Basic Inc. v. Levinson, 485 U.S. 224 (1988)

Basic Inc. v. Levinson, 485 U.S. 224 (1988)

Description

Beginning in late 1976, Combustion Engineering Inc. commenced discussions with Basic Inc.'s management concerning a potential merger. Despite the discussions, Basic Inc. issued three public statements in 1977 and 1978 denying that it was involved in any merger negotiations. Finally, in December of 1978, Basic Inc. announced its pending merger with Combustion Engineering Inc. Investors who had sold Basic Inc. stock from the date of Basic Inc.'s first public denial of any merger up to the announcement of the Combustion Engineering Inc. merger brought a class action suit against Basic Inc. and its board of directors, alleging a material misstatement in violation of Rule 10b-5 and section 10(b) of the Securities Exchange Act of 1934. The investors claimed that Basic Inc.'s public denials depressed the share price, resulting in a lower sale price when the investors sold their Basic Inc. shares during the class period. Writing for a plurality of the Supreme Court, Justice Harry Blackmun addressed two key issues concerning the application of Rule 10b-5: materiality and reliance. First, Blackmun dealt with the definition of materiality regarding contingent events. Blackmun followed the Second Circuit's lead in assessing contingent events based on the probability multiplied by the magnitude of such events. Because of the large magnitude of a merger, particularly for a target company, information on the merger even at early stages, when the probability is relatively low, may still be material. While the probability multiplied by the magnitude approach provides a framework to assess the materiality of contingent events, several questions remain after Basic. Merely invoking the probability multiplied by the magnitude formulation leaves open the question of the threshold above which the formulation is material. Is it $1 million, $10 million, or more (or less)? Moreover, how is a jury (or judge) to decide the probability of an event at a time in the distant past? Juries may suffer from hindsight bias in assessing the ex ante probability of known events after they actually occurred. The second major issue in Basic involved reliance. For the plurality, Blackmun ruled on whether the Basic Inc. class action plaintiffs had to demonstrate reliance on the part of each class member or, instead, whether a presumption of reliance would apply. The plurality in Basic established the “fraud on the market” presumption. Under the presumption, plaintiffs in a securities fraud action under Rule 10b-5 do not individually need to establish reliance on publicly disclosed affirmative misstatements. Instead, if plaintiffs demonstrate that the traded company's securities trade in a relatively liquid, efficient market, a presumption of reliance is applied. Blackmun justified the fraud on the market presumption in part based on the presence of a growing empirical economic literature in support of the Efficient Capital Markets Hypothesis (ECMH). While debate exists as to the validity of the ECMH, Blackmun justified applying the fraud on the market presumption as follows: “Presumptions typically serve to assist courts in managing circumstances in which direct proof, for one reason or another, is rendered difficult.” Several variants of the ECMH exist. For purposes of the fraud on the market presumption, the most important (and empirically defensible) variant is the semi-strong version of the ECMH that holds that securities prices incorporate all publicly available information on the traded company.

Source Publication

Encyclopedia of the Supreme Court of the United States

Source Editors/Authors

David S. Tanenhaus

Publication Date

2008

Volume Number

1: A—C

Basic Inc. v. Levinson, 485 U.S. 224 (1988)

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