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Adopting a broad reading of securities fraud laws, a federal appeals court has ruled that a corporation and its officers can be sued by the shareholders of another corporation for allegedly disseminating false information about the chances that the two companies would merge. In Semerenko v. Cendant Corp., the 3rd U.S. Circuit Court of Appeals rejected the argument that such plaintiffs cannot satisfy the requirements of Section 10(b) of the Securities and Exchange Act since the first company’s allegedly false or misleading statements cannot be considered as uttered “in connection with” a purchase of the second company’s stock. Instead, the court looked to decisions from the 2nd and 9th Circuits which have held that the alleged misrepresentations must always be considered in context and that courts should look only to whether a reasonable investor would have relied on the misrepresentation. U.S. Circuit Judge Arthur L. Alarcon of the 9th Circuit, sitting on the 3rd Circuit by invitation, explained that the 2nd Circuit and his own home circuit have adopted a broad reading of the phrase “in connection with” in order to give the securities laws their full intended effect. “Where the fraud alleged involves the public dissemination of information in a medium upon which an investor would presumably rely, the ‘in connection with’ element may be established by proof of the materiality of the misrepresentation and the means of its dissemination.” Under that standard, Alarcon said, “it is irrelevant that the misrepresentations were not made for the purpose or the object of influencing the investment decisions of market participants.” Alarcon, who was joined by U.S. Circuit Judge Carol Los Mansmann and Morton I. Greenberg, said that such a “materiality and public dissemination approach” should apply to the case against Cendant over the statements it made in connection with the proposed-but-never-consummated merger with American Bankers Insurance Group Inc. “The purpose underlying Section 10(b) and Rule 10b-5 is to ensure that investors obtain fair and full disclosure of material facts in connection with their decisions to purchase or sell securities,” Alarcon wrote. “That purpose is best satisfied by a rule that recognizes the realistic causal effect that material misrepresentations, which raise the public’s interest in particular securities, tend to have on the investment decisions of market participants who trade in those securities.” Adopting the reasoning of the 2nd and 9th Circuits, Alarcon said the 3rd Circuit now holds that investors may establish the “in connection with” element “simply by showing that the misrepresentations in question were material, and that they were disseminated to the public in a medium upon which a reasonable investor would rely. Under that standard, Alarcon said, the class of investors “is not required to establish that the defendants actually envisioned that members of the class would rely upon the alleged misrepresentations when making their investment decisions. … Rather, it must only show that the alleged misrepresentations were reckless.” CASE REVIVED The ruling revives a case that was dismissed by U.S. District Judge William Walls of the District of New Jersey. But because the appellate panel articulated a new standard, it ruled that Walls must be given the first chance to apply it. The opinion explicitly left open the possibility that Walls could dismiss the case again. The suit was filed by investors who purchased shares of American Bankers Insurance Group Inc. common stock during the course of Cendant’s tender offer — from Jan. 27, 1998, to Oct. 13, 1998. Named as defendants in the suit are Cendant and four of its former officers and directors — Walter A. Forbes, E. Kirk Shelton, Christopher K. McLeod and Cosmo Corigliano — as well as its accountant, Ernst & Young. The complaint does not allege that any member of the class purchased securities issued by Cendant or that any member of the class tendered shares of ABI common stock to Cendant. Instead, it alleges that the defendants made certain misrepresentations about Cendant that artificially inflated the price at which the class purchased their shares of ABI common stock and that the class suffered a corresponding loss when those misrepresentations were disclosed to the public and the merger agreement was terminated. In December 1997, the American International Group Inc. announced that it would acquire 100 percent of the outstanding shares of ABI common stock for $47 per share. Cendant made a competing tender offer in January 1998 to purchase the same shares at a price of $58 per share, or a total price of approximately $2.7 billion. In conjunction with its tender offer, Cendant filed papers with the Securities and Exchange Commission that allegedly overstated its income. AIG matched Cendant’s bid and offered to pay ABI shareholders $58 for each share of outstanding ABI common stock. But Cendant eventually raised its bid price to $67 per share. It then executed an agreement to purchase ABI for approximately $3.1 billion, payable in part cash and in part shares of Cendant common stock. Things started to go wrong in April 1998, however, when Cendant announced that it had discovered potential accounting irregularities and that it had hired Willkie Farr & Gallagher and Arthur Andersen to perform an independent investigation. It also announced that it had retained Deloitte & Touche to reaudit its financial statements and that “the company’s previously issued financial statements and auditors’ reports should not be relied upon.” Nonetheless, the announcement reported that the irregularities occurred in a single-business unit that “accounted for less than one third” of Cendant’s net income, and it indicated that Cendant would restate its annual and quarterly earnings for the 1997 fiscal year by 11 cents to 13 cents per share. Immediately after Cendant disclosed the accounting irregularities, the price of ABI common stock dropped from nearly $65 to $57.75 — an 11 percent decrease from the price at which the shares had been trading. Following the announcement, Cendant made several pubic statements in which it represented that it was committed to completing the merger with ABI notwithstanding the discovery of the accounting irregularities. In May 1998, Cendant stated that “over 80 percent of the company’s net income for the first quarter of 1998 came from Cendant business units not impacted by the potential accounting irregularities.” But by July, Cendant had revealed that the April announcement was inaccurate and that the actual reduction in income would be twice as much as previously announced. It also acknowledged that its investigation had uncovered several accounting irregularities that had not previously been disclosed and that those accounting irregularities affected additional Cendant business units and other fiscal years. Estimated earnings, it said, would be reduced by as much as 28 cents per share in 1997. After those disclosures, the price of ABI common stock dropped until Cendant issued several public statements indicating that it still intended to continue the tender offer and that it was “contractually committed” to completing the ABI merger. The market price of ABI common stock was “buoyed” by Cendant’s repeated statements that it was committed to completing the merger. In August 1998, Cendant issued a press release announcing that its investigation into the accounting irregularities was complete. The company said it would restate its earnings by 28 cents per share in 1997, by 19 cents per share in 1996 and by 14 cents per share in 1995. An audit report filed with the SEC included findings that “fraudulent financial reporting” and other “errors” had inflated Cendant’s pretax income by approximately $500 million from 1995 to 1997 and that Forbes and Shelton were “among those who must bear responsibility.” On that news, the price of ABI common stock closed at $53.50 per share and fell further to a closing price of less than $52 on Aug. 31, 1998, the first day of trading following the disclosure. On Sept. 29, 1998, Cendant filed an amended Form 10-K for the 1997 fiscal year announcing that Cendant had actually lost $217.2 million in 1997 rather than earning $55.5 million, as previously reported. That announcement caused the price of ABI common stock to drop further to $43 per share by the close of trading. On Oct. 13, 1998, Cendant and ABI announced that they were terminating the merger agreement and that Cendant would pay ABI a $400 million dollar break-up fee, despite the fact that it was not contractually bound to do so. The termination agreement, which was executed the same day, provided that the termination of the merger would not result in liability on the part of Cendant or ABI, or on the part of any of their directors, officers, employees, agents, legal and financial advisers, or shareholders. In response to the news, the price of ABI common stock plummeted to $35.50 per share by the end of the day. The ABI investors were represented in the case by attorneys Andrew Barroway and David Kessler of Schiffrin & Barroway in Bala Cynwyd, Pa.; Arthur N. Abbey, Jill S. Abrams, Stephen J. Fearon Jr. and Nancy Kaboolian of Abbey Gardy & Squitieri in New York; and Allyn Z. Lite, Joseph J. DePalma and Mary Jean Pizza of Lite DePalma Greenberg & Rivas in Newark, N.J. Arguing for Cendant was attorney Samuel Kadet of Skadden Arps Slate Meagher & Flom in New York who was joined on the brief by his partner, Jonathan J. Lerner, and attorneys Michael M. Rosenbaum and Carl Greenberg of Budd Larner Gross Rosenbaum Greenberg & Sade in Short Hills, N.J. Arguing for Forbes and MacLeod was Dennis J. Block of Cadwalader Wickersham & Taft in New York, who was joined on the brief by his partner, Howard R. Hawkins Jr., and attorneys James M. Hirschhorn and Steven S. Radin of Sills Cummis Radin Tischman Epstein & Gross in Newark, N.J.; and Greg A. Danilow and Timothy E. Hoeffner of Weil Gotshal & Manges in New York. Attorney Richard Schaeffer of Dornbush Mensch Mandelstam & Schaeffer in New York argued the appeal for defendant E. Kirk Shelton; and J. Andrew Heaton, an in-house attorney with Ernst & Young also argued. The plaintiffs’ position was supported by an amicus brief from the SEC authored by attorneys Harvey J. Goldschmid, Jacob H. Stillman, Eric Summergrad and Hope Hall Augustini.

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