Justices Say Firm Can’t Lie About Merger Talks : Rule Investors May Win Damages From Directors Who Falsely Deny Holding Serious Discussions

In a ruling that could send shudders through corporate board rooms, the Supreme Court said Monday that investors may win damages from company directors who falsely denied that they were involved in negotiations that led to corporate mergers.

The justices ruled that “misleading” statements denying rumors of a pending merger may provide investors who sold stock during that period with sufficient basis to win damages from the company officers.

But the ruling suggested that company directors may avoid liability simply by refusing to make any comment on possible mergers.

“The key message is: Once you speak up, make sure the statement is accurate,” said Stephen M. Shapiro, a Chicago attorney who represented the American Corporate Counsel Assn.

The case involved the 1978 merger of Basic Inc. of Cleveland and Combustion Engineering of Connecticut, two manufacturers of refractories for the steel industry. Stockholders sued Basic’s directors for denying merger talks after they had begun.

Basic’s directors relied on two traditional legal defenses against damage claims, but the Supreme Court rejected them both.

First, attorneys for Basic’s board said that the directors had no duty to tell the truth about merger talks until a firm agreement was reached. On a 6-0 vote, the Supreme Court disagreed.

Justice Harry A. Blackmun wrote for the court that the nation’s securities laws seek to protect investors by “substituting a philosophy of full disclosure for a philosophy of caveat emptor. Disclosure, and not paternalistic withholding of accurate information, is the policy chosen and expressed by Congress.”

Second, the corporate lawyers said that only investors who could prove that they relied on a misleading statement had grounds for suing. The high court rejected that argument, 4 to 2.

The court held that all stockholders who sold during the period of intensive negotiations were harmed by the company’s denial whether or not they believed it or relied on it. Because misleading statements could hold the stock price at an artificially low level, it found, all stockholders who sold while the merger talks were under way were victims of a “fraud.”

Securities experts said that this was the first time that the high court had accepted the so-called “fraud on the market” theory as a basis for deciding whether someone was the victim of a fraud.

Class-Action Suits Seen

Attorneys representing certified public accountants said that this approach could lead to “mammoth class-action suits” by investors against auditors who unwittingly approve misleading corporate statements.

In the case decided Monday, executives of Combustion Engineering began talks with Basic Inc. officers in 1976 about a possible merger. The off-again, on-again talks continued through 1977 but got more serious in early 1978, when Basic’s stock was selling for less than $20 a share.

The stock then began rising in price, and, in response to Wall Street rumors of a merger, Basic issued three public statements denying that its officers knew of any reason for the steady rise in its stock price. As late as Nov. 6, 1978, the company directors said that “we remain unaware of any present or pending development” that could explain the run-up in its stock price.

Sale of Firm Approved

On Dec. 19, 1978, however, Basic’s board voted to approve the company’s sale to Combustion at $46 a share.

Several stockholders filed suit against Basic’s board, contending that they were misled into selling their stock at the low, pre-merger price. A district judge in Cleveland rejected their suit but a federal appeals court reinstated it in 1986, ruling that such statements were both significant and misleading.

The high court sent the case (Basic Inc. vs. Levinson, 86-279) back to the district judge for trial.

Blackmun’s opinion appeared to seek a midpoint between requiring full disclosure of merger talks and permitting corporate officers to deny everything until the day a merger is announced.

Federal securities laws say that investors are entitled to know about “material” developments, Blackmun wrote. What is “material” depends on the facts of each case, but corporate boards must not deny merger talks that reach the level of “board resolutions, instructions to investment bankers and actual negotiations between principals,” Blackmun held.

Silence May Be Shield

In a footnote to his opinion, however, Blackmun seemed to suggest that a firm policy of refusing to comment may shield the board.

“To be actionable, of course, a statement must also be misleading,” he said. “Silence, absent a duty to disclose, is not misleading under Rule 10-5 (of the Securities Exchange Act). ‘No comment’ statements are generally the functional equivalent of silence.”

Paul Gonson, solicitor for the Securities and Exchange Commission, said that the footnote may carry more weight than all the talk in the court’s opinion about full disclosure.

“We encourage disclosure to investors of all material information,” Gonson said. “But what the court seems to be saying there is that you are always safe if you say ‘no comment.’ ”

Wayne Cross, a New York lawyer who represented the stockholders who filed the suit, said that damages ultimately could amount to $20 million to all the stockholders who sold Basic stock during the merger talks.

Tougher on Management

The Supreme Court’s ruling, Cross said, “makes things a little tougher for management. The Supreme Court has clearly said you can’t put out evasive statements about mergers, and that will be a benefit to investors.”

“For the sophisticated board, this ruling means that you either put a tight lid on any information about mergers so no rumors get started or, if information does get out, you need to put out an accurate statement about the talks,” Cross said.

William M. Golub, an attorney for the company board, said that “in general, it is a bad decision for management. It will make the job of management that much more difficult.”

Because company directors do not know whether merger talks will lead to actual mergers, Golub said, most are not inclined to respond to market rumors. But this ruling “creates a lot of uncertainty,” he said, by suggesting that merger talks become “material developments” at some undefined point.

Blackmun’s opinion was joined in full by Justices William J. Brennan Jr., Thurgood Marshall and John Paul Stevens. Justices Byron R. White and Sandra Day O’Connor agreed in part but disagreed with the court’s adoption of the broad “fraud on the market” theory.

Chief Justice William H. Rehnquist and Justices Antonin Scalia and Anthony M. Kennedy took no part. Rehnquist said that his daughter’s law firm played a part in the case; Scalia refused to say why he recused himself. Kennedy is not voting on any cases that were heard before he arrived on the court on Feb. 19.