securities and exchange commission

securities and exchange commission v. Texas Gulf Sulphur Co.

United States Court of Appeals 401 F.2d 833 (2nd Cir. 1968)

The SEC (plaintiff) brought an action against the Texas Gulf Sulphur Company (TGS) and 13 of its directors, officers, and employees (defendants) for violation of Section 10(b) of the Exchange Act and SEC Rule 10(b)-5, seeking an injunction against further misleading press releases and requesting rescission of the defendants’ purchases and stock options. On June 6, 1963, TGS had acquired an option to buy 160 acres of land in Timmons, Ontario. On November 11, 1963, preliminary drilling indicated that there would be major copper and zinc finds. TGS acquired the land and resumed drilling on March 31, 1964, and by April 8, it was evident that there were substantial copper and zinc deposits. On April 9, Toronto and New York newspapers reported that TGS had discovered “one of the largest copper deposits in America.” On April 12, TGS’s management said that the rumors of a major find were without factual basis. At 10 a.m. on April 14, the board of directors authorized the issuance of a statement confirming the copper and zinc finds and announcing the discovery of silver deposits as well. On April 20, the NYSE announced that it “was barring stop orders [orders to brokers to buy a stock if its price rises to a certain level to lock in profits in case of a sharp rally in that stock] in Texas Gulf Sulphur” because of the extreme volatility in the trading of the stock.

Approximately one month later, rumors circulated about insider trading. It was later found that when drilling began on November 12, 1963, TGS’s directors, officers, and employees owned only 1,135 shares of stock in the company and had no calls (options to purchase shares at a fixed price). By March 31, 1964, when drilling resumed, insiders (tippers) and their tippees had acquired an additional 7,100 shares and 12,300 calls. On February 20, 1964, TGS had issued stock options to three officers and two other employees as part of a compensation package.

From April 9, 1964 to April 14, 1964, when the confirmatory press release was issued, 10 insiders and their tippees made estimated profits of $273,892 on the purchase of their shares or calls of TGS stock. The federal district court dismissed charges against all but two defendants. Those defendants, Clayton and Crawford, appealed, and the SEC appealed from the part of the district court decision that had dismissed the complaint against TGS and the nine other individual defendants.

Judge Waterman

Rule 10(b)-5 was promulgated pursuant to the grant of authority given the SEC by Congress in Section 10(b) of the Securities Exchange Act of 1934. By that Act Congress proposed to prevent inequitable and unfair practices and to ensure fairness in securities transactions generally, whether conducted face-to-face, over the counter, or on exchanges. The Act and the Rule apply to the transactions here, all of which were consummated on exchanges.

The essence of the Rule is that anyone who, trading for his own account in the securities of a corporation, has “access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone” may not take “advantage of such information knowing it is unavailable to those with whom he is dealing,” i.e., the investing public. Insiders, as directors or management officers, are, of course, by this Rule, precluded from so unfairly dealing, but the Rule is also applicable to one possessing the information who may not be strictly termed an “insider” within the means of Sec. 10(b) of the Act. Thus, anyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing it in order to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such insider information remains undisclosed. So, it is here no justification for insider activity that disclosure was forbidden by the legitimate corporate objective of acquiring options to purchase the land surrounding the exploration site; if the information was, as the SEC contends, material, its possessors should have kept out of the market until disclosure was accomplished.

As we stated in List v. Fashion Park, Inc., “The basic test of materiality is whether a reasonable man would attach importance in determining his choice of action in the transaction in question.” This, of course, encompasses any fact “which in reasonable and objective contemplation might affect the value of the corporation’s stock or securities.” Such a fact is a material fact and must be effectively disclosed to the investing public prior to the commencement of insider trading in the corporation’s securities. The speculators and chartists of Wall and Bay Streets are also “reasonable” investors entitled to the same legal protection afforded conservative traders. Thus, material facts include not only information disclosing the earnings and distributions of a company but also those facts which affect the probable future of the company and those which may affect the desire of investors to buy, sell, or hold the company’s securities.

The core of Rule 10(b)-5 is the implementation of the Congressional purpose that all investors should have equal access to the rewards of participation in securities transactions. It was the intent of Congress that all members of the investing public should be subject to identical market risks—which market risks include, of course, the risk that one’s evaluative capacity or one’s capital available to put at risk may exceed another’s capacity or capital. The insiders here were not trading on an equal footing with the outside investors. They alone were in a position to evaluate the probability and magnitude of what seemed from the outset to be a major ore strike; they alone could invest safely, secure in the expectation that the price of TGS stock would rise substantially in the event such a major strike should materialize, but would decline little, if at all, in the event of failure, for the public, ignorant at the outset of the favorable probabilities, would likewise be unaware of the unproductive exploration, and the additional exploration costs would not significantly affect TGS market prices. Such inequities based upon unequal access to knowledge should not be shrugged off as inevitable in our way of life, or, in view of the congressional concern in the area, remain uncorrected.

We hold, therefore, that all transactions in TGS stock or calls by individuals apprised of the drilling results of K-55-1 were made in violation of Rule 10(b)-5.*

Reversed and remanded in favor of Plaintiff, SEC.

Linking Law and Business Economics: Efficient Markets

In microeconomics, you learned that the law of supply and demand brings about equilibrium price levels, assuming a free flow of information and mobility of resources. These factors will create efficient markets.

Microeconomics presents an important link to securities law. When plaintiffs argue a fraud-on-the- market theory, they are arguing that there is a distortion or omission of information and, thus, the purchase or sale of the security is subject to fraud and a violation of securities law.

Corporate Mismanagement and Section 10(b)

The third controversial area of securities fraud under Section 10(b) is corporate mismanagement. Suits alleging corporate mismanagement and fraud brought by minority shareholders in class action or derivative suits must prove three elements: (1) that the transaction being attacked (e.g., the sale of a controlling stock interest in a corporation at a premium) involves the purchase or sale of securities, (2) that the alleged fraud is in connection with a purchase or sale, and (3) that the plaintiff is either a purchaser or a seller of securities in the transaction involved. The Hochfelder case, referred to in the Schreiber case excerpted earlier in this chapter, is an example of fraud perpetrated on shareholders by management. Other cases alleging fraud dealing with reorganizations and mergers have been brought, but since the mid-1970s, the Supreme Court has been reluctant to allow cases brought under Section 10(b) to preempt state laws and, thus, has made plaintiffs meet all three elements in an exacting manner.

Fraud-on-the-Market Theory and Section 10(b)

The Supreme Court has attached stringent criteria to all private-party actions brought under Section 10(b)-5 and SEC Rule 10(b)-5. Defrauded investors generally need to show that their losses resulted from specific conduct of the company or its employees or agents and that they relied on specific misstatements, omissions, or fraudulent actions in making investment decisions. More recently, shareholders have used an efficient-market concept as the basis for suits claiming fraud. That is, they have alleged that they relied on the integrity of an efficient market to assimilate all information about a company and to reflect this information in a fair price for securities. The plaintiff in such a suit argues that when a company makes fraudulent disclosures or omissions, it distorts the information flow to the market and thus fixes the price of the company’s securities too high, in violation of Section 10(b) and Rule 10(b)-5. This fraud-on-the-market theory assumes that the market price reflects all known material information. In a landmark decision (United States v. James O’Hagan, 117 S. Ct. 2199 [1997]) the U.S. Supreme Court upheld this theory.

Insider Trading Bills: Is Congress Corrupt?

The Senate bill states in part: “No member of Congress and no employee of Congress shall use any non-public information derived from the individual’s position as a member of Congress or employee of Congress or gained from performance of the individual’s duties” for personal benefit.

For many years, a separate industry, known as “political intelligence,” was practiced by political insiders connected with hedge funds, mutual funds, and other investors. When bills were passed by members of the House and Senate, powerful new tools were added by which prosecutors could pursue public corruption cases. Numerous amendments were passed. For the first time, firms that collect “political intelligence” must register and report their activities as lobbyists. All such activities obtained from Congress and federal agencies that are used to influence or guide investment decisions must be reported.

Liability and Remedies Under The 1934 Exchange Act

Criminal Penalties

Violations of Section 10(b) and Rule 10(b) may lead individuals to be fined up to $5 million or imprisoned up to 20 years, or both under the Sarbanes-Oxley Act as discussed earlier in this chapter. A partnership or corporation may be fined $25 million for a proven willful violation. The violator may be imprisoned for 25 years in addition to being fined. The SEC must refer all criminal actions to the Justice Department.

SEC Action

Under the Insider Trading Sanctions Act of 198412 and the Insider Trading and Securities Enforcement Act of 1988, the SEC may bring a civil suit against anyone violating or aiding or abetting a violation of the 1934 Act or an SEC rule by purchasing or selling a security while in possession of material, nonpublic information. Violations must occur on or through a national securities exchange or from or through a broker or dealer. If the defendant is found liable, the court may impose a fine in an amount triple (treble) the profits that were gained illegally.

12 15 U.S.C. § 78u(d)(2)(A).

The Insider Trading and Securities Fraud Enforcement Act of 1988 enlarged the class of people who may be subject to civil liability for insider trading. Also, bonus payments can be given to anyone providing information leading to the prosecution of insider-trading violations.13

The assignment should consist of a Word Document . It should include a summary of the relevant facts, the law, judicial opinion and answer the case questions. All that is necessary for an understanding of the case is important and required.

The report must go beyond the discussion of the problem posed in the textbook, to achieve a superior grade. Do research outside the textbook- this must include research outside the case citation such as the Lexus-Nexis in the DeVry Library or FindLaw.com, do research on the parties and circumstances of the case itself and incorporate some visual modality as a part of the case analysis.something about one of the parties, as well as some background contained in the legal opinion. Doing significant research outside the textbook is essential.

Utilize the case format below.

Your grade comes from the content contained in the actual submission. 

Case Analysis Format

Read and understand the case or question assigned. Show your Analysis and Reasoning and make it clear you understand the material. Be sure to incorporate the concepts of the chapter we are studying to show your reasoning. Dedicate at least one heading to each following outline topic:

Parties [Identify the plaintiff and the defendant]

Facts [Summarize only those facts critical to the outcome of the case]

Procedure [Who brought the appeal? What was the outcome in the lower court(s)?]

Issue [Note the central question or questions on which the case turns]

Explain the applicable law(s). Use the textbook here. The law should come from the same chapter as the case. Be sure to use citations from the textbook including page numbers.

Holding [How did the court resolve the issue(s)? Who won?]

Reasoning [Explain the logic that supported the court’s decision]

Do significant research outside of the book and demonstrate that you have in a very obvious way. This refers to research beyond the legal research. This involves something about the parties or other interesting related area. Show something you have discovered about the case, parties or other important element from your own research. Be sure this is obvious and adds value beyond the legal reasoning of the case.

Dedicate 1 heading to each of the case question(s) immediately following the case, if there are any. Be sure to restate and fully answer the questions.

Quality in terms of substance, form, grammar and context. Be entertaining! Use excellent visual material!

Wrap up with a Conclusion. This should summarize the key aspects of the decision and also your recommendations on the court’s ruling.

Include citations and a reference page with your sources. Use APA style citations and references.