On 6 November 2019, the United States Court of Appeals for the Second Circuit (the Court) issued a summary order in In re Eaton Corporation Securities Litigation in favor of Eaton Corporation PLC (Eaton) and two of its officers (collectively, the Defendants), affirming the holding of the United States District Court for the Southern District of New York on a motion for summary judgment.

Several pension plans, retirement trusts and individual stockholders (collectively, Plaintiffs) had brought a securities litigation action under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, alleging that Defendants intentionally misrepresented and omitted material information to the detriment of the stockholders and the stock price in connection with comments related to a spin-off of its automotive division.

In 2012, Eaton, a vehicle component manufacturer, formerly based in the US, inverted to Ireland via a merger with and into Cooper Industries PLC, an electrical products manufacturer, based in Ireland, and reincorporated the merged entity in Ireland. The merger was subject to the inversion rules under section 7874, which were properly disclosed to Eaton shareholders and investors.

After the merger, the resulting Irish entity would continue to be treated as a foreign corporation for US federal income tax purposes under section 7874(b) because former Eaton shareholders received less than 80% of the surviving entity in the merger. However, under section 7874(a), the surviving entity would be restricted in the use of its tax attributes to offset any inversion gain because the former Eaton shareholders received at least a 60% interest in the surviving entity. The term “inversion gain” generally means the income or gain recognized by reason of the transfer of stock or property by inverted entity during the 10-year period following the merger. (See section 7874(d)(1) and (2)). Eaton did not expect to have any inversion gain as a result of the merger because the merger qualified as a reorganization under section 368(a)(2)(E) (see also section 361(c)). Although the shareholders recognized gain under section 367(a) and Treas. Reg. 1.367(a)-3(c)(1)(1)(i), such gain was not treated as inversion gain. Instead, such inversion gain could result if Eaton itself recognized any gain, including if it sold or divested of any stock or property during the ten-year period following the merger.

Generally, section 355 allows a corporation to spin off a division to its shareholders on a tax-free basis without recognition of gain, provided certain requirements are satisfied. One of these requirements is that both the controlled corporation and the distributing corporation must be engaged in an active trade or business immediately following the spin-off, the trade or business had been actively conducted throughout a five-year period preceding the spin-off, and the trade or business was not acquired within such period in a transaction in which gain or loss was recognized, in whole or in part. (See section 355(b)(2)). Because Eaton’s shareholders recognized gain under section 367(a) as a result of the merger, Eaton could not technically satisfy the active trade or business requirement and it would have recognized gain (or loss) if it spun-off a part of its business during a five-year period following the merger.

The Plaintiffs sued the Defendants in the United States District Court for the Southern District of New York asserting that Eaton’s CEO misled investors about the possibility that Eaton could divest its vehicle business after the merger, including in a potential tax-free spin-off. There was in fact speculation after the merger that Eaton would spin-off the automotive division. However, on calls with investors in 2012 and 2013 as well as in proxy statements during this period, the CEO repeatedly reiterated that it had no plans to divest of its vehicle business and that “there [was] nothing structural in [its] deal structure or any of [its] covenants that … would prevent [it] from making changes to [its] portfolio.” The CEO provided a similar response when asked by an investor whether Eaton “would be precluded by any element of the tax structure of the deal to spin off” its vehicle business.

In 2014, two years after the inversion, Eaton’s CEO stated that it could not undertake a tax-free spin-off for five years following the merger. As a result, Eaton’s shares fell by 8%. The Plaintiffs argued that Eaton omitted information regarding Eaton’s ability to conduct a tax-free spin-off after the merger.

In order to avoid dismissal under Section 10(b) and Rule 10b-5 a complaint must plausibly allege all of the following:

(1) a material misrepresentation or omission;

(2) scienter;

(3) a connection with the purchase or sale of a security;

(4) reliance;

(5) economic loss; and

(6) loss causation.

The Court systematically reviewed ten alleged misrepresentations or omissions in the Plaintiffs’ complaint and concluded that no material misrepresentation or omission occurred (the Court did not reach conclusions on the other elements of the claim).

Despite the fact that Eaton’s stock fell by 8% in 2014 after the CEO’s announcement, the Court found that there was no material misrepresentation at any time, stating that Eaton’s CEO:

[H]ad no obligation to provide tax information about an action Eaton had no intention of taking. And there was no inaccuracy in his statement that Eaton saw no “strong case” to divest. Eaton, at all times, retained the option to divest and was not strictly prevented from doing so, even in the face of an increased tax burden.

The Court cited precedent holding that an alleged misrepresentation is material only if there is a substantial likelihood that a reasonable person would consider it important in deciding whether to buy or sell stock. In relation to this particular case, the Court held that an omission is actionable under the securities laws only when the corporation is subject to a duty to disclose the omitted facts, and a company has no duty to disclose information merely because a reasonable investor would like to know. Further, the Court held that securities laws do not create an affirmative duty to disclose any and all material information. Ultimately, the Court found that the Plaintiffs did not make any false statements and did not omit any material information because the Company did not have to divest its automotive business, did not state it would actually divest it, and still could have done so, albeit not on a tax-free basis.

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