An acquiring company stated a claim for common-law fraud against hedge funds that engaged in a creeping takeover of a target company under the cover of allegedly false Section 13 beneficial-ownership filings. In so ruling, the Delaware Chancery Court first decided that it had jurisdiction to provide a common-law fraud remedy for claims arising out of statements made in SEC-mandated filings. Although the federal government has an obvious interest in enforcing the disclosure scheme established by the Exchange Act, said Vice Chancellor Laster, Delaware has an interest in preventing the entities it charters from being used as vehicles for fraud. Nacco Industries, Inc. v. Applica, Inc., (Del Ch. 2009).

The court rejected the assertion that one need not disclose any intent in a 13D filing other than an investment intent until a bid is actually made. The hedge funds could offer no legal support for this view, said the court, and there has been a recent and persuasive rejection of what the Vice Chancellor called a "similarly self-serving, formalistic, and bright-line interpretation" advanced by frequent Schedule 13D filers. CSX Corp. v. Children’s Inv. Fund Mgmt. (UK) LLP, (S.D.N.Y. 2008), aff’d, (2d Cir. 2008).

On the same day that it announced a merger with the acquiring company, noted the Vice Chancellor, the management of the target company contacted the hedge funds and signaled that an all-cash offer would likely be successful. The hedge funds had acquired a nearly 40-percent stake in the target while the acquiring company was under a standstill agreement. The hedge funds continued to maintain that they were holding the shares for investment purposes.

The hedge funds then topped the merger by offering to acquire all of the outstanding shares of the target company for $6.00 per share. In conjunction with their bid, the hedge funds filed a Schedule 13D/A amending the disclosure in its prior Schedule 13 forms. The amended disclosure stated that rather than acquiring its shares for investment purposes, the hedge funds purchased the shares in order to acquire control of the company. The target company terminated the merger, paid a $4 million termination fee, and entered into a merger agreement with the hedge funds.

Section 27 of the Exchange Act provides that federal courts have exclusive jurisdiction over violations of the Act. At the same time, Section 28(a) of the Exchange Act provides that the rights and remedies provided by the Act are in addition to any and all other rights and remedies that may exist at law or in equity. The Chancery Court held that the federal statutory remedies of the Act over which the federal courts have exclusive jurisdiction are intended to coexist with claims based on state law and not preempt them. Thus, the state law claim for common-law fraud could proceed, ruled the Vice Chancellor, even though the statements giving rise to the claim appeared in filings made pursuant to the Exchange Act.

The company’s real claim, said the court, is that the information in the hedge funds’ Schedule 13G and 13D filings was false and misleading, regardless of whether the information was required to be included under federal law. This issue can be adjudicated by a state court as a question of fact, separate and independent from what the line items of Schedule 13G and Schedule 13D require, the court explained.

It was alleged that the Schedule 13D filings made affirmative statements of fact that were false or materially misleading because they were incomplete. The court felt that it did not have to consider federal law to evaluate the truth, falsity, or misleading nature of the factual statements. In the court’s view, the company adequately claimed that the hedge funds falsely disclosed that they were acquiring shares for investment purposes when in fact they were purchasing shares to control or influence at a time when plans for a merger involving the target company existed and at a time when there were plans to defeat the acquisition.

Delaware’s common-law fraud remedy does not provide investors with expansive, market-wide relief. However, Delaware law does require a plaintiff to show reliance, the court explained, and the state’s supreme court has declined to permit the fraud-on-the-market theory to be used as a substitute. In this regard, the company was entitled to treat the disclosures as true and accurate and reasonably rely on the disclosures.

The court acknowledged that at some point it became unreasonable for the company to trust that hedge funds engaging in conduct resembling a creeping takeover wanted only to receive their ratable share of the benefits from the existing deal. However, the line when the company’s reliance became unreasonable is difficult to draw, the court explained, and the issue cannot be resolved on a motion to dismiss.

The court concluded that the company relied on the disclosures in deciding what to do and what not to do and that the false disclosures were material to the company. Critical to the court’s ruling was the fact that the company alleged a reasonable basis for an inference that the hedge funds intentionally made false disclosures about their investment intent in a context where they expected the company to rely on them and where the company reasonably did so.