The opinion of the court was delivered by: VAUGHN R. WALKER
ORDER GRANTING IN PART AND DENYING IN PART DEFENDANTS' MOTION FOR SUMMARY JUDGMENT.
This case requires the court to examine the showing required to support a "truth on the market" defense to a federal securities action brought under Rule 10b-5, 17 CFR § 240.10b-5, and premised upon the "fraud on the market" theory. For the reasons stated below, the court holds that summary judgment in favor of defendants asserting a truth on the market defense cannot be granted where the parties' evidence of "what the market knew" consists of competing volumes of contradictory analysts' reports and articles printed in the popular press. Establishment of a truth on the market defense requires a showing that the price of the security was not systematically biased in the same way that proof of a fraud on the market requires proof of such bias.
It is just this distinction which forms the factual context for this securities fraud lawsuit. In 1988, manufacturers of IBM-compatible personal computers, and IBM itself, began to move from 5-1/4" floppy disk drives to the 3-1/2" size. Of course, the manufacturers of rigid disk drives, including Seagate, sought to time their switch from the larger sized drive to the smaller to meet the change in market demand. At the time, Seagate maintained a cost advantage over its competitors in the 5-1/4" model, and embarked on a risky strategy of expanding capacity and aggressively marketing 5-1/4" disk drives while delaying the company's entry into the more competitive market for 3-1/2" disk drives. In the first six months of 1988, Seagate announced a need to increase production capacity, heavy demand, growing market share and price increases for its products.
In retrospect, Seagate's strategy failed. In July 1988, Seagate announced that net income for the fourth quarter, ending June 30, 1988, had fallen 56%. In August 1988, Seagate disclosed an expected loss for the quarter ending September 30, 1988. On October 26, 1988, Seagate in fact reported a large loss for the quarter ending September 30, and announced inventory write-offs and other charges. Plaintiffs point out that the price of Seagate's common stock fell precipitously after each of these announcements, and in the aggregate tumbled from around $ 18 per share just prior to the July 1988 announcement to just above $ 7 per share following the October 26 disclosure.
The scope of this case has been significantly narrowed in orders issued before this case was assigned to the undersigned. Seagate now moves for summary judgment on the six alleged misrepresentations which remain in the case.
Plaintiffs allege that Seagate's positive announcements prior to October 1988 were materially false and misleading because they failed to disclose: (1) Seagate was suffering from severe excess production capacity, and that such capacity was continuing to expand at a rate well in excess of demand; (2) Seagate had seriously overestimated market demand for its products; (3) Seagate had been increasing its production capacity at the same time that it was reducing per-unit prices in an attempt to increase market share, but that the strategy had backfired, resulting in a reduction in Seagate's net income; (4) Seagate had seriously overestimated demand, and that as a result inventory was swelling rapidly; (5) Seagate had incurred substantial operating losses as a result of its strategy of increasing expansion production capacity ahead of demand and slashing prices and selling near or below cost; and (6) Seagate's plant in Watsonville, California, was not completed when opened, that completion and production of disk drives at the plant was not expected for months and that Seagate had no present plans to fully equip or utilize the plant. Complaint PP 61(a), 61(b), 61(d), 61(e), 61(m), 61(q).
Seagate's motion for summary judgment is premised upon a "truth on the market" theory. Admitting, as it must, that the company did not itself disclose the information which plaintiffs allege should have been disclosed prior to October 1988, Seagate supplements its motion with over 50 documents produced and publicly distributed by third parties prior to October 1988 which, according to Seagate, apprised the market of the information not disclosed by the company. Naturally, plaintiffs file in opposition to Seagate's motion a large number of third party documents which indicate that market analysts were "hoodwinked" by Seagate's failure to disclose.
The fraud on the market theory, seemingly approved by the Supreme Court in Basic, Inc. v. Levinson, 485 U.S. 224, 99 L. Ed. 2d 194, 108 S. Ct. 978 (1988), is based on the hypothesis that, in a market for securities which is "information efficient," the price of the securities issued by a company is determined by the available material information regarding the company and its business. Basic, 485 U.S. at 241. See also Robert G. Newkirk, Sufficient Efficiency: Fraud on the Market in the Initial Public Offering Context, 58 U Chi L Rev 1393, 1396-1400 (1991). Investors transacting in such markets rely generally on the supposition that the market price is validly set and that no unsuspected manipulation has artificially inflated the price. Blackie v. Barrack, 524 F.2d 891, 907 (9th Cir 1975). Misleading statements therefore defraud investors who rely on the validity of the market price even if the investors do not directly rely on the misstatements. Basic, 485 U.S. at 241-42, citing Peil v. Speiser, 806 F.2d 1154, 1160 (3d Cir 1986).
The fraud on the market theory does not eliminate the traditional requirements of a securities fraud action brought under Rule 10b-5. Plaintiffs must still prove, inter alia, justifiable reliance, materiality, causation and damages. Under the theory, however, reliance on the misleading statements of the defendant is presumed once the plaintiff proves reliance on the market price. Basic, 485 U.S. at 245.
The theory also subsumes the inquiry into materiality, causation and damages. Generally, an omitted fact is material if there is a substantial likelihood that the disclosure of the fact would have been viewed by a reasonable investor as having significantly altered the "total mix" of information made available. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449, 48 L. Ed. 2d 757, 96 S. Ct. 2126 (1976). In a fraud on the market case, if an allegedly misleading omission could have no effect on the security's market price, the undisclosed information cannot be material. Similarly, if a statement or omission had no effect on the market price, there can be no causal ...