Securities and Exchange Commission v. Texas Gulf Sulphur Co.

Court of Appeals for the Second Circuit
401 F.2d 833 (1968)

ELI5:

Rule of Law:

Anyone in possession of material inside information must either disclose it to the investing public or abstain from trading in or recommending the securities concerned while such information remains undisclosed. A corporation may also be liable under Rule 10b-5 for issuing a misleading press release that would affect a reasonable investor's judgment.

Facts:

In 1959, Texas Gulf Sulphur Co. (TGS) conducted aerial surveys in Canada and detected a significant geophysical anomaly on a parcel of land known as Kidd 55.
On November 12, 1963, TGS completed drilling a test hole, K-55-1, which yielded a core visually rich in copper and zinc, with subsequent chemical assays confirming exceptionally high mineral content.
TGS President Claude O. Stephens instructed the exploration team to maintain strict secrecy about the drilling results to allow the company to acquire the surrounding land at a low price.
Between November 12, 1963, and April 1964, various TGS officers, directors, and employees, including Charles Fogarty, Richard Mollison, Walter Holyk, and Kenneth Darke, who knew of the K-55-1 results, purchased TGS stock or call options. Darke also tipped off outsiders who then purchased TGS securities.
On February 20, 1964, TGS's Stock Option Committee, which was not informed of the drilling results, granted stock options to several officers, including Stephens, Fogarty, and Harold B. Kline, who were aware of the promising discovery.
After drilling resumed on March 31, 1964, further drill holes confirmed the presence of a massive and rich ore body.
Amidst growing rumors of a major mineral strike, TGS issued a press release on April 12, 1964, which downplayed the discovery, stating that recent drilling had led to 'preliminary indications' and that any statement on size and grade would be 'premature and possibly misleading.'
On the morning of April 16, 1964, TGS held a press conference and officially announced a major strike of at least 25 million tons of ore. Several insiders, including Richard Clayton, David Crawford, and Francis Coates, placed purchase orders between the time of the April 12 release and the full public dissemination of the April 16 announcement.

Procedural Posture:

The Securities and Exchange Commission (SEC) filed a lawsuit in the U.S. District Court for the Southern District of New York against Texas Gulf Sulphur Co. (TGS) and thirteen of its officers, directors, and employees.
The SEC sought injunctive relief against all defendants and rescission of securities transactions and stock options for the individual defendants, alleging violations of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5.
After a trial without a jury, the district court held that the information on the mineral discovery was not material until the evening of April 9, 1964.
The district court dismissed the complaint against all individuals for transactions occurring before April 9, 1964.
The district court found that defendants Clayton and Crawford had violated Rule 10b-5 by trading after April 9 but before public disclosure, but dismissed the complaint against defendant Coates.
The district court dismissed the complaint against TGS regarding its April 12 press release, holding it was not issued for a manipulative purpose and was not misleading on the basis of facts then known.
The SEC appealed to the U.S. Court of Appeals for the Second Circuit from the dismissal of its complaint against TGS and nine of the individual defendants. Defendants Clayton and Crawford appealed from the judgment against them.

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Issue:

Does Rule 10b-5 prohibit corporate insiders, and their tippees, from trading on undisclosed information that a reasonable investor would consider important, even if that information is not yet conclusive, and is a corporation liable for issuing a press release about that information that is misleading to a reasonable investor?

Opinions:

Majority - Judge Waterman

Yes. Rule 10b-5 prohibits insiders from trading on material non-public information, requires corporations to avoid issuing misleading public statements, and mandates that insiders wait for information to be effectively disseminated to the public before trading. The materiality of speculative information depends on a balance between the indicated probability of the event and its anticipated magnitude. The results of the first drill core (K-55-1) were material from the outset because knowledge of such a potentially vast discovery would have been important to a reasonable investor. Therefore, all individuals who traded or tipped others based on this information before its public disclosure violated the 'disclose or abstain' rule. Furthermore, a corporation violates Rule 10b-5 if it issues a press release in a manner reasonably calculated to influence the investing public that is misleading to the reasonable investor; a showing of specific fraudulent intent is not required for the SEC to obtain an injunction, only a lack of due diligence. Finally, insiders may not trade until the material information has been effectively disseminated to the public and absorbed, not merely at the moment of announcement.

Concurring - Judge Friendly

Yes. The majority reaches the correct result, but clarification is needed on two points. First, regarding the stock options, senior officers like Stephens and Fogarty had an affirmative duty to inform the Stock Option Committee that it was an inappropriate time to grant options, whereas lower-level employees did not. Second, while the April 12 press release was clearly misleading and negligently prepared, imposing civil damage liability on the corporation for mere negligence is a 'frightening' prospect that could deter corporate disclosure. For an SEC injunction, a negligence standard is appropriate, but the court should be wary of extending this standard to private damage actions, which might require a showing of scienter (fraudulent intent).

Dissenting - Judge Moore

No. The majority improperly usurps the trial court's role as fact-finder by re-evaluating expert testimony and witness credibility. The trial court's finding that the information from the first drill core was not material until April 9, 1964, was based on extensive expert testimony that a single drill core is inconclusive and should be upheld. The April 12 press release was an exercise of reasonable business judgment to quell speculative and inaccurate rumors, not a misleading statement. Furthermore, the press release was not issued 'in connection with the purchase or sale of any security' by TGS, as required by the statute, because the company did not trade and had no manipulative purpose. The majority's broad interpretation of Rule 10b-5 creates an unrealistic and unworkable standard for corporate disclosures that will ultimately harm investors by chilling corporate speech.

Analysis:

This landmark decision fundamentally shaped modern securities law by dramatically expanding the scope and application of Rule 10b-5. It established the flexible 'probability/magnitude' test for materiality, making it easier to classify preliminary or contingent information as material. The ruling solidified the 'disclose or abstain' doctrine, extending it beyond traditional corporate insiders to any individual in possession of material non-public information. Finally, it broadened corporate liability for public statements, holding that a company could be enjoined for a negligent, misleading press release, thereby setting a higher standard for corporate disclosure and communication with the investing public.

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