On Appeal from the United States District Court for the District of Delaware, D.C. Civil No. 86-00595.
Gibbons Chief Judge, and Weis and Greenberg, Circuit Judges.
Robert M. Deutschman appeals from a Fed. R. Civ. P. 12(b)(6) dismissal of his amended class action complaint against Beneficial Corporation (Beneficial), Finn M. W. Caspersen, Beneficial's Chairman and Chief Executive Officer, and Andrew C. Helvorsen, its Chief Financial Officer. The two count complaint alleges that the defendants violated (1) section 10(b) and 20(a) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b), 78t(a) (1982), and (2) the state common law of negligent misrepresentation. Deutschman, a purchaser of call options on Beneficial stock, seeks to act as a class representative for purchasers of such call options and for purchasers of Beneficial stock. The district court held that the purchaser of a call option lacks standing to sue under the Securities Exchange Act, and is thus not an appropriate class representative for purchasers of Beneficial stock. Because the federal claim was dismissed on standing grounds, the pendent state law claim was dismissed as well. We will reverse.
Since the order appealed from granted a Rule 12(b(6) motion, we accept as true the factual allegations of Deutschman's amended complaint. Deutschman alleges that in 1986 and part of 1987 Beneficial's insurance division suffered severe losses which had an adverse impact on Beneficial's financial condition; that Caspersen and Halversen held stock and stock options in Beneficial which would be adversely affected by a decline in the market price of that stock; that disclosures were made about the losses in Beneficial's insurance division which caused declines in that market price; that in order to prevent further declines Caspersen and Halversen, on Beneficial's behalf, issued statements about the problems in the insurance division, which they knew to be false and misleading, to the effect that those problems were behind it and were covered by sufficient reserves; that these misleading statements placed an artificial floor under the market price of Beneficial stock; that purchasers of Beneficial stock and purchasers of call options in Beneficial stock made purchases at prices which were artificially inflated by the market's reliance on defendants' misstatements, and that both purchasers of Beneficial stock and purchasers of Beneficial call options suffered losses as a consequence. Beneficial stock is traded on the New York Stock Exchange and on other national stock exchanges. Options on Beneficial stock are traded on the Pacific Stock Exchange. The complaint does not allege that Beneficial, Caspersen, or Halversen, during the time period complained of, traded in Beneficial stock or in put or call options on Beneficial stock. It alleges that Deutschman suffered losses when, upon disclosure of the facts, call options on Beneficial's stock that he had purchased in reliance on the market price created by defendants' misstatements, became worthless. It does not allege that Deutschman purchased Beneficial stock.
The district court held that option traders who suffered losses as a result of intentional misstatements by the management of a corporation, the stock of which is the subject of those options, lack standing to assert a cause of action for damages under section 10(b) of the 1934 Act, 15 U..C. § 78j(b), and Rule 10b-5 of the Securities and Exchange Commission, 17 C.F.R. § 240.10b-5. The court reasoned that in the absence of an allegation that Deutschman bought or sold Beneficial stock, or of an allegation that the defendants bought or sold options, there was no duty owed to him to refrain even from affirmative misstatements which would affect the market price of Beneficial stock.
Put and call options have been a feature of the national financial markets since 1790. Under these contracts a seller agrees to sell or a purchaser agrees to buy a security at a fixed price on or before a fixed date in the future. Such contracts permit investors to hedge against future movements in the market price of securities. Prior to the early 1970's the utility of put and call options was limited because of high transaction costs, and because of the absence of a secondary market for the option contracts. In 1973, the Chicago Board Options Exchange became the first registered exchange for trading in option contracts. Within a short time that exchange had been joined by the American, Philadelphia, Pacific, and Midwest exchanges. By 1985, those exchanges were trading options on over 400 stocks, and the volume of contracts traded exceeded 118.6 million. See Green Stock Option Trading Gains Popularity as Takeovers and Hedging Spur Surge, Wall St. J., July 23, 1986, at 35, col. 1.
The option contract gives its owner the right to buy (call) or sell (put) a fixed number of shares of a specified underlying stock at a given price (the striking price) on or before the expiration date of the contract. For this option a premium is paid, and the contract is worth more or less than the premium depending upon the direction of the market price of the underlying stock relative to the striking price. The market price for options is directly responsive, therefore, to changes in the market price of the underlying stock, and to information affecting that price. See generally, Rubenstein, An Economic Evaluation of Organized Option Markets, 2 J. of Comp. Corp. Law and Sec. Reg. 49 (1979).
Because the market value of an option contract is responsive to changes in the market price of the underlying stock, holders of option contracts are susceptible to two separate types of deceptive practices: insider trading and affirmative misrepresentation. Insiders trading on undisclosed material information can injure option holders either by market activity which causes the price of the underlying stock to move, or by market activity directly in the options market. Insiders or others who do not trade in either market can injure option holders by misstating material facts to the public, thereby causing a distortion in the market price of the underlying security, and in the necessarily related market price of the option contract. Only the second type of harm is pleaded by Deutschman: affirmative misrepresentation by corporate managers having the effect of artificially supporting the market price of the underlying stock, and concomitantly the market price of the option contract for that stock.
Section 10(b) prohibits the use "in connection with the purchase or sale of any security . . . [of] any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe." 15 U.S.C. § 78j(b). The relevant SEC rule provides that:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances ...