In re Digital Island Securities Litigation

• Decision Date: 06 February 2004
• Docket Number: No. 03-1055.,03-1055.
• Citation: 357 F.3d 322
• Parties: In re: DIGITAL ISLAND SECURITIES LITIGATION William Blair Massey, Lead Plaintiff as representative of a class consisting of all holders of the common stock of Digital Island, INC., Appellant.
• Court: U.S. Court of Appeals — Third Circuit

357 F.3d 322

In re: DIGITAL ISLAND SECURITIES LITIGATION

William Blair Massey, Lead Plaintiff

as representative of a class consisting of all holders of the common stock of Digital Island, INC., Appellant.

No. 03-1055.

United States Court of Appeals, Third Circuit.

Argued November 4, 2003.

February 6, 2004.

COPYRIGHT MATERIAL OMITTED

Jeffrey G. Smith, Robert Abrams [Argued], Wolf, Haldenstein, Adler, Freeman & Herz, New York, Pamela S. Tikellis, Chimicles & Tikellis, Wilmington, for Appellants.

Jerrold J. Ganzfried [Argued], Mark D. Wegener, Howrey, Simon, Arnold & White, Washington, Philip A. Rovner, Potter, Anderson & Corroon, Wilmington, for Appellees.

Before McKEE, SMITH, and WEIS, Circuit Judges.

OPINION

SMITH, Circuit Judge.

This securities class action lawsuit arises out of the acquisition of Digital Island, Inc. by Cable & Wireless, PLC ("C & W"). Pursuant to a May 14, 2001 Merger Agreement between Digital Island and C & W, Dali Acquisition Corp. ("Dali"), a wholly-owned subsidiary of C & W, made a cash tender offer to shareholders of Digital Island under which it acquired 80 percent of the shares of Digital Island. Dali was thereafter merged into Digital Island, which survived as a wholly-owned subsidiary of C & W.

Plaintiffs filed a Consolidated Amended Class Action Complaint (the "Complaint") on May 15, 2002. Plaintiffs in this case represent a class comprised of all persons, other than the named defendants and certain related parties, who owned Digital Island common stock during the relevant period and who received the tender offer.¹ Defendants are Digital Island, members of Digital Island's Board of Directors during the relevant time period, including Digital Island's CEO, Ruann Ernst (the "Directors"),² C & W, C & W's CEO, Graham Wallace,³ and Dali. Plaintiffs allege that, in connection with the tender offer, Defendants made misleading statements and failed to disclose material information in violation of Section 14(e) of the Securities and Exchange Act of 1934 (the "'34 Act"), as amended by the Williams Act of 1968. 15 U.S.C. § 78n(e). Plaintiffs further allege that the Directors received "extra consideration" for their shares in violation of Section 14(d)(7) of the '34 Act, 15 U.S.C. § 78n(d)(7), and Securities and Exchange Commission ("SEC") Rule 14d-10, the so-called "Best Price Rule," 17 C.F.R. § 240.14d-10(a). Plaintiffs allege both individual violations by Defendants of these provisions, as well as "control person liability" under Section 20(a) of the '34 Act. 15 U.S.C. § 78t(a).

The District Court dismissed Plaintiffs' consolidated amended complaint, with prejudice, for failure to state a claim pursuant to Fed.R.Civ.P. 12(b)(6) and the Private Securities Litigation Reform Act of 1995 (the "PSLRA"), 15 U.S.C. § 78u-4. In re Digital Island Sec. Litig., 223 F.Supp.2d 546 (D.Del.2002). By a subsequent order, the District Court denied Plaintiffs' motion, pursuant to Fed. R.Civ.P. 59(e), which sought to alter the court's judgment and to permit Plaintiffs to file an amended complaint under Fed. R.Civ.P. 15(a). Because we conclude that Plaintiffs' proposed Second Consolidated Amended Class Action Complaint (the "proposed amended Complaint") does not articulate a viable theory of fraud, we will affirm both orders of the District Court.

I.

The following facts are drawn from the proposed amended Complaint and from Digital Island's Securities and Exchange Commission ("SEC") Form 14D-9, which is referenced in the proposed amended Complaint and included in the Joint Appendix. See Oran v. Stafford, 226 F.3d 275, 289 (3d Cir.2000) (taking judicial notice of documents required by law to be filed with the SEC). Digital Island provides a global e-business delivery network and suite of services for enterprises that use the internet to deploy business applications and conduct e-commerce. Digital Island began searching for a potential acquirer in August of 2000, at which time representatives of Digital Island contacted representatives of C & W to gauge C & W's interest in a strategic partnership with Digital Island. In March of 2001, C & W indicated that it was interested in a potential business combination with Digital Island. In April of 2001, C & W delivered an initial draft of the Merger Agreement and made an initial offer to purchase Digital Island for $2.25 a share. After considering the offer and meeting with its financial advisors, Digital Island advised C & W that it was prepared to begin negotiations, provided that the offer price was increased to at least $3.25.

Negotiations between Digital Island and C & W continued through April and into May, but C & W would not agree to raise its offer to $3.25 per share. On May 10, 2001, Digital Island announced an agreement to provide certain business services to Microsoft Corporation. The price of Digital Island's stock rose that day from $2.00 per share to $3.69 per share. On May 11, 2001, representatives of C & W indicated that C & W's board of directors had preliminarily approved an offer of $3.40 per share.⁴ Digital Island made a counter-proposal of $4.10 per share, which was rejected by C & W. On May 13, 2001, the Digital Island board met and voted unanimously to approve the execution of the Merger Agreement with a per share tender offer price of $3.40 and to recommend to the shareholders that they accept the tender offer.

On May 14, 2001, Digital Island and C & W executed the Merger Agreement, which contemplated a first step tender offer followed by a second step merger. Under the tender offer, shareholders who tendered their shares were to receive $3.40 per share. Under the merger, all remaining shares of Digital Island would be canceled, and shareholders would receive $3.40 per share. The tender offer period expired on June 18, 2001, and on June 19, 2001, Digital Island announced that approximately 80 percent of its outstanding stock had been tendered.

Plaintiffs' Section 14(e) claim is based on two significant business deals that were announced immediately after the expiration of the tender offer. On June 20, 2001, Digital Island announced a major business agreement with Bloomberg LP, and on July 2, 2001, Digital Island announced another major business agreement with Major League Baseball ("MLB"). According to Plaintiffs, both the Bloomberg and MLB deals had substantial value to Digital Island, and, if disclosed, would have substantially influenced the shareholders' decision to tender their shares.⁵

Plaintiffs allege that Defendants knew of the Bloomberg and MLB deals prior to expiration of the tender offer, but deliberately or recklessly failed to disclose the deals until after the expiration of the tender offer. Plaintiffs argue that Defendants had an affirmative duty to disclose the Bloomberg and MLB deals, or, alternatively, that Defendants' failure to mention those deals in the tender offer and the Schedule 14D-9 rendered those documents materially misleading. Plaintiffs allege that Defendants were motivated to suppress the Bloomberg and MLB deals because the success of the tender offer and resulting merger created a windfall for Defendants that was not enjoyed by Digital Island's other shareholders. Specifically, Plaintiffs allege that, pursuant to the merger, the Directors received substantial cash payments for outstanding options to purchase Digital Island common stock, as well as for their shares of restricted common stock. Additionally, Plaintiffs allege that CEO Ernst had executed a lucrative contract for employment to serve as President and CEO of the surviving entity.⁶

Such extra consideration was given to Digital Island officers and directors in order to induce them to support the Offer to Purchase at the $3.40 price per share and to withhold the announcement of the Bloomberg and Major League Baseball deals until after the expiration of the Offer to Purchase in order to preclude the need for C & W to increase the consideration in the Offer to Purchase.

App. at 338. According to Plaintiffs, disclosure of the Bloomberg and MLB deals threatened to derail the merger with C & W:

If the announcement induced more than 50 percent of Digital Island stockholders not to tender their shares, the Merger would not be consummated and the Digital Island officers would lose their lucrative employment agreements, as well as the extra consideration for their shares. Thus, any announcement concerning the Bloomberg or Major League Baseball Deals carried with it the threat of undermining the Merger Agreement.

App. at 352.

In addition to their Section 14(e) claim, Plaintiffs allege that, by virtue of these cash payments and the Ernst employment agreement, the Directors received "extra consideration" for their shares in violation of Section 14(d)(7) of the '34 Act and the SEC's Best Price Rule. Plaintiffs allege individual violations by Defendants of Sections 14(e) and the Best Price Rule, as well as "control person liability" under Section 20(a) of the '34 Act.⁷

The District Court dismissed the Complaint on September 10, 2002, for failure to state a claim. The District Court held that Plaintiffs' Section 14(e) claim failed to meet the heightened pleading requirements of the PSLRA in two respects: (1) the Complaint did not identify with specificity the statements that were allegedly misleading, and (2) the Complaint did not plead facts giving rise to a strong inference of scienter. 15 U.S.C. § 78u-4(b). The District Court further held that Plaintiffs failed to state a claim for violation of the Best Price Rule because that provision applies only to payments made during a tender offer, and the extra consideration alleged by Plaintiffs was received pursuant to agreements executed prior to the tender offer. Finally, the District Court dismissed Plaintiffs'"control person liability" claim because (1) the predicate violations on which that claim was based (i.e., the Section 14(e) and Best Price Rule claims) were dismissed, and (2) because P...