule that “would imperil countless Nevertheless, we believe that allowing
ordinary transactions [including] simple Plaintiffs an opportunity to amend this
employment agreements under which the claim would be futile. Plaintiffs’ theory of
surviving entity promises to employ fraud with respect to their Best Price Rule
managers for stated terms or give claim mirrors the theory underpinning their
severance pay”). Section 14(e) claim and we have rejected
as implausible Plaintiffs’ most recent the District Court’s order denying
iteration of this theory. We see no reason Plaintiffs leave to amend.
to allow them a third opportunity under the
Best Price Rule. VII.
V. Because Plaintiffs failed to allege
facts giving rise to a strong inference that
Section 20(a) provides, in pertinent Defendants acted with scienter in regard to
part: “Every person who, directly or their statements and/or silence concerning
indirectly, controls any person liable under the Bloomberg and MLB deals, we will
any provision of this chapter or of any rule affirm the District Court’s dismissal of
or regulation thereunder shall also be their Section 14(e) claim. Likewise, we
liable jointly and severally with and to the will affirm dismissal of Plaintiffs’ Best
same extent as such controlled person . . . Price Rule claim because it depends on the
.” 15 U.S.C. § 78t(a). Liability under same implausible theory of fraud as their
Section 20(a) is derivative and must be Section 14(e) claim. Moreover, dismissal
predicated upon an independent violation of these claims compels dismissal of
of the ‘34 Act. Advanta, 180 F.3d at 541. Plaintiffs’ Section 20(a) claims, which are
Accordingly, because we will affirm the derivative of the Section 14(e) and Best
District Court’s dismissal of Plaintiffs’ Price Rule claims. Finally, our analysis
fraud and Best Price Rule claims for has taken into consideration the additional
failure to state a claim, the proposed allegations in Plaintiffs’ proposed
amended Complaint necessarily fails to amended Complaint. We therefore will
state a claim under Section 20(a). affirm the District Court’s denial of leave
to amend on the basis of futility.
VI.
Finally, we address the District
Court’s denial of Plaintiffs’ motion under
Rules 59(e) and 15(a) to alter the judgment
and to obtain leave to file an amended
complaint. We have determined that
Plaintiffs’ proposed amended Complaint
fails to state a claim under Rule 12(b)(6)
and the PSLRA and that leave to amend
would therefore be futile. Foman v. Davis,
371 U.S. 178, 182 (1962); In re NAHC,
Inc. Sec. Litig., 306 F.3d 1314, 1332 (3d
Cir. 2002). Accordingly, we will affirm