485 U. S. 224
March 7, 1988
A company known as Basic Inc. made three public denials that it had any plans to merge. But these denials were lies, and it soon merged anyway. Investors who had sold their Basic stock during that time frame sued the company for securities fraud. Under the Securities Exchange act, private investors could recover if they were induced to sell stock due to material misstatements by a company. The Court had to decide whether Basic’s denials were material misstatements.
The Court ruled 4-2 that they were (Rehnquist, Scalia, and Kennedy did not participate). First though, the Court unanimously issued a few parameters for future cases. Blackmun said that something is material if it affects the behavior of a reasonable investor. He rejected the argument that merger talks were not material until finalized, because potential mergers certainly did affect stock prices. But Blackmun also rejected the argument that any lie was material, since some lies truly are harmless in the investing world. He ultimately concluded that courts should look, on a case by case basis, at the probability of the merger, and the importance of the merger.
Then, Blackmun said that the case could go forward with a presumption that the stockholders had been defrauded by the misstatements about the merger. Because stock price is dependent on common knowledge of facts, widely spread lies will result in a stock price which is inaccurate – a sort of fraud on the market. But this presumption was rebuttable – Basic could prove that the misstatements did not actually affect stock price, or that everyone really knew the denials were false.
White, joined by O’Connor, took issue with giving the investors a presumption that they had been defrauded. He objected that the fraud-on-the-market theory was judicial activism, and contrary to the intent of Congress so far as legislative material disclosed. He also did not think that inaccurately priced stock even was a fraud on the market, since stock trading is all about finding over- or under-priced stocks. Finally, White noted that Basic stock actually increased during the time period when the denials were issued, and found it baffling that the investors could even claim to have been ‘defrauded’. He predicted that unscrupulous investors would eventually be able to game the system.
I was immediately sympathetic to Blackmun’s opinion – companies ought to be held accountable for lying to stockholders. Telling the same lie three times felt like something straight out of the Bible! But then I read White’s opinion, and was won over. He was right that the cure prescribed by the majority ended up being worse than the disease. And if it weren’t for all the asinine recusals, his dissent probably would have been the majority opinion too.