Basic, Inc. v. LevinsonAnnotate this Case
485 U.S. 224 (1988)
U.S. Supreme Court
Basic, Inc. v. Levinson, 485 U.S. 224 (1988)
Basic, Inc. v. Levinson
Argued November 2, 1987
Decided March 7, 1988
485 U.S. 224
CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR
THE SIXTH CIRCUIT
The Securities and Exchange Commission's Rule 10b-5, promulgated under § 10(b) of the Securities Exchange Act of 1934 (Act), prohibits, in connection with the purchase or sale of any security, the making of any untrue statement of a material fact or the omission of a material fact that would render statements made not misleading. In December 1978, Combustion Engineering, Inc., and Basic Incorporated agreed to merge. During the preceding two years, representatives of the two companies had various meetings and conversations regarding the possibility of a merger; during that time Basic made three public statements denying that any merger negotiations were taking place or that it knew of any corporate developments that would account for heavy trading activity in its stock. Respondents, former Basic shareholders who sold their stock between Basic's first public denial of merger activity and the suspension of trading in Basic stock just prior to the merger announcement, filed a class action against Basic and some of its directors, alleging that Basic's statements had been false or misleading, in violation of § 10(b) and Rule 10b-5, and that respondents were injured by selling their shares at prices artificially depressed by those statements. The District Court certified respondents' class, but granted summary judgment for petitioners on the merits. The Court of Appeals affirmed the class certification, agreeing that, under a "fraud-on-the-market" theory, respondents' reliance on petitioners' misrepresentations could be presumed, and thus that common issues predominated over questions pertaining to individual plaintiffs. The Court of Appeals reversed the grant of summary judgment and remanded, rejecting the District Court's view that preliminary merger discussions are immaterial as a matter of law, and holding that even discussions that might not otherwise have been material become so by virtue of a statement denying their existence.
1. The standard set forth in TSC Industries, Inc. v. Northway, Inc.,426 U. S. 438, whereby an omitted fact is material if there is a substantial likelihood that its disclosure would have been considered significant by a reasonable investor, is expressly adopted for the § 10(b) and Rule 10b-5 context. Pp. 485 U. S. 230-232.
2. The "agreement-in-principle" test, under which preliminary merger discussions do not become material until the would-be merger partners have reached agreement as to the price and structure of the transaction, is rejected as a bright-line materiality test. Its policy-based rationales do not justify the exclusion of otherwise significant information from the definition of materiality. Pp. 485 U. S. 232-236.
3. The Court of Appeals' view that information concerning otherwise insignificant developments becomes material solely because of an affirmative denial of their existence is also rejected: Rule 10b-5 requires that the statements be misleading as to a
material fact. Pp. 485 U. S. 237-238.
4. Materiality in the merger context depends on the probability that the transaction will be consummated, and its significance to the issuer of the securities. Thus, materiality depends on the facts, and is to be determined on a case-by-case basis. Pp. 485 U. S. 238-241.
5. The courts below properly applied a presumption of reliance, supported in part by the fraud-on-the-market theory, instead of requiring each plaintiff to show direct reliance on Basic's statements. Such a presumption relieves the Rule 10b-5 plaintiff of an unrealistic evidentiary burden, and is consistent with, and supportive of, the Act's policy of requiring full disclosure and fostering reliance on market integrity. The presumption is also supported by common sense and probability: an investor who trades stock at the price set by an impersonal market does so in reliance on the integrity of that price. Because most publicly available information is reflected in market price, an investor's reliance on any public material misrepresentations may be presumed for purposes of a Rule 10b-5 action. Pp. 485 U. S. 241-247.
6. The presumption of reliance may be rebutted: Rule 10b-5 defendants may attempt to show that the price was not affected by their misrepresentation, or that the plaintiff did not trade in reliance on the integrity of the market price. Pp. 485 U. S. 248-249.
786 F.2d 741, vacated and remanded.
BLACKMUN, J., delivered the opinion of the Court, in which BRENNAN, MARSHALL, and STEVENS, JJ., joined, and in Parts I, II, and III of which WHITE and O'CONNOR, JJ., joined. WHITE, J., filed an opinion concurring in part and dissenting in part, in which O'CONNOR, J., joined, post, p. 485 U. S. 250. REHNQUIST, C.J., and SCALIA and KENNEDY, JJ., took no part in the consideration or decision of the case.
JUSTICE BLACKMUN delivered the opinion of the Court.
This case requires us to apply the materiality requirement of § 10(b) of the Securities Exchange Act of 1934 (1934 Act), 48 Stat. 881, as amended, 15 U.S.C. § 78a et seq., and the Securities and Exchange Commission's Rule 10b-5, 17 CFR § 240. 10b-5 (1987), promulgated thereunder, in the context of preliminary corporate merger discussions. We must also determine whether a person who traded a corporation's shares on a securities exchange after the issuance of a materially misleading statement by the corporation may invoke a rebuttable presumption that, in trading, he relied on the integrity of the price set by the market.
Prior to December 20, 1978, Basic Incorporated was a publicly traded company primarily engaged in the business of manufacturing chemical refractories for the steel industry. As early as 1965 or 1966, Combustion Engineering, Inc., a company producing mostly alumina-based refractories, expressed some interest in acquiring Basic, but was deterred from pursuing this inclination seriously because of antitrust concerns it then entertained. See App. 81-83. In 1976, however, regulatory action opened the way to a renewal of
Combustion's interest. [Footnote 1] The "Strategic Plan," dated October 25, 1976, for Combustion's Industrial Products Group included the objective: "Acquire Basic Inc. $30 million." App. 337.
Beginning in September, 1976, Combustion representatives had meetings and telephone conversations with Basic officers and directors, including petitioners here, [Footnote 2] concerning the possibility of a merger. [Footnote 3] During 1977 and 1978, Basic made three public statements denying that it was engaged in merger negotiations. [Footnote 4] On December 18, 1978, Basic asked
the New York Stock Exchange to suspend trading in its shares and issued a release stating that it had been "approached" by another company concerning a merger. Id. at 413. On December 19, Basic's board endorsed Combustion's offer of $46 per share for its common stock, id. at 335, 414-416, and on the following day publicly announced its approval of Combustion's tender offer for all outstanding shares.
Respondents are former Basic shareholders who sold their stock after Basic's first public statement of October 21, 1977, and before the suspension of trading in December, 1978. Respondents brought a class action against Basic and its directors, asserting that the defendants issued three false or misleading public statements, and thereby were in violation of § 10(b) of the 1934 Act and of Rule 10b-5. Respondents alleged that they were injured by selling Basic shares at artificially depressed prices in a market affected by petitioners' misleading statements and in reliance thereon.
The District Court adopted a presumption of reliance by members of the plaintiff class upon petitioners' public statements that enabled the court to conclude that common questions of fact or law predominated over particular questions pertaining to individual plaintiffs. See Fed.Rule Civ.Proc. 23(b)(3). The District Court therefore certified respondents' class. [Footnote 5] On the merits, however, the District Court granted
summary judgment for the defendants. It held that, as a matter of law, any misstatements were immaterial: there were no negotiations ongoing at the time of the first statement, and although negotiations were taking place when the second and third statements were issued, those negotiations were not "destined, with reasonable certainty, to become a merger agreement in principle." App. to Pet. for Cert. 103a.
The United States Court of Appeals for the Sixth Circuit affirmed the class certification, but reversed the District Court's summary judgment, and remanded the case. 786 F.2d 741 (1986). The court reasoned that, while petitioners were under no general duty to disclose their discussions with Combustion, any statement the company voluntarily released could not be "so incomplete as to mislead.'" Id. at 746, quoting SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 862 (CA2 1968) (en banc), cert. denied sub nom. Coates v. SEC, 394 U.S. 976 (1969). In the Court of Appeals' view, Basic's statements that no negotiations were taking place, and that it knew of no corporate developments to account for the heavy trading activity, were misleading. With respect to materiality, the court rejected the argument that preliminary merger discussions are immaterial as a matter of law, and held that,
"once a statement is made denying the existence of any discussions, even discussions that might not have been material in absence of the denial, are material because they make the statement made untrue."
786 F.2d at 749.
The Court of Appeals joined a number of other Circuits in accepting the "fraud-on-the-market theory" to create a rebuttable presumption that respondents relied on petitioners' material
misrepresentations, noting that, without the presumption, it would be impractical to certify a class under Federal Rule of Civil Procedure 23(b)(3). See 786 F.2d at 750-751.
We granted certiorari, 479 U.S. 1083 (1987), to resolve the split, see Part III, infra, among the Courts of Appeals as to the standard of materiality applicable to preliminary merger discussions, and to determine whether the courts below properly applied a presumption of reliance in certifying the class, rather than requiring each class member to show direct reliance on Basic's statements.
The 1934 Act was designed to protect investors against manipulation of stock prices. See S.Rep. No. 792, 73d Cong., 2d Sess., 1-5 (1934). Underlying the adoption of extensive disclosure requirements was a legislative philosophy:
"There cannot be honest markets without honest publicity. Manipulation and dishonest practices of the market place thrive upon mystery and secrecy."
H.R.Rep. No. 1383, 73d Cong., 2d Sess., 11 (1934). This Court "repeatedly has described the fundamental purpose' of the Act as implementing a `philosophy of full disclosure.'" Santa Fe Industries, Inc. v. Green,430 U. S. 462, 430 U. S. 477-478 (1977), quoting SEC v. Capital Gains Research Bureau, Inc.,375 U. S. 180, 375 U. S. 186 (1963).
Pursuant to its authority under § 10(b) of the 1934 Act, 15 U.S.C. § 78j, the Securities and Exchange Commission promulgated Rule 10b-5. [Footnote 6] Judicial interpretation and application,
legislative acquiescence, and the passage of time have removed any doubt that a private cause of action exists for a violation of § 10(b) and Rule 10b-5, and constitutes an essential tool for enforcement of the 1934 Act's requirements. See, e.g., Ernst & Ernst v. Hochfelder,425 U. S. 185, 425 U. S. 196 (1976); Blue Chip Stamps v. Manor Drug Stores,421 U. S. 723, 421 U. S. 730 (1975).
The Court previously has addressed various positive and common law requirements for a violation of § 10(b) or of Rule 10b-5. See, e.g., Santa Fe Industries, Inc. v. Green, supra, ("manipulative or deceptive" requirement of the statute); Blue Chip Stamps v. Manor Drug Stores, supra, ("in connection with the purchase or sale" requirement of the Rule); Dirks v. SEC,463 U. S. 646 (1983) (duty to disclose); Chiarella v. United States,445 U. S. 222 (1980) (same); Ernst & Ernst v. Hochfelder, supra, (scienter). See also Carpenter v. United States,484 U. S. 19 (1987) (confidentiality). The Court also explicitly has defined a standard of materiality under the securities laws, see TSC Industries, Inc. v. Northway, Inc.,426 U. S. 438 (1976), concluding in the proxy-solicitation context that "[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote." Id. at 426 U. S. 449. [Footnote 7] Acknowledging that certain information concerning corporate developments could well be of "dubious significance," id. at 426 U. S. 448, the Court was careful not to set too low a standard of materiality; it was concerned that a minimal standard might bring an overabundance of information within its reach, and lead management "simply to bury the shareholders in an avalanche of trivial information -- a result that is hardly conducive to informed decisionmaking." Id. at 426 U. S. 448-449. It further explained that, to fulfill the materiality requirement,
"there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the
reasonable investor as having significantly altered the 'total mix' of information made available."
The application of this materiality standard to preliminary merger discussions is not self-evident. Where the impact of the corporate development on the target's fortune is certain and clear, the TSC Industries materiality definition admits straightforward application. Where, on the other hand, the event is contingent or speculative in nature, it is difficult to ascertain whether the "reasonable investor" would have considered the omitted information significant at the time. Merger negotiations, because of the ever-present possibility that the contemplated transaction will not be effectuated, fall into the latter category. [Footnote 9]
Petitioners urge upon us a Third Circuit test for resolving this difficulty. [Footnote 10] See Brief for Petitioners 20-22. Under this
approach, preliminary merger discussions do not become material until "agreement-in-principle" as to the price and structure of the transaction has been reached between the would-be merger partners. See Greenfield v. Heublein, Inc., 742 F.2d 751, 757 (CA3 1984), cert. denied, 469 U.S. 1215 (1985). By definition, then, information concerning any negotiations not yet at the agreement-in-principle stage could be withheld or even misrepresented without a violation of Rule 10b-5.
Three rationales have been offered in support of the "agreement-in-principle" test. The first derives from the concern expressed in TSC Industries that an investor not be overwhelmed by excessively detailed and trivial information, and focuses on the substantial risk that preliminary merger discussions may collapse: because such discussions are inherently tentative, disclosure of their existence itself could mislead investors and foster false optimism. See Greenfield v. Heublein, Inc., 742 F.2d at 756; Reiss v. Pan American World Airways, Inc., 711 F.2d 11, 14 (CA2 1983). The other two justifications for the agreement-in-principle standard are based on management concerns: because the requirement of "agreement-in-principle" limits the scope of disclosure obligations, it helps preserve the confidentiality of merger discussions where earlier disclosure might prejudice the negotiations; and the test also provides a usable, bright-line rule for determining when disclosure must be made. See Greenfield v. Heublein, Inc., 742 F.2d at 757; Flamm
v. Eberstadt, 814 F.2d 1169, 1176-1178 (CA7), cert. denied, 484 U.S. 853 (1987).
None of these policy-based rationales, however, purports to explain why drawing the line at agreement-in-principle reflects the significance of the information upon the investor's decision. The first rationale, and the only one connected to the concerns expressed in TSC Industries, stands soundly rejected, even by a Court of Appeals that otherwise has accepted the wisdom of the agreement-in-principle test. "It assumes that investors are nitwits, unable to appreciate -- even when told -- that mergers are risky propositions up until the closing." Flamm v. Eberstadt, 814 F.2d at 1175. Disclosure, and not paternalistic withholding of accurate information, is the policy chosen and expressed by Congress. We have recognized time and again, a "fundamental purpose" of the various Securities Acts, "was to substitute a philosophy of full disclosure for the philosophy of caveat emptor, and thus to achieve a high standard of business ethics in the securities industry." SEC v. Capital Gains Research Bureau, Inc., 375 U.S. at 375 U. S. 186. Accord, Affiliated Ute Citizens v. United States,406 U. S. 128, 406 U. S. 151 (1972); Santa Fe Industries, Inc. v. Green, 430 U.S. at 406 U. S. 477. The role of the materiality requirement is not to "attribute to investors a child-like simplicity, an inability to grasp the probabilistic significance of negotiations," Flamm v. Eberstadt, 814 F.2d at 1175, but to filter out essentially useless information that a reasonable investor would not consider significant, even as part of a larger "mix" of factors to consider in making his investment decision. TSC Industries, Inc. v. Northway, Inc., 426 U.S. at 426 U. S. 448-449.
The second rationale, the importance of secrecy during the early stages of merger discussions, also seems irrelevant to an assessment whether their existence is significant to the trading decision of a reasonable investor. To avoid a "bidding war" over its target, an acquiring firm often will insist that negotiations remain confidential, see, e.g., In re Carnation
Co., Exchange Act Release No. 22214, 33 S.E. C. Docket 1025 (1985), and at least one Court of Appeals has stated that "silence pending settlement of the price and structure of a deal is beneficial to most investors, most of the time." Flamm v. Eberstadt, 814 F.2d at 1177. [Footnote 11]
We need not ascertain, however, whether secrecy necessarily maximizes shareholder wealth -- although we note that the proposition is at least disputed as a matter of theory and empirical research [Footnote 12] -- for this case does not concern the timing of a disclosure; it concerns only its accuracy and completeness. [Footnote 13] We face here the narrow question whether information concerning the existence and status of preliminary merger discussions is significant to the reasonable investor's trading decision. Arguments based on the premise that some disclosure would be "premature" in a sense are more properly considered under the rubric of an issuer's duty to disclose. The "secrecy" rationale is simply inapposite to the definition of materiality.
The final justification offered in support of the agreement-in-principle test seems to be directed solely at the comfort of corporate managers. A bright-line rule indeed is easier to follow than a standard that requires the exercise of judgment in the light of all the circumstances. But ease of application alone is not an excuse for ignoring the purposes of the Securities Acts and Congress' policy decisions. Any approach that designates a single fact or occurrence as always determinative of an inherently fact-specific finding such as materiality must necessarily be overinclusive or under-inclusive. In TSC Industries, this Court explained:
"The determination [of materiality] requires delicate assessments of the inferences a 'reasonable shareholder' would draw from a given set of facts and the significance of those inferences to him. . . ."
426 U.S. at 426 U. S. 450. After much study, the Advisory Committee on Corporate Disclosure cautioned the SEC against administratively confining materiality to a rigid formula. [Footnote 14] Courts also would do well to heed this advice.
We therefore find no valid justification for artificially excluding from the definition of materiality information concerning merger discussions, which would otherwise be considered significant to the trading decision of a reasonable investor, merely because agreement-in-principle as to price and structure has not yet been reached by the parties or their representatives.
The Sixth Circuit explicitly rejected the agreement-in-principle test, as we do today, but in its place adopted a rule that, if taken literally, would be equally insensitive, in our view, to the distinction between materiality and the other elements of an action under Rule 10b-5:
"When a company whose stock is publicly traded makes a statement, as Basic did, that 'no negotiations' are underway, and that the corporation knows of 'no reason for the stock's activity,' and that 'management is unaware of any present or pending corporate development that would result in the abnormally heavy trading activity,' information concerning ongoing acquisition discussions becomes material by virtue of the statement denying their existence. . . ."
"* * * *"
". . . In analyzing whether information regarding merger discussions is material such that it must be affirmatively disclosed to avoid a violation of Rule 10b-5, the discussions and their progress are the primary considerations. However, once a statement is made denying the existence of any discussions, even discussions that might not have been material in absence of the denial are material because they make the statement made untrue."
786 F.2d at 748-749 (emphasis in original). [Footnote 15]
This approach, however, fails to recognize that, in order to prevail on a Rule 10b-5 claim, a plaintiff must show that the statements were misleading as to a material fact. It is not enough that a statement is false or incomplete, if the misrepresented fact is otherwise insignificant.
Even before this Court's decision in TSC Industries, the Second Circuit had explained the role of the materiality requirement of Rule 10b-5, with respect to contingent or speculative information or events, in a manner that gave that term meaning that is independent of the other provisions of the Rule. Under such circumstances, materiality
"will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity."
SEC v. Texas Gulf Sulphur Co., 401 F.2d at 849. Interestingly, neither the Third Circuit decision adopting the agreement-in-principle test nor petitioners here take issue with this general standard. Rather, they suggest that, with respect to preliminary merger discussions, there are good reasons to draw a line at agreement on price and structure.
In a subsequent decision, the late Judge Friendly, writing for a Second Circuit panel, applied the Texas Gulf Sulphur probability/magnitude approach in the specific context of preliminary merger negotiations. After acknowledging that materiality is something to be determined on the basis of the particular facts of each case, he stated:
"Since a merger in which it is bought out is the most important event that can occur in a small corporation's life, to-wit, its death, we think that inside information, as regards a merger of this sort, can become material at an earlier stage than would be the case as regards lesser transactions -- and this even though the mortality rate of mergers in such formative stages is doubtless high."
SEC v. Geon Industries, Inc., 531 F.2d 39, 47-48 (1976).
We agree with that analysis. [Footnote 16]
Whether merger discussions in any particular case are material therefore depends on the facts. Generally, in order to assess the probability that the event will occur, a factfinder will need to look to indicia of interest in the transaction at the highest corporate levels. Without attempting to catalog all such possible factors, we note by way of example that board resolutions, instructions to investment bankers, and actual negotiations between principals or their intermediaries may serve as indicia of interest. To assess the magnitude of the transaction to the issuer of the securities allegedly manipulated, a factfinder will need to consider such facts as the size of the two corporate entities and of the potential premiums over market value. No particular event or factor short of closing the transaction need be either necessary or sufficient by itself to render merger discussions material. [Footnote 17]
As we clarify today, materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information. [Footnote 18] The fact-specific inquiry we endorse here is consistent with the approach a number of courts have taken in assessing the materiality of merger negotiations. [Footnote 19] Because the standard of materiality we have
adopted differs from that used by both courts below, we remand the case for reconsideration of the question whether a grant of summary judgment is appropriate on this record. [Footnote 20]
We turn to the question of reliance and the fraud-on-the-market theory. Succinctly put:
"The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company's stock is determined by the available material information regarding the company and its business. . . . Misleading statements will therefore
defraud purchasers of stock even if the purchasers do not directly rely on the misstatements. . . . The causal connection between the defendants' fraud and the plaintiffs' purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations."
Peil v. Speiser, 806 F.2d 1154, 1160-1161 (CA3 1986). Our task, of course, is not to assess the general validity of the theory, but to consider whether it was proper for the courts below to apply a rebuttable presumption of reliance, supported in part by the fraud-on-the-market theory. Cf. the comments of the dissent, post at 485 U. S. 252-255.
This case required resolution of several common questions of law and fact concerning the falsity or misleading nature of the three public statements made by Basic, the presence or absence of scienter, and the materiality of the misrepresentations, if any. In their amended complaint, the named plaintiffs alleged that, in reliance on Basic's statements, they sold their shares of Basic stock in the depressed market created by petitioners. See Amended Complaint in No. C79-1220 (ND Ohio),