BUSINESS LAW - CORPORATE RIGHTS CASE

Corporate Law and Economics

Economics – MSPE

Martin K. Perry

Summer 2020

Course Packet – Corporate Duties and Statements

Laidlaw v. Organ (1817) – Caveat Emptor (Buyer Beware) Page 2

Basic, Inc. v. Levinson (1988) – Materiality Page 6

In Re: Donald J. Trump Casino Securities Litigation (1993) Page 18

Dirks v. Securities and Exchange Commission (1983) Page 27

United States, Petitioner v. James Herman O’Hagan (1997) Page 34

Laidlaw v. Organ

U.S. Supreme Court

15 U.S. (2 Wheat.) 178 (1817)

Error to the District Court for the Louisiana District

The defendant in error [buyer Organ] filed his petition or libel in the court below, stating that on 18 February, 1815, he purchased of the plaintiffs in error [seller Laidlaw] one hundred and eleven hogsheads of tobacco, as appeared by the copy of a bill of parcels annexed, and that the same were delivered to him by the said Laidlaw & Co., and that he was in the lawful and quiet possession of the said tobacco, when, on the 20th day of the said month, the said Laidlaw & Co., by force and of their own wrong, took possession of the same and unlawfully withheld the same from the petitioner notwithstanding he was at all times, and still was, ready to do and perform all things on his part stipulated to be done and performed in relation to said purchase, and had actually tendered to the said Laidlaw & Co. bills of exchange for the amount of the purchase money, agreeably to the said contract, to his damage, &c.

Wherefore the petition prayed that the said Laidlaw & Co. might be cited to appear and answer to his plaint and that judgment might be rendered against them for his damages, &c. And inasmuch as the petitioner did verily believe that the said one hundred and eleven hogsheads of tobacco would be removed, concealed, or disposed of by the said Laidlaw & Co., he prayed that a writ of sequestration might issue and that the same might be sequestered in the hands of the marshal to abide the judgment of the court, and that the said one hundred and eleven hogsheads of tobacco might be finally adjudged to the petitioner, together with his damages, &c., and costs of suit, and that the petitioner might have such other and further relief as to the court should seem meet, &c.

The bill of parcels referred to in the petition was in the following words and figures, to-wit:

"Mr. Organ bought of Peter Laidlaw & Co. 111 hhds. Tobacco, weighing 120,715 pounds n't. -- fr. $7,544.69."

"New Orleans, 18 February, 1815"

On 21 February, 1815, a citation to the said Laidlaw & Co. was issued, and a writ of sequestration, by order of the court, to the marshal, commanding him to sequester 111 hogsheads of tobacco in their possession, and the same so sequestered to take into his (the marshal's) possession, and safely keep, until the further order of the court; which was duly executed by the marshal. And on 2 March, 1815, counsel having been heard in the case, it was ordered that the petitioner enter into a bond or stipulation, with sufficient sureties in the sum of $1,000, to the said Laidlaw & Co., to indemnify them for the damages which they might sustain in consequence of prosecuting the writ of sequestration granted in the case.

On 22 March, 1815, the plaintiffs in error [seller Laidlaw] filed their answer stating that they had no property in the said tobacco claimed by the said petitioner or ownership whatever in the same, nor had they at any time previous to the bringing of said suit, but disclaimed all right, title, interest, and claim to the said tobacco, the subject of the suit. And on the same day, Messrs. Boorman & Johnston filed their bill of interpleader or intervention stating that the petitioner [buyer Organ] having brought his suit and filed his petition, claiming of the said Laidlaw & Co. 111 hogsheads of tobacco, for which he had obtained a writ of sequestration when, in truth, the said tobacco belonged to the said Boorman & Johnston, and was not the property of the said Laidlaw & Co., and praying that they, the said Boorman & Johnston, might be admitted to defend their right, title, and claim, to the said tobacco against the claim and pretensions of the petitioner, the justice of whose claim, under the sale as stated in his petition, was wholly denied, and that the said tobacco might be restored to them, &c.

On 20 April, 1815, the cause was tried by a jury, who returned the following verdict, to-wit: "The jury finds for the plaintiff for the tobacco named in the petition, without damages, payable as per contract." Whereupon the court rendered judgment:

"That the plaintiff recover of the said defendants the said 111 hogsheads of tobacco, mentioned in the plaintiff's petition, and sequestered in this suit, with his costs of suit to be taxed, and ordered that the marshal deliver the said tobacco to the said plaintiff and that he have execution for his costs aforesaid upon the said plaintiff's depositing in this court his bills of exchange for the amount of the purchase money endorsed, &c., for the use of the defendants, agreeably to the verdict of the jury."

On 29 April, 1815, the plaintiffs in error filed the following bill of exceptions, to-wit:

"Be it remembered that on 20 April in the year of our Lord, 1815, the above cause came on for trial before a jury duly sworn and empanelled, the said Peter Laidlaw & Co. having filed a disclaimer, and Boorman and Johnston of the City of New York, having filed their claim. And now the said Hector M. Organ having closed his testimony, the said claimants, by their counsel, offered Francis Girault, one of the above firm of Peter Laidlaw & Co., as their witness; whereupon the counsel for the plaintiff objected to his being sworn, on the ground of his incompetency.

The claimants proved that Peter Laidlaw & Co., before named, were, at the date of the transaction which gave rise to the above suit, commission merchants, and were then known in the City of New Orleans as such, and that it is invariably the course of trade in said city for commission merchants to make purchases and sales in their own names for the use of their employers, upon which the claimants again urged the propriety of suffering the said Francis Girault to be sworn, it appearing in evidence that the contract was made by Organ, the plaintiff, with said Girault, one of the said firm of Peter Laidlaw & Co. in their own name, and there being evidence that factors and commission merchants do business on their own account as well as for others, and there being no evidence that the plaintiff, at the time of the contract, had any knowledge of the existence of any other interest in the said tobacco, except that of the defendants, Peter Laidlaw & Co.

The court sustained the objection, and rejected the said witness. To which decision of the court the counsel for the claimants aforesaid begged leave to except, and prayed that this bill of exceptions might be signed and allowed. And it appearing in evidence in the said cause that on the night of 18 February, 1815, Messrs. Livingston, White, and Shepherd brought from the British fleet the news that a treaty of peace had been signed at Ghent by the American and British commissioners, contained in a letter from Lord Bathurst to the Lord Mayor of London, published in the British newspapers, and that Mr. White caused the same to be made public in a handbill on Sunday morning, 8 o'clock, 18 February, 1815, and that the brother of Mr. Shepherd, one of these gentlemen, and who was interested in one-third of the profits of the purchase set forth in said plaintiff's petition, had, on Sunday morning, 19 February, 1815, communicated said news to the plaintiff; that the said plaintiff, on receiving said news, called on Francis Girault (with whom he had been bargaining for the tobacco mentioned in the petition, the evening previous), said Francis Girault being one of the said house of trade of Peter Laidlaw & Co., soon after sunrise on the morning of Sunday, 19 February, 1815, before he had heard said news. Said Girault asked if there was any news which was calculated to enhance the price or value of the article about to be purchased, and that the said purchase was then and there made, and the bill of parcels annexed to the plaintiff's petition delivered to the plaintiff between 8 and 9 o'clock in the morning of that day, and that in consequence of said news the value of said article had risen from 30 to 50 percent.

There being no evidence that the plaintiff had asserted or suggested anything to the said Girault calculated to impose upon him with respect to said news and to induce him to think or believe that it did not exist, and it appearing that the said Girault, when applied to, on the next day, Monday, 20 February, 1815, on behalf of the plaintiff, for an invoice of said tobacco, did not then object to the said sale, but promised to deliver the invoice to the said plaintiff in the course of the forenoon of that day; the court charged the jury to find for the plaintiff. Wherefore, that justice, by due course of law, may be done in this case, the counsel of said defendants, for them, and on their behalf, prays the court that this bill of exceptions be filed, allowed, and certified as the law directs."

"DOMINICK A. HALL, District Judge"

"New Orleans, 3 May, 1815"

On 29 April, 1815, a writ of error was allowed to this Court, and on 3 May, 1815, the defendant in error deposited in the court below, for the use of the plaintiffs in error, the bills of exchange mentioned in the pleadings, according to the verdict of the jury and the judgment of the court thereon, which bills were thereupon taken out of court by the plaintiffs in error.

MR. CHIEF JUSTICE MARSHALL delivered the opinion of the Court.

The question in this case is whether the intelligence of extrinsic circumstances, which might influence the price of the commodity and which was exclusively within the knowledge of the vendee [buyer Organ], ought to have been communicated by him to the vendor [seller Laidlaw]. The Court is of opinion that he [Organ] was not bound to communicate it. It would be difficult to circumscribe the contrary doctrine within proper limits where the means of intelligence are equally accessible to both parties. But at the same time, each party must take care not to say or do anything tending to impose upon the other.

The Court thinks that the absolute instruction of the judge was erroneous, and that the question, whether any imposition was practiced by the vendee [buyer Organ] upon the vendor [seller Laidlaw] ought to have been submitted to the jury. For these reasons, the judgment must be reversed and the cause remanded to the District Court of Louisiana with directions to award a venire facias de novo.

Venire de novo awarded. [New trial by jury]

Basic, Inc. v. Levinson

U.S. Supreme Court

485 U.S. 224

Argued November 2, 1987

Decided March 7, 1988

Certiorari to the United States Court of Appeals for the Sixth Circuit

Justice Blackmun delivered the opinion of the Court.

The Chief Justice, Justice Scalia, and Justice Kennedy took no part in the consideration or decision of this case.

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.

I

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. 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, concerning the possibility of a merger. During 1977 and 1978, Basic made three public statements denying that it was engaged in merger negotiations. 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.

[Footnote 4: On October 21, 1977, after heavy trading and a new high in Basic stock, the following news item appeared in the Cleveland Plain Dealer:

"[Basic] President Max Muller said the company knew no reason for the stock's activity and that no negotiations were under way with any company for a merger. He said Flintkote recently denied Wall Street rumors that it would make a tender offer of $26 a share for control of the Cleveland-based maker of refractories for the steel industry." App. 363.

On September 25, 1978, in reply to an inquiry from the New York Stock Exchange, Basic issued a release concerning increased activity in its stock and stated that

"management is unaware of any present or pending company development that would result in the abnormally heavy trading activity and price fluctuation in company shares that have been experienced in the past few days." Id. at 401.

On November 6, 1978, Basic issued to its shareholders a "Nine Months Report 1978." This Report stated:

"With regard to the stock market activity in the Company's shares, we remain unaware of any present or pending developments which would account for the high volume of trading and price fluctuations in recent months." Id. at 403.]

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. 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."

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.

II

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. 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. 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."

Id. at 426 U. S. 449. We now expressly adopt the TSC Industries standard of materiality for the § 10(b) and Rule 10b-5 context.

III

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.

A

Petitioners urge upon us a Third Circuit test for resolving this difficulty.  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.

[Footnote 10: See Staffin v. Greenberg, 672 F.2d 1196, 1207 (CA3 1982) (defining duty to disclose existence of ongoing merger negotiations as triggered when agreement-in-principle is reached); Greenfield v. Heublein, Inc., 742 F.2d 751 (CA3 1984) (applying agreement-in-principle test to materiality inquiry), cert. denied, 469 U.S. 1215 (1985). Citing Staffin, the United States Court of Appeals for the Second Circuit has rejected a claim that defendant was under an obligation to disclose various events related to merger negotiations. Reiss v. Pan American World Airways, Inc., 711 F.2d 11, 13-14 (1983). The Seventh Circuit recently endorsed the agreement-in-principle test of materiality. See Flamm v. Eberstadt, 814 F.2d 1169, 1174-1179 (describing agreement-in-principle as an agreement on price and structure), cert. denied, 484 U.S. 853 (1987). In some of these cases, it is unclear whether the court based its decision on a finding that no duty arose to reveal the existence of negotiations or whether it concluded that the negotiations were immaterial under an interpretation of the opinion in TSC Industries, Inc. v. North,way, Inc., 426 U. S. 438 (1976).]

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.

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 -- for this case does not concern the timing of a disclosure; it concerns only its accuracy and completeness. 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. 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.

B

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).

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.

C

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.

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.

As we clarify today, materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information. 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. 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.

IV

A

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), 27, 29, 35, 40; see also id. 33 (alleging effect on market price of Basic's statements). Requiring proof of individualized reliance from each member of the proposed plaintiff class effectively would have prevented respondents from proceeding with a class action, since individual issues then would have overwhelmed the common ones. The District Court found that the presumption of reliance created by the fraud-on-the-market theory provided

"a practical resolution to the problem of balancing the substantive requirement of proof of reliance in securities cases against the procedural requisites of [Federal Rule of Civil Procedure] 23."

The District Court thus concluded that with reference to each public statement and its impact upon the open market for Basic shares, common questions predominated over individual questions, as required by Federal Rules of Civil Procedure 23(a)(2) and (b)(3).

Petitioners and their amici complain that the fraud-on-the-market theory effectively eliminates the requirement that a plaintiff asserting a claim under Rule 10b-5 prove reliance. They note that reliance is and long has been an element of common law fraud, see, e.g., Restatement (Second) of Torts § 525 (1977); W. Keeton, D. Dobbs, R. Keeton, & D. Owen, Prosser and Keeton on Law of Torts § 108 (5th ed.1984), and argue that because the analogous express right of action includes a reliance requirement, see, e.g., § 18(a) of the 1934 Act, as amended, 15 U.S.C. § 78r(a), so too must an action implied under § 10(b).

We agree that reliance is an element of a Rule 10b-5 cause of action. See Ernst & Ernst v. Hochfelder, 425 U.S. at 425 U. S. 206 (quoting Senate Report). Reliance provides the requisite causal connection between a defendant's misrepresentation and a plaintiff's injury. See, e.g., Wilson v. Comtech Telecommunications Corp., 648 F.2d 88, 92 (CA2 1981); List v. Fashion Park, Inc., 340 F.2d 457, 462 (CA2), cert. denied sub nom. List v. Lerner, 382 U.S. 811 (1965). There is, however, more than one way to demonstrate the causal connection. Indeed, we previously have dispensed with a requirement of positive proof of reliance, where a duty to disclose material information had been breached, concluding that the necessary nexus between the plaintiffs' injury and the defendant's wrongful conduct had been established. See Affiliated Ute Citizens v. United States, 406 U.S. at 406 U. S. 153-154. Similarly, we did not require proof that material omissions or misstatements in a proxy statement decisively affected voting, because the proxy solicitation itself, rather than the defect in the solicitation materials, served as an essential link in the transaction. See Mills v. Electric AutoLite Co., 396 U. S. 375, 396 U. S. 384-385 (1970).

The modern securities markets, literally involving millions of shares changing hands daily, differ from the face-to-face transactions contemplated by early fraud cases, and our understanding of Rule 10b-5's reliance requirement must encompass these differences.

"In face-to-face transactions, the inquiry into an investor's reliance upon information is into the subjective pricing of that information by that investor. With the presence of a market, the market is interposed between seller and buyer and, ideally, transmits information to the investor in the processed form of a market price. Thus, the market is performing a substantial part of the valuation process performed by the investor in a face-to-face transaction. The market is acting as the unpaid agent of the investor, informing him that given all the information available to it, the value of the stock is worth the market price."

In re LTV Securities Litigation, 88 F.R.D. 134, 143 (ND Tex.1980). Accord, e.g., Peil v. Speiser, 806 F.2d at 1161 ("In an open and developed market, the dissemination of material misrepresentations or withholding of material information typically affects the price of the stock, and purchasers generally rely on the price of the stock as a reflection of its value"); Blackie v. Barrack, 524 F.2d 891, 908 (CA9 1975) ("[T]he same causal nexus can be adequately established indirectly, by proof of materiality coupled with the common sense that a stock purchaser does not ordinarily seek to purchase a loss in the form of artificially inflated stock"), cert. denied, 429 U.S. 816 (1976).

B

Presumptions typically serve to assist courts in managing circumstances in which direct proof, for one reason or another, is rendered difficult. See, e.g., 1 D. Louisell & C. Mueller, Federal Evidence 541-542 (1977). The courts below accepted a presumption, created by the fraud-on-the-market theory and subject to rebuttal by petitioners, that persons who had traded Basic shares had done so in reliance on the integrity of the price set by the market, but because of petitioners' material misrepresentations that price had been fraudulently depressed. Requiring a plaintiff to show a speculative state of facts, i.e., how he would have acted if omitted material information had been disclosed, see Affiliated Ute Citizens v. United States, 406 U.S. at 406 U. S. 153-154, or if the misrepresentation had not been made, see Sharp v. Coopers & Lybrand, 649 F.2d 175, 188 (CA3 1981), cert. denied, 455 U.S. 938 (1982), would place an unnecessarily unrealistic evidentiary burden on the Rule 10b-5 plaintiff who has traded on an impersonal market. Cf. Mills v. Electric Auto-Lite Co., 396 U.S. at 396 U. S. 385.

Arising out of considerations of fairness, public policy, and probability, as well as judicial economy, presumptions are also useful devices for allocating the burdens of proof between parties. See E. Cleary, McCormick on Evidence 968-969 (3d ed.1984); see also Fed.Rule Evid. 301 and Advisory Committee Notes, 28 U.S.C.App. p. 685. The presumption of reliance employed in this case is consistent with, and, by facilitating Rule 10b-5 litigation, supports, the congressional policy embodied in the 1934 Act. In drafting that Act, Congress expressly relied on the premise that securities markets are affected by information, and enacted legislation to facilitate an investor's reliance on the integrity of those markets:

"No investor, no speculator, can safely buy and sell securities upon the exchanges without having an intelligent basis for forming his judgment as to the value of the securities he buys or sells. The idea of a free and open public market is built upon the theory that competing judgments of buyers and sellers as to the fair price of a security brings [sic] about a situation where the market price reflects as nearly as possible a just price. Just as artificial manipulation tends to upset the true function of an open market, so the hiding and secreting of important information obstructs the operation of the markets as indices of real value."

H.R.Rep. No. 1383, at 11. See Lipton v. Documation, Inc., 734 F.2d 740, 748 (CA11 1984), cert. denied, 469 U.S. 1132 (1985).

The presumption is also supported by common sense and probability. Recent empirical studies have tended to confirm Congress' premise that the market price of shares traded on well developed markets reflects all publicly available information, and, hence, any material misrepresentations. It has been noted that "it is hard to imagine that there ever is a buyer or seller who does not rely on market integrity. Who would knowingly roll the dice in a crooked crap game?" Schlanger v. Four-Phase Systems Inc., 555 F. Supp. 535, 538 (SDNY 1982). Indeed, nearly every court that has considered the proposition has concluded that, where materially misleading statements have been disseminated into an impersonal, well-developed market for securities, the reliance of individual plaintiffs on the integrity of the market price may be presumed. Commentators generally have applauded the adoption of one variation or another of the fraud-on-the-market theory. An investor who buys or sells stock at the price set by the 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, therefore, may be presumed for purposes of a Rule 10b-5 action.

C

The Court of Appeals found that petitioners

"made public, material misrepresentations and [respondents] sold Basic stock in an impersonal, efficient market. Thus the class, as defined by the district court, has established the threshold facts for proving their loss."

786 F.2d at 751. The court acknowledged that petitioners may rebut proof of the elements giving rise to the presumption, or show that the misrepresentation in fact did not lead to a distortion of price or that an individual plaintiff traded or would have traded despite his knowing the statement was false. Id. at 750, n. 6.

Any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff or his decision to trade at a fair market price will be sufficient to rebut the presumption of reliance. For example, if petitioners could show that the "market makers" were privy to the truth about the merger discussions here with Combustion, and thus that the market price would not have been affected by their misrepresentations, the causal connection could be broken; the basis for finding that the fraud had been transmitted through market price would be gone. Similarly, if, despite petitioners' allegedly fraudulent attempt to manipulate market price, news of the merger discussions credibly entered the market and dissipated the effects of the misstatements, those who traded Basic shares after the corrective statements would have no direct or indirect connection with the fraud. Petitioners also could rebut the presumption of reliance as to plaintiffs who would have divested themselves of their Basic shares without relying on the integrity of the market. For example, a plaintiff who believed that Basic's statements were false and that Basic was indeed engaged in merger discussions, and who consequently believed that Basic stock was artificially underpriced, but sold his shares nevertheless because of other unrelated concerns, e.g., potential antitrust problems, or political pressures to divest from shares of certain businesses could not be said to have relied on the integrity of a price he knew had been manipulated.

V

In summary:

1. We specifically adopt, for the § 10(b) and Rule 10b-5 context, the standard of materiality set forth in TSC Industries, Inc. v. Northway, Inc., 426 U.S. at  426 U. S. 449 .

2. We reject "agreement-in-principle as to price and structure" as the bright-line rule for materiality.

3. We also reject the proposition that "information becomes material by virtue of a public statement denying it."

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. Materiality depends on the facts, and thus is to be determined on a case-by-case basis.

5. It is not inappropriate to apply a presumption of reliance supported by the fraud-on-the-market theory.

6. That presumption, however, is rebuttable.

7. The District Court's certification of the class here was appropriate when made, but is subject on remand to such adjustment, if any, as developing circumstances demand.

The judgment of the Court of Appeals is vacated, and the case is remanded to that court for further proceedings consistent with this opinion.

It is so ordered.

In Re: Donald J. Trump Casino Securities Litigation

Taj Mahal Litigation

United States Court of Appeals for the Third Circuit

7 F.3d 357

January 29, 1993, Argued

October 14, 1993, Filed

PRIOR HISTORY: On Appeal From the United States District Court for the District of New Jersey

JUDGES: Circuit Judges Becker, Alito, and District Judge Atkins

OPINION OF THE COURT: Circuit Judge Becker

This is an appeal from orders of the district court for the District of New Jersey dismissing a number of complaints brought under various provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934 by a class of investors who purchased bonds to provide financing for the acquisition and completion of the Taj Mahal, a lavish casino/hotel on the boardwalk in Atlantic City, New Jersey. The defendants are Donald J. Trump ("Trump"), Robert S. Trump, Harvey S. Freeman, the Trump Organization Inc., Trump Taj Mahal Inc., Taj Mahal Funding Inc. and Trump Taj Mahal Associates Limited Partnership (the "Partnership") (collectively the "Trump defendants") and Merrill Lynch, Pierce, Fenner and Smith Inc. ("Merrill Lynch"). The complaints allege that the prospectus accompanying the issuance of the bonds contained affirmatively misleading statements and materially misleading omissions in contravention of the federal securities laws.

The district court dismissed the securities law claims under Fed. R. Civ. P. 12(b)(6) for failure to state a claim upon which relief can be granted. The linchpin of the district court's decision was what has been described as the "bespeaks caution" doctrine, according to which a court may determine that the inclusion of sufficient cautionary statements in a prospectus renders misrepresentations and omissions contained therein nonactionable. While the viability of the bespeaks caution doctrine is an issue of first impression for this court, we believe that it primarily represents new nomenclature rather than substantive change in the law. As we see it, "bespeaks caution" is essentially shorthand for the well-established principle that a statement or omission must be considered in context, so that accompanying statements may render it immaterial as a matter of law.

We believe that the bespeaks caution doctrine is both viable and applicable to the facts of this appeal. The prospectus here took considerable care to convey to potential investors the extreme risks inherent in the venture while simultaneously carefully alerting the investors to a variety of obstacles the Taj Mahal would face, all of which were relevant to a potential investor's decision concerning purchase of the bonds. We conclude that, given these warning signals in the text of the prospectus itself, the plaintiffs cannot establish that a reasonable investor would find the alleged misstatements and omissions material to his or her decision to invest in the Taj Mahal. Hence we will affirm the district court's orders.

I. Facts and Procedural History

In November, 1988 the Trump defendants offered to the public $675 million in first mortgage investment bonds (the "bonds") with Merrill Lynch acting as the sole underwriter. The interest rate on the bonds was 14%, a high rate in comparison to the 9% yield offered on quality corporate bonds at the time. The Trump defendants issued the bonds to raise capital to: (1) purchase the Taj Mahal, a partially-completed casino/hotel located on the boardwalk, from Resorts International, Inc. (which had already invested substantial amounts in its construction); (2) complete construction of the Taj Mahal; and (3) open the Taj Mahal for business.

As is well-known, the Taj Mahal was widely touted as Atlantic City's largest and most lavish casino resort. When ultimately opened in April, 1990 it was at least twice the size of any other casino in Atlantic City. It consisted of a 42-story hotel tower that contained approximately 1,250 guest rooms and an adjacent low-rise building encompassing roughly 155,000 square feet of meeting, ballroom and convention space, a 120,000 square foot casino, and numerous restaurants, lounges and stores. The entire structure occupied approximately seventeen acres of land.

The prospectus accompanying the bonds estimated the completion cost of the Taj Mahal, including the payment of interest on the bonds for the first fifteen months of operation, at $805 million. It explained that, to obtain that amount, the Trump defendants were relying on the $675 million in bond proceeds, a $75 million capital contribution by Donald Trump, investment income derived from those sums, a contingent additional loan of $25 million from the Trump Line of Credit, and loans from other sources.

Plaintiffs ground their lawsuits in the text of the prospectus. Their strongest attack focuses on the "Management Discussion and Analysis" ("MD&A") section of the prospectus, which stated: "The Partnership believes that funds generated from the operation of the Taj Mahal will be sufficient to cover all of its debt service (interest and principal)." The plaintiffs' primary contention is that this statement was materially misleading because the defendants possessed neither a genuine nor a reasonable belief in its truth. However, as the defendants emphasize, the prospectus contained numerous disclaimers and cautionary statements in conjunction with this statement. The cautionary statements stressed, among other things: the intense competition in the casino industry; the absence of an operating history for the Taj Mahal which could serve as a basis for its valuation; the unprecedented size of the Taj Mahal casino in Atlantic City; and the enterprise's potential inability to repay the interest on the bonds in the event of a mortgage default and subsequent liquidation of the Taj Mahal.

After learning that the Trump defendants planned to file Chapter 11 bankruptcy proceedings and establish a reorganization plan, various bondholders filed separate complaints in the United States District Courts for the Southern District of New York, the Eastern District of New York and the District of New Jersey. The complaints each alleged that the prospectus accompanying the issuance of the bonds contained material misrepresentations and material omissions in violation of the 1933 and 1934 Acts. Pursuant to 28 U.S.C. §1407, the JPML subsequently transferred the complaints for consolidated pre-trial proceedings to the District of New Jersey. See MDL Docket No. 864 (In re Donald J. Trump Sec. Litig.).

The consolidated complaints pleaded four counts. In count one, the plaintiffs alleged that the prospectus contained misrepresentations and omissions of material fact in violation of §§11, 12(2) and 15 of the Securities Act of 1933 (the "1933 Act"), 15 U.S.C. §§77k(a), 77l(2), 77o. Count two of the complaints alleged fraud in the prospectus, based on the same alleged misrepresentations and omissions, but in violation of §§10(b) and 20(a) of the Securities Exchange Act of 1934 (the "1934 Act") and Rule 10(b)(5) promulgated thereunder, 15 U.S.C. §§78j(b), 78t(a), and 17 C.F.R. §240.10(b)-5. Counts three and four alleged state common law claims.

The defendants moved to dismiss the complaints pursuant to Rule 12(b)(6), asserting that the plaintiffs had failed to state actionable securities fraud claims, and also pursuant to Fed. R. Civ. P. 9(b), contending that the plaintiffs failed to plead their fraud allegations with sufficient particularity. The district court granted the defendants' motion under Rule 12(b)(6), reasoning that the abundance of cautionary statements that directly addressed the alleged misrepresentations and omissions rendered the plaintiffs' claims nonactionable as a matter of law. See In re Donald J. Trump Casino Sec. Litig., 793 F. Supp. 543 (D.N.J. 1992). The district court also rejected the plaintiffs' motion to amend their complaints to add allegations based on an appraisal of the future value of the Taj Mahal which had been issued by the accounting firm of Laventhol and Horwath ("the Laventhol Report"). The district court did not reach the defendants' motion to dismiss based on Rule 9(b). Having disposed of the federal claims, the court subsequently dismissed the plaintiffs' claims of breach of fiduciary duty and false advertising without prejudice for lack of pendent jurisdiction. 793 F. Supp. at 568. This appeal followed.

The district court had jurisdiction over the federal securities law claims under 15 U.S.C. §§77v and 78aa and over the state law claims under 28 U.S.C. §1367. We have jurisdiction under 28 U.S.C. §1291. We exercise plenary review over the district court's dismissal of the plaintiffs' complaint under Rule 12(b)(6). Marshall-Silver Constr. Co. v. Mendel, 894 F.2d 593, 595 (3d Cir. 1990). In this regard, we must accept the plaintiffs' factual allegations as true and give the plaintiffs the benefit of the inferences which we may fairly draw from them. See Scheuer v. Rhodes, 416 U.S. 232, 236, 94 S. Ct. 1683, 1686, 40 L. Ed. 2d 90 (1974).

II. The Parties' Contentions

The plaintiffs allege that the prospectus contained material misrepresentations. Their principal claim is that the defendants had neither an honest belief in nor a reasonable basis for one statement in the MD&A section of the prospectus: "The Partnership believes that funds generated from the operation of the Taj Mahal will be sufficient to cover all of its debt service (interest and principal)." Before the district court and again before us, the plaintiffs concentrate on this statement and its allegedly misleading character.

The plaintiffs also argue that the prospectus was misleading in its omission of allegedly material information. The plaintiffs submit that the prospectus failed to disclose, inter alia, that: 1) the Taj Mahal required an average "casino win" of approximately $1.3 million per day on a continuing basis in order to service its debtload; 2) Donald Trump had personally guaranteed hundreds of millions of dollars in bank loans for other properties; and 3) the Taj Mahal had an "unprecedented" debt to equity ratio. The plaintiffs contend that these allegedly material misrepresentations and omissions form the basis for actionable securities fraud claims and that, to the extent that the prospectus contained cautionary language, the district court improperly considered the effect of this language on a motion to dismiss.

The defendants respond that the myriad warnings and cautionary statements contained in the prospectus sufficiently disclosed to the bondholders the multifarious risks inherent in the investment. With respect to the plaintiffs' primary argument -- that the statement relating the Partnership's belief in the Taj Mahal's capacity to generate ample income for the Partnership to make full payment on the bonds was materially misleading -- the defendants contend that there was also adequate cautionary language surrounding this statement to render it nonactionable as a matter of law. That is, they insist that when a prospectus (such as this one) contains abundant warnings and cautionary statements which qualify the statements plaintiffs claim they relied upon, plaintiffs cannot, as a matter of law, contend that they were misled by the alleged misrepresentations and/or omissions.

IV. The Alleged Affirmative Material Misrepresentations in the Prospectus

As we explained above, the plaintiffs assert that the Trump defendants had neither an honest nor a reasonable belief in their statement on page 28 of the prospectus that "the Partnership believes that funds generated from the operation of the Taj Mahal will be sufficient to cover all of its debt service (interest and principal)." The plaintiffs contend that, in view of this allegation, they have stated a cause of action under the federal securities laws. We disagree

A. General Legal Principles

At a minimum, each of the securities fraud provisions which the bondholders allege the Trump defendants violated requires proof that the defendants made untrue or misleading statements or omissions of material fact. See Shapiro v. UJB Fin. Corp., 964 F.2d 272, (3d Cir.), cert denied, 113 S. Ct. 365 (1992). We have squarely held that opinions, predictions and other forward-looking statements are not per se inactionable under the securities laws. Rather, such statements of "soft information" may be actionable misrepresentations if the speaker does not genuinely and reasonably believe them. See, e.g., Herskowitz v. Nutri/System, Inc., 857 F.2d 179, 184 (3d Cir. 1988), cert. denied, 489 U.S. 1054, 109 S. Ct. 1315, 103 L. Ed. 2d 584 (1989); Eisenberg v. Gagnon, 766 F.2d 770, 776 (3d Cir.), cert. denied sub nom. Wasserstrom v. Eisenberg, 474 U.S. 946,106 S. Ct. 342, 88 L. Ed. 2d 290, 106 S. Ct. 343 (1985). Therefore, the plaintiffs' complaint does not falter just because it alleges that the defendants made a misrepresentation with their statement that they believed they would be able to repay the principal and interest on the bonds. Rather, the complaint cannot survive a motion to dismiss because ultimately it does not sufficiently allege that the defendants made a material misrepresentation.

The Supreme Court in TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, (1976), defined materiality within the proxy-solicitation context of §14(a) of the 1934 Act. Subsequently the Court expressly made the TSC standard applicable to actions under §10 and Rule 10b-5, see Basic Inc. v. Levinson, 485 U.S. 224 (1988), and we have made it applicable as well to claims under §§11 and 12(2) of the 1933 Act, see Craftmatic Sec. Litig. v. Kraftsow, 890 F.2d 628 (3d Cir. 1989). TSC instructs that "an omitted fact is material if there is a substantial likelihood that a reasonable [investor] would consider it important in deciding how to [act]." 426 U.S. at 449. For an omission to be deemed material, "there must be a substantial likelihood that [its disclosure] would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."

As the statement quoted immediately above implies, materiality is a relative concept, so that a court must appraise a misrepresentation or omission in the complete context in which the author conveys it. See I. Meyer Pincus & Assocs. v. Oppenheimer & Co., 936 F.2d 759, 763 (2d Cir. 1991). In other words, a particular misrepresentation or omission significant to a reasonable investor in one document or circumstance may not influence a reasonable investor in another. We accordingly take into account not only the assertion that the Partnership believed the Taj Mahal could meet the obligations of the bonds, but also other relevant statements contained in the prospectus.

B. The Text of the Prospectus

The prospectus at issue contained an abundance of warnings and cautionary language which bore directly on the prospective financial success of the Taj Mahal and on the Partnership's ability to repay the bonds. We believe that given this extensive yet specific cautionary language, a reasonable factfinder could not conclude that the inclusion of the statement "the Partnership believes that funds generated from the operation of the Taj Mahal will be sufficient to cover all of its debt service (interest and principal)" would influence a reasonable investor's investment decision. More specifically, we believe that due to the disclaimers and warnings the prospectus contains, no reasonable investor could believe anything but that the Taj Mahal bonds represented a rather risky, speculative investment which might yield a high rate of return, but which alternatively might result in no return or even a loss. We hold that under this set of facts, the bondholders cannot prove that the alleged misrepresentation was material.

The statement the plaintiffs assail as misleading is contained in the MD&A section of the prospectus, which follows the sizable "Special Considerations" section, a section notable for its extensive and detailed disclaimers and cautionary statements. More precisely, the prospectus explained that, because of its status as a new venture of unprecedented size and scale, a variety of risks inhered in the Taj Mahal which could affect the Partnership's ability to repay the bondholders. For example, it stated:

“The casino business in Atlantic City, New Jersey has a seasonal nature of which summer is the peak season. . . . Since the third interest payment date on the Bonds [(which constitutes the first interest payment not paid out of the initial financing)] occurs before the summer season, the Partnership will not have the benefit of receiving peak season cash flow prior to the third interest payment date, which could adversely affect its ability to pay interest on the Bonds.. . . The Taj Mahal has not been completed and, accordingly, has no operating history. The Partnership, therefore, has no history of earnings and its operations will be subject to all of the risks inherent in the establishment of a new business enterprise. Accordingly, the ability of the Partnership to service its debt to [Taj Mahal Funding Inc., which issued the bonds,] is completely dependent upon the success of that operation and such success will depend upon financial, business, competitive, regulatory and other factors affecting the Taj Mahal and the casino industry in general as well as prevailing economic conditions. . . .The Taj Mahal will be the largest casino/hotel complex in Atlantic City, with approximately twice the room capacity and casino space of many of the existing casino/hotels in Atlantic City. [No] other casino/hotel operator has had experience operating a complex the size of the Taj Mahal in Atlantic City. Consequently, no assurance can be given that, once opened, the Taj Mahal will be profitable or that it will generate cash flow sufficient to provide for the payment of the debt service . . . .”.

The prospectus went on to relate, as part of its "Security for the Bonds" subsection, the potential effect of the Partnership's default on its mortgage payments. For example, this subsection unreservedly explained that if a default occurred prior to completion of the Taj Mahal, "there would not be sufficient proceeds [from a foreclosure sale of the Taj Mahal] to pay the principal of, and accrued interest on, the Bonds."

The "Special Considerations" section also detailed the high level of competition for customers the completed Taj Mahal would face once opened to the public:

“Competition in the Atlantic City casino/hotel market is intense. At present, there are twelve casino/hotels in Atlantic City . . . . Some Atlantic City casino/hotels recently have completed renovations or are in the process of expanding and improving their facilities. . . . The Partnership believes that, based upon historical trends, casino win per square foot of casino space will decline in 1990 as a result of a projected increase in casino floor space, including the opening of the Taj Mahal.”

In a section following the MD&A section, the prospectus reiterated its reference to the intense competition in the Atlantic City casino industry:

“Growth in Atlantic City casino win is expected to be restrained until further improvements to the City's transportation system and infrastructure are undertaken and completed and the number of non-casino hotel rooms and existing convention space are increased. No assurance can be given with respect to either the future growth of the Atlantic City gaming market or the ability of the Taj Mahal to attract a representative share of that market.”

The prospectus additionally reported that there were risks of delay in the construction of the Taj Mahal and a risk that the casino might not receive the numerous essential licenses and permits from the state regulatory authorities.

In this case the Partnership did not bury the warnings about risks amidst the bulk of the prospectus. Indeed, it was the allegedly misleading statement which was buried amidst the cautionary language. At all events, in addition to reading the allegedly misleading statement setting forth the Partnership's belief that it could repay the principal and interest on the bonds, a prospective investor would have also read the dire warnings and cautionary statements a sampling of which we have just outlined. Moreover, an investor would have read the sentence immediately following the challenged statement, which cautioned: "no assurance can be given, however, that actual operating results will meet the Partnership's expectations."

As we explained above, we must consider an alleged misrepresentation within the context in which the speaker communicated it. Here the context clearly and precisely relayed to the bondholders the substantial uncertainties inherent in the completion and operation of the Taj Mahal. The prospectus contained both general warnings that the Partnership could not assure the repayment of the bonds as well as specific discussions detailing a variety of risk factors that rendered the completion and profitable operation of the Taj Mahal highly uncertain. Within this broad context the statement at issue was, at worst, harmless.

C. The Bespeaks Caution Doctrine

The district court applied what has come to be known as the "bespeaks caution" doctrine. In so doing it followed the lead of a number of courts of appeals which have dismissed securities fraud claims under Rule 12(b)(6) because cautionary language in the offering document negated the materiality of an alleged misrepresentation or omission. * * * We are persuaded by the ratio decidendi of these cases and will apply bespeaks caution to the facts before us.

The application of bespeaks caution depends on the specific text of the offering document or other communication at issue, i.e., courts must assess the communication on a case-by-case basis. See Flynn v. Bass Bros. Enters., 744 F.2d 978 (3d Cir. 1984) (holding courts must determine the materiality of soft information on a case-by-case basis). Nevertheless, we can state as a general matter that, when an offering document's forecasts, opinions or projections are accompanied by meaningful cautionary statements, the forward-looking statements will not form the basis for a securities fraud claim if those statements did not affect the "total mix" of information the document provided investors. In other words, cautionary language, if sufficient, renders the alleged omissions or misrepresentations immaterial as a matter of law.

The bespeaks caution doctrine is, as an analytical matter, equally applicable to allegations of both affirmative misrepresentations and omissions concerning soft information. Whether the plaintiffs allege a document contains an affirmative prediction/opinion which is misleading or fails to include a forecast or prediction which failure is misleading, the cautionary statements included in the document may render the challenged predictive statements or opinions immaterial as a matter of law. Of course, a vague or blanket (boilerplate) disclaimer which merely warns the reader that the investment has risks will ordinarily be inadequate to prevent misinformation. To suffice, the cautionary statements must be substantive and tailored to the specific future projections, estimates or opinions in the prospectus which the plaintiffs challenge.

Because of the abundant and meaningful cautionary language contained in the prospectus, we hold that the plaintiffs have failed to state an actionable claim regarding the statement that the Partnership believed it could repay the bonds. We can say that the prospectus here truly bespeaks caution because, not only does the prospectus generally convey the riskiness of the investment, but its warnings and cautionary language directly address the substance of the statement the plaintiffs challenge. That is to say, the cautionary statements were tailored precisely to address the uncertainty concerning the Partnership's prospective ability to repay the bondholders.

Moreover, contrary to the submission of the plaintiffs, the Supreme Court's reasoning in Virginia Bankshares, Inc. v. Sandberg, 111 S. Ct. 2749 (1991) supports rather than undermines the application of the bespeaks caution doctrine in this case. In Virginia Bankshares, the Court considered the actionability of statements of reasons, opinions or beliefs in the proxy-solicitation context under §4(a) of the 1934 Act, 15 U.S.C. §78n(a). The Court rejected the defendants' argument that a statement by corporate directors, made in the midst of an effort to effectuate a "freeze-out" merger, that in their opinion $42 a share was a fair price which would offer "high" value to the minority stockholders, was inactionable under the securities laws. Consistent with our decisions pre-dating Virginia Bankshares, see, e.g., Eisenberg v. Gagnon, 766 F.2d at 776, the Court held that statements of opinion or belief may be actionable when they expressly or impliedly assert something false or misleading about their subject matter. The Court further held that the specific statement at issue in the case was a proper basis for liability under §14(a) because the minority shareholders reasonably understood it to rest on a factual basis.

The Court then refined this general principle to take on the same contours as what we have denoted as the bespeaks caution doctrine. In particular, the Court acknowledged that "not every mixture with the true will neutralize the deceptive. If it would take a financial analyst to spot the tension between the one and the other, whatever is misleading will remain materially so, and liability should follow." In fact, this notion really comports with the general principle, because it merely underscores that when the subject of a misrepresentation or omission is such that the accompanying language does not diminish the importance of the misrepresentation or omission to the investor, the misrepresentation or omission remains actionable. In a word, a misrepresentation or omission is actionable when materially misleading.

This reading of Virginia Bankshares just restates what what we explained above, namely, that materiality involves a context-specific analysis such that warnings and cautionary language will sometimes suffice to render the allegedly misleading misrepresentations or omissions immaterial as a matter of law. We understand Virginia Bankshares to indicate that if the nature of the subject matter or the manner of presentation of an alleged misrepresentation or omission or its accompanying statements is such that for a reasonable investor the accompanying statements do not offset the misleading effect of the misrepresentation or omission, then bespeaks caution is unavailable as a defense. Therefore, contrary to the plaintiffs' assertion, we believe that our analysis comports with the Supreme Court's reasoning in Virginia Bankshares.

D. Conclusion

Returning to the instant case, we think it clear that the accompanying warnings and cautionary language served to negate any potentially misleading effect that the prospectus' statement about the Partnership's belief in its ability to repay the bonds would have on a reasonable investor. The prospectus clearly and precisely cautioned that the bonds represented an exceptionally risky, perhaps even speculative, venture and that the Partnership's ability to repay the bonds was uncertain. Given this context, we believe that no reasonable jury could conclude that the subject projection materially influenced a reasonable investor.

VI. Conclusion

For the foregoing reasons we will affirm the orders of the district court dismissing the plaintiffs' complaints under Rule 12(b)(6). In view of our disposition of the plaintiffs' federal causes of action, we will also affirm the district court's dismissal without prejudice of the plaintiffs' state law claims for lack of pendent jurisdiction.

Dirks v. Securities and Exchange Commission

Supreme Court of the United States

463 U.S. 646

March 21, 1983 Argued

July 1, 1983, Decided

PRIOR HISTORY: Certiorari to the United States Court of Appeals for the District of Columbia Circuit.

DISPOSITION: 220 U. S. App. D. C. 309, 681 F.2d 824, reversed.

DECISION: Tippee of material nonpublic information held not to have violated federal securities laws by repeating allegations of corporation's fraud to investors.

OPINION: Justice Powell delivered the opinion of the Court.

Petitioner Raymond Dirks received material nonpublic information from "insiders" of a corporation with which he had no connection. He disclosed this information to investors who relied on it in trading in the shares of the corporation. The question is whether Dirks violated the antifraud provisions of the federal securities laws by this disclosure.

I.

In 1973, Dirks was an officer of a New York broker-dealer firm who specialized in providing investment analysis of insurance company securities to institutional investors. On March 6, Dirks received information from Ronald Secrist, a former officer of Equity Funding of America. Secrist alleged that the assets of Equity Funding, a diversified corporation primarily engaged in selling life insurance and mutual funds, were vastly overstated as the result of fraudulent corporate practices. Secrist also stated that various regulatory agencies had failed to act on similar charges made by Equity Funding employees. He urged Dirks to verify the fraud and disclose it publicly.

Dirks decided to investigate the allegations. He visited Equity Funding's headquarters in Los Angeles and interviewed several officers and employees of the corporation. The senior management denied any wrongdoing, but certain corporation employees corroborated the charges of fraud. Neither Dirks nor his firm owned or traded any Equity Funding stock, but throughout his investigation he openly discussed the information he had obtained with a number of clients and investors. Some of these persons sold their holdings of Equity Funding securities, including five investment advisers who liquidated holdings of more than $16 million. [Footnote 2: Dirks received from his firm a salary plus a commission for securities transactions above a certain amount that his clients directed through his firm. But "[it] is not clear how many of those with whom Dirks spoke promised to direct some brokerage business through [Dirks' firm] to compensate Dirks, or how many actually did so." The Boston Company Institutional Investors, Inc., promised Dirks about $25,000 in commissions, but it is unclear whether Boston actually generated any brokerage business for his firm.]

During the 2-week period in which Dirks pursued his investigation and spread word of Secrist's charges, the price of Equity Funding stock fell from $26 per share to less than $15 per share. This led the New York Stock Exchange to halt trading on March 27. Shortly thereafter California insurance authorities impounded Equity Funding's records and uncovered evidence of the fraud. Only then did the Securities and Exchange Commission (SEC) file a complaint against Equity Funding [Footnote 3: As early as 1971, the SEC had received allegations of fraudulent accounting practices at Equity Funding. Moreover, on March 9, 1973, an official of the California Insurance Department informed the SEC's regional office in Los Angeles of Secrist's charges of fraud. Dirks himself voluntarily presented his information at the SEC's regional office beginning on March 27.] and only then, on April 2, did the Wall Street Journal publish a front-page story based largely on information assembled by Dirks. Equity Funding immediately went into receivership. [Footnote 4: A federal grand jury in Los Angeles subsequently returned a 105-count indictment against 22 persons, including many of Equity Funding's officers and directors. All defendants were found guilty of one or more counts, either by a plea of guilty or a conviction after trial.]

The SEC began an investigation into Dirks' role in the exposure of the fraud. After a hearing by an Administrative Law Judge, the SEC found that Dirks had aided and abetted violations of §17(a) of the Securities Act of 1933, 48 Stat. 84, as amended, 15 U. S. C. § 77q(a), {Section 17(a)} § 10(b) of the Securities Exchange Act of 1934, 48 Stat. 891, 15 U. S. C. § 78j(b), and SEC Rule 10b-5, 17 CFR § 240.10b-5 (1983), by repeating the allegations of fraud to members of the investment community who later sold their Equity Funding stock. The SEC concluded: "Where 'tippees' -- regardless of their motivation or occupation -- come into possession of material 'corporate information that they know is confidential and know or should know came from a corporate insider,' they must either publicly disclose that information or refrain from trading." (quoting Chiarella v. United States, 445 U.S. 222 (1980)). Recognizing, however, that Dirks "played an important role in bringing [Equity Funding's] massive fraud to light,", the SEC only censured him.

Dirks sought review in the Court of Appeals for the District of Columbia Circuit. The court entered judgment against Dirks "for the reasons stated by the Commission in its opinion." Judge Wright, a member of the panel, subsequently issued an opinion. Judge Robb concurred in the result and Judge Tamm dissented; neither filed a separate opinion. Judge Wright believed that "the obligations of corporate fiduciaries pass to all those to whom they disclose their information before it has been disseminated to the public at large." Alternatively, Judge Wright concluded that, as an employee of a broker-dealer, Dirks had violated "obligations to the SEC and to the public completely independent of any obligations he acquired" as a result of receiving the information.

In view of the importance to the SEC and to the securities industry of the question presented by this case, we granted a writ of certiorari. 459 U.S. 1014 (1982). We now reverse.

II.

In the seminal case of In re Cady, Roberts & Co., 40 S. E. C. 907 (1961), the SEC recognized that the common law in some jurisdictions imposes on "corporate 'insiders,' particularly officers, directors, or controlling stockholders" an "affirmative duty of disclosure . . . when dealing in securities." The SEC found that not only did breach of this common-law duty also establish the elements of a Rule 10b-5 violation, but that individuals other than corporate insiders could be obligated either to disclose material nonpublic information before trading or to abstain from trading altogether. In Chiarella, we accepted the two elements set out in Cady, Roberts for establishing a Rule 10b-5 violation: "(i) the existence of a relationship affording access to inside information intended to be available only for a corporate purpose, and (ii) the unfairness of allowing a corporate insider to take advantage of that information by trading without disclosure." In examining whether Chiarella had an obligation to disclose or abstain, the Court found that there is no general duty to disclose before trading on material nonpublic information, and held that "a duty to disclose under §10(b) does not arise from the mere possession of nonpublic market information." Such a duty arises rather from the existence of a fiduciary relationship.

III.

We were explicit in Chiarella in saying that there can be no duty to disclose where the person who has traded on inside information "was not [the corporation's] agent, . . . was not a fiduciary, [or] was not a person in whom the sellers [of the securities] had placed their trust and confidence." Not to require such a fiduciary relationship, we recognized, would "[depart] radically from the established doctrine that duty arises from a specific relationship between two parties" and would amount to "recognizing a general duty between all participants in market transactions to forgo actions based on material, nonpublic information." This requirement of a specific relationship between the shareholders and the individual trading on inside information has created analytical difficulties for the SEC and courts in policing tippees who trade on inside information. Unlike insiders who have independent fiduciary duties to both the corporation and its shareholders, the typical tippee has no such relationships. In view of this absence, it has been unclear how a tippee acquires the Cady, Roberts duty to refrain from trading on inside information.

[Footnote 14: Under certain circumstances, such as where corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may become fiduciaries of the shareholders. The basis for recognizing this fiduciary duty is not simply that such persons acquired nonpublic corporate information, but rather that they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes. When such a person breaches his fiduciary relationship, he may be treated more properly as a tipper than a tippee. For such a duty to be imposed, however, the corporation must expect the outsider to keep the disclosed nonpublic information confidential, and the relationship at least must imply such a duty.]

A.

The SEC's position, as stated in its opinion in this case, is that a tippee "inherits" the Cady, Roberts obligation to shareholders whenever he receives inside information from an insider. This view differs little from the view that we rejected as inconsistent with congressional intent in Chiarella. In that case, the Court of Appeals agreed with the SEC and affirmed Chiarella's conviction, holding that "[anyone] -- corporate insider or not -- who regularly receives material nonpublic information may not use that information to trade in securities without incurring an affirmative duty to disclose." United States v. Chiarella, 588 F.2d 1358, 1365 (CA2 1978) (emphasis in original). Here, the SEC maintains that anyone who knowingly receives nonpublic material information from an insider has a fiduciary duty to disclose before trading.

In effect, the SEC's theory of tippee liability in both cases appears rooted in the idea that the antifraud provisions require equal information among all traders. This conflicts with the principle set forth in Chiarella that only some persons, under some circumstances, will be barred from trading while in possession of material nonpublic information. Judge Wright correctly read our opinion in Chiarella as repudiating any notion that all traders must enjoy equal information before trading: "[The] 'information' theory is rejected. Because the disclose-or-refrain duty is extraordinary, it attaches only when a party has legal obligations other than a mere duty to comply with the general antifraud proscriptions in the federal securities laws." See Chiarella, 445 U.S., at 235, n. 20. We reaffirm today that "[a] duty [to disclose] arises from the relationship between parties . . . and not merely from one's ability to acquire information because of his position in the market."

Imposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market. It is commonplace for analysts to "ferret out and analyze information," and this often is done by meeting with and questioning corporate officers and others who are insiders. And information that the analysts obtain normally may be the basis for judgments as to the market worth of a corporation's securities. The analyst's judgment in this respect is made available in market letters or otherwise to clients of the firm. It is the nature of this type of information, and indeed of the markets themselves, that such information cannot be made simultaneously available to all of the corporation's stockholders or the public generally.

The conclusion that recipients of inside information do not invariably acquire a duty to disclose or abstain does not mean that such tippees always are free to trade on the information. The need for a ban on some tippee trading is clear. Not only are insiders forbidden by their fiduciary relationship from personally using undisclosed corporate information to their advantage, but they also may not give such information to an outsider for the same improper purpose of exploiting the information for their personal gain. See 15 U. S. C. §78t(b) (making it unlawful to do indirectly "by means of any other person" any act made unlawful by the federal securities laws). Similarly, the transactions of those who knowingly participate with the fiduciary in such a breach are "as forbidden" as transactions "on behalf of the trustee himself." As the Court explained in Mosser, a contrary rule "would open up opportunities for devious dealings in the name of others that the trustee could not conduct in his own." Thus, the tippee's duty to disclose or abstain is derivative from that of the insider's duty. As we noted in Chiarella, "[the] tippee's obligation has been viewed as arising from his role as a participant after the fact in the insider's breach of a fiduciary duty."

Thus, some tippees must assume an insider's duty to the shareholders not because they receive inside information, but rather because it has been made available to them improperly. And for Rule 10b-5 purposes, the insider's disclosure is improper only where it would violate his Cady, Roberts duty. Thus, a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach. As Commissioner Smith perceptively observed in In re Investors Management Co., 44 S. E. C. 633 (1971): "[Tippee] responsibility must be related back to insider responsibility by a necessary finding that the tippee knew the information was given to him in breach of a duty by a person having a special relationship to the issuer not to disclose the information . . . .". Tipping thus properly is viewed only as a means of indirectly violating the Cady, Roberts disclose-or-abstain rule.

C.

In determining whether a tippee is under an obligation to disclose or abstain, it thus is necessary to determine whether the insider's "tip" constituted a breach of the insider's fiduciary duty. All disclosures of confidential corporate information are not inconsistent with the duty insiders owe to shareholders. In contrast to the extraordinary facts of this case, the more typical situation in which there will be a question whether disclosure violates the insider's Cady, Roberts duty is when insiders disclose information to analysts. In some situations, the insider will act consistently with his fiduciary duty to shareholders, and yet release of the information may affect the market. For example, it may not be clear -- either to the corporate insider or to the recipient analyst -- whether the information will be viewed as material nonpublic information. Corporate officials may mistakenly think the information already has been disclosed or that it is not material enough to affect the market. Whether disclosure is a breach of duty therefore depends in large part on the purpose of the disclosure. This standard was identified by the SEC itself in Cady, Roberts: a purpose of the securities laws was to eliminate "use of inside information for personal advantage." Thus, the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach. As Commissioner Smith stated in Investors Management Co.: "It is important in this type of case to focus on policing insiders and what they do . . . rather than on policing information per se and its possession. . . ."

The SEC argues that, if inside-trading liability does not exist when the information is transmitted for a proper purpose but is used for trading, it would be a rare situation when the parties could not fabricate some ostensibly legitimate business justification for transmitting the information. We think the SEC is unduly concerned. In determining whether the insider's purpose in making a particular disclosure is fraudulent, the SEC and the courts are not required to read the parties' minds. Scienter in some cases is relevant in determining whether the tipper has violated his Cady, Roberts duty. But to determine whether the disclosure itself "[deceives], [manipulates], or [defrauds]" shareholders, Aaron v. SEC, 446 U.S. 680, 686 (1980), the initial inquiry is whether there has been a breach of duty by the insider. This requires courts to focus on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings. Brudney, Insiders, Outsiders, and Informational Advantages Under the Federal Securities Laws, 93 Harv. L. Rev. 322, 348 (1979) ("The theory . . . is that the insider, by giving the information out selectively, is in effect selling the information to its recipient for cash, reciprocal information, or other things of value for himself . . ."). There are objective facts and circumstances that often justify such an inference. For example, there may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient. The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.

Determining whether an insider personally benefits from a particular disclosure, a question of fact, will not always be easy for courts. But it is essential, we think, to have a guiding principle for those whose daily activities must be limited and instructed by the SEC's inside-trading rules, and we believe that there must be a breach of the insider's fiduciary duty before the tippee inherits the duty to disclose or abstain. In contrast, the rule adopted by the SEC in this case would have no limiting principle.

Under the inside-trading and tipping rules set forth above, we find that there was no actionable violation by Dirks. It is undisputed that Dirks himself was a stranger to Equity Funding, with no pre-existing fiduciary duty to its shareholders. He took no action, directly or indirectly, that induced the shareholders or officers of Equity Funding to repose trust or confidence in him. There was no expectation by Dirks' sources that he would keep their information in confidence. Nor did Dirks misappropriate or illegally obtain the information about Equity Funding. Unless the insiders breached their Cady, Roberts duty to shareholders in disclosing the nonpublic information to Dirks, he breached no duty when he passed it on to investors as well as to the Wall Street Journal.

It is clear that neither Secrist nor the other Equity Funding employees violated their Cady, Roberts duty to the corporation's shareholders by providing information to Dirks. The tippers received no monetary or personal benefit for revealing Equity Funding's secrets, nor was their purpose to make a gift of valuable information to Dirks. As the facts of this case clearly indicate, the tippers were motivated by a desire to expose the fraud. In the absence of a breach of duty to shareholders by the insiders, there was no derivative breach by Dirks. Dirks therefore could not have been "a participant after the fact in [an] insider's breach of a fiduciary duty."

V.

We conclude that Dirks, in the circumstances of this case, had no duty to abstain from use of the inside information that he obtained. The judgment of the Court of Appeals therefore is reversed.

United States, Petitioner v. James Herman O’Hagan

Supreme Court of the United States

521 U.S. 642

April 16, 1997, Argued

June 25, 1997, Decided

PRIOR HISTORY: On writ of certiorari to the United States Court of Appeals for the Eighth Circuit

DISPOSITION: 92 F.3d 612, reversed and remanded.

JUDGES: Justice Ginsburg delivered the opinion of the Court, in which Justices Stevens, O’Connor, Kennedy, Souter, and Breyer joined, and in Parts I, III, and IV of which Justice Scalia joined. Justice Scalia filed an opinion concurring in part and dissenting in part. Justice Thomas filed an opinion concurring in the judgment in part and dissenting in part, in which Justice Rehnquist joined.

OPINION: Justice Ginsburg delivered the opinion of the Court.

This case concerns the interpretation and enforcement of §10(b) and §14(e) of the Securities Exchange Act of 1934, and rules made by the Securities and Exchange Commission pursuant to these provisions, Rule 10b-5 and Rule 14e-3(a). Two prime questions are presented. The first relates to the misappropriation of material, nonpublic information for securities trading; the second concerns fraudulent practices in the tender offer setting. In particular, we address and resolve these issues: (1) Is a person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of the information, guilty of violating §10(b) and Rule 10b-5? (2) Did the Commission exceed its rulemaking authority by adopting Rule 14e-3(a), which proscribes trading on undisclosed information in the tender offer setting, even in the absence of a duty to disclose? Our answer to the first question is yes, and to the second question, viewed in the context of this case, no.

I.

Respondent James Herman O'Hagan was a partner in the law firm of Dorsey & Whitney in Minneapolis, Minnesota. In July 1988, Grand Metropolitan PLC (Grand Met), a company based in London, England, retained Dorsey & Whitney as local counsel to represent Grand Met regarding a potential tender offer for the common stock of the Pillsbury Company, headquartered in Minneapolis. Both Grand Met and Dorsey & Whitney took precautions to protect the confidentiality of Grand Met's tender offer plans. O'Hagan did no work on the Grand Met representation. Dorsey & Whitney withdrew from representing Grand Met on September 9, 1988. Less than a month later, on October 4, 1988, Grand Met publicly announced its tender offer for Pillsbury stock.

On August 18, 1988, while Dorsey & Whitney was still representing Grand Met, O'Hagan began purchasing call options for Pillsbury stock. Each option gave him the right to purchase 100 shares of Pillsbury stock by a specified date in September 1988. Later in August and in September, O'Hagan made additional purchases of Pillsbury call options. By the end of September, he owned 2,500 unexpired Pillsbury options, apparently more than any other individual investor. O'Hagan also purchased, in September 1988, some 5,000 shares of Pillsbury common stock, at a price just under $39 per share. When Grand Met announced its tender offer in October, the price of Pillsbury stock rose to nearly $60 per share. O'Hagan then sold his Pillsbury call options and common stock, making a profit of more than $4.3 million.

The Securities and Exchange Commission (SEC or Commission) initiated an investigation into O'Hagan's transactions, culminating in a 57-count indictment. The indictment alleged that O'Hagan defrauded his law firm and its client, Grand Met, by using for his own trading purposes material, nonpublic information regarding Grand Met's planned tender offer. Id., at 8. [Footnote 1] According to the indictment, O'Hagan used the profits he gained through this trading to conceal his previous embezzlement and conversion of unrelated client trust funds. Id., at 10. O'Hagan was charged with 20 counts of mail fraud, in violation of 18 U.S.C. §1341; 17 counts of securities fraud, in violation of §10(b) of the Securities Exchange Act of 1934 (Exchange Act), 48 Stat. 891, 15 U.S.C. §78j(b), and SEC Rule 10b-5, 17 CFR §240.10b-5 (1996); 17 counts of fraudulent trading in connection with a tender offer, in violation of §14(e) of the Exchange Act, 15 U.S.C. § 78n(e), and SEC Rule 14e-3(a), 17 CFR §240.14e-3(a) (1996); and 3 counts of violating federal money laundering statutes, 18 U.S.C. §§1956(a)(1)(B)(i), 1957. A jury convicted O'Hagan on all 57 counts, and he was sentenced to a 41-month term of imprisonment.

[Footnote 1: As evidence that O'Hagan traded on the basis of nonpublic information misappropriated from his law firm, the Government relied on a conversation between O'Hagan and the Dorsey & Whitney partner heading the firm's Grand Met representation. That conversation allegedly took place shortly before August 26, 1988. See Brief for United States 4. O'Hagan urges that the Government's evidence does not show he traded on the basis of nonpublic information. O'Hagan points to news reports on August 18 and 22, 1988, that Grand Met was interested in acquiring Pillsbury, and to an earlier, August 12, 1988, news report that Grand Met had put up its hotel chain for auction to raise funds for an acquisition. O'Hagan's challenge to the sufficiency of the evidence remains open for consideration on remand.]

A divided panel of the Court of Appeals for the Eighth Circuit reversed all of O'Hagan's convictions. 92 F.3d 612 (1996). Liability under §10(b) and Rule 10b-5, the Eighth Circuit held, may not be grounded on the "misappropriation theory" of securities fraud on which the prosecution relied. The Court of Appeals also held that Rule 14e-3(a)--which prohibits trading while in possession of material, nonpublic information relating to a tender offer--exceeds the SEC's §14(e) rulemaking authority because the rule contains no breach of fiduciary duty requirement. The Eighth Circuit further concluded that O'Hagan's mail fraud and money laundering convictions rested on violations of the securities laws, and therefore could not stand once the securities fraud convictions were reversed. Judge Fagg, dissenting, stated that he would recognize and enforce the misappropriation theory, and would hold that the SEC did not exceed its rulemaking authority when it adopted Rule 14e-3(a) without requiring proof of a breach of fiduciary duty.

Decisions of the Courts of Appeals are in conflict on the propriety of the misappropriation theory under §10(b) and Rule 10b-5, and on the legitimacy of Rule 14e-3(a) under §14(e), see infra, at 25. We granted certiorari, 519 U.S. (1997), and now reverse the Eighth Circuit's judgment.

II. [Rule 10b-5]

We address first the Court of Appeals' reversal of O'Hagan's convictions under §10(b) and Rule 10b-5. Following the Fourth Circuit's lead, see United States v. Bryan, 58 F.3d 933, 943-959 (1995), the Eighth Circuit rejected the misappropriation theory as a basis for §10(b) liability. We hold, in accord with several other Courts of Appeals, that criminal liability under §10(b) may be predicated on the misappropriation theory.

A.

Liability under Rule 10b-5, our precedent indicates, does not extend beyond conduct encompassed by §10(b)'s prohibition. See Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976) (scope of Rule 10b-5 cannot exceed power Congress granted Commission under §10(b)); see also Central Bank of Denver, N. A. v. First Interstate Bank of Denver, N. A., 511 U.S. 164 (1994) ("We have refused to allow [private] 10b-5 challenges to conduct not prohibited by the text of the statute.").

Under the "traditional" or "classical theory" of insider trading liability, §10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information. Trading on such information qualifies as a "deceptive device" under §10(b), we have affirmed, because "a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation." Chiarella v. United States, 445 U.S. 222 (1980). That relationship, we recognized, "gives rise to a duty to disclose [or to abstain from trading] because of the 'necessity of preventing a corporate insider from . . . taking unfair advantage of . . . uninformed . . . stockholders.'" The classical theory applies not only to officers, directors, and other permanent insiders of a corporation, but also to attorneys, accountants, consultants, and others who temporarily become fiduciaries of a corporation. See Dirks v. SEC, 463 U.S. 646 (1983).

The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates §10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information.

The two theories are complementary, each addressing efforts to capitalize on nonpublic information through the purchase or sale of securities. The classical theory targets a corporate insider's breach of duty to shareholders with whom the insider transacts; the misappropriation theory outlaws trading on the basis of nonpublic information by a corporate "outsider" in breach of a duty owed not to a trading party, but to the source of the information. The misappropriation theory is thus designed to "protect the integrity of the securities markets against abuses by 'outsiders' to a corporation who have access to confidential information that will affect the corporation's security price when revealed, but who owe no fiduciary or other duty to that corporation's shareholders."

In this case, the indictment alleged that O'Hagan, in breach of a duty of trust and confidence he owed to his law firm, Dorsey & Whitney, and to its client, Grand Met, traded on the basis of nonpublic information regarding Grand Met's planned tender offer for Pillsbury common stock. This conduct, the Government charged, constituted a fraudulent device in connection with the purchase and sale of securities.

B.

We agree with the Government that misappropriation, as just defined, satisfies §10(b)'s requirement that chargeable conduct involve a "deceptive device or contrivance" used "in connection with" the purchase or sale of securities. We observe, first, that misappropriators, as the Government describes them, deal in deception. A fiduciary who "[pretends] loyalty to the principal while secretly converting the principal's information for personal gain," "dupes" or defrauds the principal. See Aldave, Misappropriation: A General Theory of Liability for Trading on Nonpublic Information, 13 Hofstra L. Rev. 101, 119 (1984).

The misappropriation theory advanced by the Government is consistent with Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977), a decision underscoring that §10(b) is not an all-purpose breach of fiduciary duty ban; rather, it trains on conduct involving manipulation or deception. In contrast to the Government's allegations in this case, in Santa Fe Industries, all pertinent facts were disclosed by the persons charged with violating §10(b) and Rule 10b-5; therefore, there was no deception through nondisclosure to which liability under those provisions could attach. Similarly, full disclosure forecloses liability under the misappropriation theory. Because the deception essential to the misappropriation theory involves feigning fidelity to the source of information, if the fiduciary discloses to the source that he plans to trade on the nonpublic information, there is no "deceptive device" and thus no §10(b) violation--although the fiduciary-turned-trader may remain liable under state law for breach of a duty of loyalty.

We turn next to the §10(b) requirement that the misappropriator's deceptive use of information be "in connection with the purchase or sale of [a] security." This element is satisfied because the fiduciary's fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities. The securities transaction and the breach of duty thus coincide. This is so even though the person or entity defrauded is not the other party to the trade, but is, instead, the source of the nonpublic information. See Aldave, 13 Hofstra L. Rev., at 120 ("a fraud or deceit can be practiced on one person, with resultant harm to another person or group of persons"). A misappropriator who trades on the basis of material, nonpublic information, in short, gains his advantageous market position through deception; he deceives the source of the information and simultaneously harms members of the investing public.

The misappropriation theory targets information of a sort that misappropriators ordinarily capitalize upon to gain no-risk profits through the purchase or sale of securities. Should a misappropriator put such information to other use, the statute's prohibition would not be implicated. The theory does not catch all conceivable forms of fraud involving confidential information; rather, it catches fraudulent means of capitalizing on such information through securities transactions.

The misappropriation theory comports with §10(b)'s language, which requires deception "in connection with the purchase or sale of any security," not deception of an identifiable purchaser or seller. The theory is also well-tuned to an animating purpose of the Exchange Act: to insure honest securities markets and thereby promote investor confidence. See 45 Fed. Reg. 60412 (1980) (trading on misappropriated information "undermines the integrity of, and investor confidence in, the securities markets"). Although informational disparity is inevitable in the securities markets, investors likely would hesitate to venture their capital in a market where trading based on misappropriated nonpublic information is unchecked by law. An investor's informational disadvantage vis-a-vis a misappropriator with material, nonpublic information stems from contrivance, not luck; it is a disadvantage that cannot be overcome with research or skill. See Brudney, Insiders, Outsiders, and Informational Advantages Under the Federal Securities Laws, 93 Harv. L. Rev. 322, 356 (1979) ("If the market is thought to be systematically populated with . . . transactors [trading on the basis of misappropriated information] some investors will refrain from dealing altogether, and others will incur costs to avoid dealing with such transactors or corruptly to overcome their unerodable informational advantages."); Aldave, 13 Hofstra L. Rev., at 122-123.

In sum, considering the inhibiting impact on market participation of trading on misappropriated information, and the congressional purposes underlying §10(b), it makes scant sense to hold a lawyer like O'Hagan a §10(b) violator if he works for a law firm representing the target of a tender offer, but not if he works for a law firm representing the bidder. The text of the statute requires no such result. The misappropriation at issue here was properly made the subject of a §10(b) charge because it meets the statutory requirement that there be "deceptive" conduct "in connection with" securities transactions.

III. [Rule 14e-3(a)]

We consider next the ground on which the Court of Appeals reversed O'Hagan's convictions for fraudulent trading in connection with a tender offer, in violation of §14(e) of the Exchange Act and SEC Rule 14e-3(a). A sole question is before us as to these convictions: Did the Commission, as the Court of Appeals held, exceed its rulemaking authority under §14(e) when it adopted Rule 14e-3(a) without requiring a showing that the trading at issue entailed a breach of fiduciary duty? We hold that the Commission, in this regard and to the extent relevant to this case, did not exceed its authority.

Section 14(e)'s first sentence prohibits fraudulent acts in connection with a tender offer. This self-operating proscription was one of several provisions added to the Exchange Act in 1968 by the Williams Act, 82 Stat. 454. The section's second sentence delegates definitional and prophylactic rulemaking authority to the Commission. Congress added this rulemaking delegation to §14(e) in 1970 amendments to the Williams Act. See §5, 84 Stat. 1497.

Relying on §14(e)'s rulemaking authorization, the Commission, in 1980, promulgated Rule 14e-3(a). As characterized by the Commission, Rule 14e-3(a) is a "disclose or abstain from trading" requirement. 45 Fed. Reg. 60410 (1980). The Second Circuit concisely described the rule's thrust:

"One violates Rule 14e-3(a) if he trades on the basis of material nonpublic information concerning a pending tender offer that he knows or has reason to know has been acquired 'directly or indirectly' from an insider of the offeror or issuer, or someone working on their behalf. Rule 14e-3(a) is a disclosure provision. It creates a duty in those traders who fall within its ambit to abstain or disclose, without regard to whether the trader owes a pre-existing fiduciary duty to respect the confidentiality of the information." United States v. Chestman, 947 F.2d 551, 557 (1991) (en banc), cert. denied, 503 U.S. 1004 (1992).

We need not resolve in this case whether the Commission's authority under § 14(e) to "define . . such acts and practices as are fraudulent" is broader than the Commission's fraud-defining authority under § 10(b), for we agree with the United States that Rule 14e-3(a), as applied to cases of this genre, qualifies under §14(e) as a "means reasonably designed to prevent" fraudulent trading on material, nonpublic information in the tender offer context. A prophylactic measure, because its mission is to prevent, typically encompasses more than the core activity prohibited. As we noted in Schreiber, §14(e)'s rulemaking authorization gives the Commission "latitude," even in the context of a term of art like "manipulative," "to regulate nondeceptive activities as a 'reasonably designed' means of preventing manipulative acts, without suggesting any change in the meaning of the term 'manipulative' itself." 472 U.S. at 11. We hold, accordingly, that under §14(e), the Commission may prohibit acts, not themselves fraudulent under the common law or §10(b), if the prohibition is "reasonably designed to prevent . . . acts and practices [that] are fraudulent." 15 U. S. C. §78n(e).

In sum, it is a fair assumption that trading on the basis of material, nonpublic information will often involve a breach of a duty of confidentiality to the bidder or target company or their representatives. The SEC, cognizant of the proof problem that could enable sophisticated traders to escape responsibility, placed in Rule 14e-3(a) a "disclose or abstain from trading" command that does not require specific proof of a breach of fiduciary duty. That prescription, we are satisfied, applied to this case, is a "means reasonably designed to prevent" fraudulent trading on material, nonpublic information in the tender offer context. See Chestman, 947 F.2d at 560 ("While dispensing with the subtle problems of proof associated with demonstrating fiduciary breach in the problematic area of tender offer insider trading, [Rule 14e-3(a)] retains a close nexus between the prohibited conduct and the statutory aims."); accord, Maio, 51 F.3d at 635; Peters, 978 F.2d at 1167. Therefore, insofar as it serves to prevent the type of misappropriation charged against O'Hagan, Rule 14e-3(a) is a proper exercise of the Commission's prophylactic power under §14(e).

IV.

The judgment of the Court of Appeals for the Eighth Circuit is reversed, and the case is remanded for further proceedings consistent with this opinion.