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Securities and Exchange Comm. v. Texas Gulf Sulphur Co.

    Brief Fact Summary.

    Texas Gulf Sulphur Co. (TGS) (Defendant) made a significantly large discovery of mineral deposits.  While hiding the magnitude of the find, certain corporate employees purchased large amounts of Defendant’s stock.  A misleading press release was issued to suppress the effect of rumors of the large discovery. Some nonemployees bought TGS (Defendant) stock just before public release of the discovery based on their advance knowledge of the release.

    Synopsis of Rule of Law.

    (1) Where corporate employees come into possession of material information, they are under no duty to disclose that information if there is a valid business reason for nondisclosure, but they may not benefit from transactions in the corporation’s securities by reason of that nondisclosure.  (2) A corporation issuing public statements about a matter that could affect the corporation’s securities in the marketplace must fully and fairly state facts upon which investors can reasonably rely.  Any departure from that standard subjects the corporations to liability for violation of the Security Exchange Commission Act of 1939 Rule 10b-5.

    Facts.

    Texas Gulf Sulphur Co. (TGS) (Defendant) was a corporation that engaged in, among other things, exploration for and mining of particular minerals.  Pursuant to this activity, Defendant conducted aerial and ground surface surveys of an area near Timmins, Ontario, Canada.  One tract in particular, known as Kidd 55, looked very promising as a source of desired minerals.  The procedure to determine if commercially feasible quantities and qualities were present involved drilling a hole to a specified depth and examining and analyzing the contents of the core of the hole.  TGS (Defendant) did not have ownership or mineral rights to Kidd 55.  In order to determine if acquisition was called for, a test hole was drilled on November 8, 1963, and was designated Kidd 55-1.  Present at the drilling site were various employees and consultants of TGS (Defendant).  Included in that group was the TGS (Defendant) employees Clayton (Defendant) and Holyk (Defendant).  An on-the-spot analysis of the core sample of Kidd 55-1 revealed a rich deposit of zinc, copper and silver.  So that the find would not be discovered, a second hole was drilled in an adjacent area that showed no signs of minerals.  Kidd 55-1 was covered over.

     

    On the basis of the content of the Kidd 55-1 TGS (Defendant) commenced acquisition of the entire Kidd tract and surrounding tracts.  To facilitate the acquisitions, the president of TGS (Defendant), Stephens (Defendant), told all on-site personnel to keep total secrecy of the find.  According to a laboratory analysis, the quality of the on-site analysis to be slightly conservative and the find was of amazing quality.  Beginning March 31, 1964, TGS (Defendant) drilled three additional holes, Kidd 55-3, Kidd 55-4, and Kidd 55-5, to determine the depth and lateral extent of the deposits.  The results of these three core samples indicated the real possibility of a substantial commercially viable deposit of zinc and copper.  Stephens (Defendant) daily communicated continuing results of the three core samplings to TGS (Defendant).  The last drilling in this series, Kidd 55-5, was completed April 10, 1964.

     

    Various rumors formulated regarding the size and quality of the find because of the activity surrounding the drilling of these core sample holes.  On April 11, Stephens (Defendant) read stories in two New York newspapers based, apparently, on these rumors.  To counteract the rumors, Stephens (Defendant) determined that a press release should be prepared stating the company’s position.  Two TGS (Defendant) employees, Fogarty (Defendant) and Carroll (Defendant), prepared the release, which was issued on April 12, 1964.  The release was credited to Fogarty (Defendant), describing him as executive vice president of TGS (Defendant).  The release denied the validity of the rumors and described them as excessively optimistic.  It described various unsuccessful ventures in Canada in general and stated that as to the core drilling near Timmins, Ontario, insufficient data or information was available to evaluate the company’s prospects there.  The only indication that was available to date was that further drilling was necessary before any conclusions could be reached.  The release ended by stating that when sufficient data was available to reach any conclusions a public statement would be issued.  The release was stated to be the company’s position based on information in its possession through April 12.

     

    Drilling of core samples continued through April 15, with five additional holes having been drilled and the analysis was completed by April 16.  Based on this additional information, a reporter for a widely read Canadian mining journal was invited to this site to report on the discovery.  The report was prepared April 13 and submitted to Mollison (Defendant), Holyk (Defendant), and Darke (Defendant), the three TGS (Defendant) employees interviewed.  They made no changes in the report, which stated that a 10-million-ton strike had been made, and the article was published April 16, 1964.  A report prepared by the three was also submitted to Ontario government officials for their release on April 15.  It was, in fact, not released until April 16, for unknown reasons.  At 10:00 A.M., a 10- to 15-minute statement was read to representatives of the American financial press detailing the discovery and announcing its size as 25 million tons.  The first release was over a brokerage house wire service at 10:29 A.M.  Dow Jones reported the news at 10:54 AM.  A review of the market price of TGS (Defendant) stock as quoted on the New York Stock Exchange was made for the period from November 8, 1963, when drilling of Kidd 55-1 started, to May 15, 1964.  On November 8, the stock sold for approximately $17.50.  When Kidd 55-1 had been completed, the stock was selling for $18.  When the results of the chemical tests of the Kidd 55-1 care were completed in December, the shares were quoted at nearly $21.  On February 21, 1964, the shares were selling at $24.  By March 31, 1964, the price had risen to $26.  On April 10, it was traded at $30.  Due to the press release of April 12, the stock rose temporarily to $32, but by April 15 had dropped back to just over $29.  On April 16, 1964, the date of the official announcement of the size of the strike, sales were around $37.  By May 15, 1964, TGS (Defendant) stock was selling at just over $58 per share.

     

    What gave rise to the action by the Securities and Exchange Commission (Plaintiff) against the individual defendants and Texas Gulf Sulphur (Defendant) was that during the period from November 8, 1963, through April 16, 1964, the named defendants had purchased either shares in TGS (Defendant) or the company had permitted them to buy shares at 95 percent of the current market value.  In addition, certain earlier named individuals who were not connected with TGS (Defendant) were also named as defendants due to their purchases of shares or calls to buy shares as a result of learning of the strike prior to complete broadcasting of the news to the public.  One of the directors of TGS (Defendant), Coates (Defendant), made purchases through his son-in-law, a broker, of 2,000 shares at 10:20 A.M., April 16, for certain family trusts for which he was trustee but not beneficiary.  As a result of the call from Coates (Defendant), the son-in-law also made substantial other purchases for his customers at the same time.  Many of the people buying shares during this time, including several employees, had never bought any stock of any corporation and had never engaged in the somewhat speculative practice of buying calls.

     

    Before November 12, 1963, the named defendants collectively owned 1,135 shares of TGS (Defendant) stock and no calls.  By March 31, 1964, they owned 8,235 shares and calls on 12,300 more shares.  The aggregate investment of four employees alone was in excess of $100,000.  On February 20, 1964, the stock options to give five employee-defendants were granted by the TGS (Defendant) board of directors.  The facts of the discovery had been concealed from the members of the board.  The recipients of the options did not notify the New York Stock Exchange as required.  The SEC filed charges against all named defendants and the corporation alleging their actions violated § 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.  Specifically, they charged that by concealing the information about the size of the find while simultaneously purchasing shares and calls and accepting options, the defendant-employees violated the provisions; that others acting on inside information purchased shares; and that TGS (Defendant) violated the provisions by the press release of April 12, 1964.

     

    Trial was held in United States District Court for the Southern District of New York.  The judge, in a lengthy opinion, declared all defendants, except for two individuals, were not guilty of violations for any offenses charged.  The two defendants found to have committed illegal acts had traded in TSG (Defendant) stock between April 9, 1964, and April 16, 1964.  The trial judge concluded that before April 9, no material information had been concealed and, therefore, any trading before that date did not violate the act and that the press release was not misleading as there were no material facts to misstate at that time.

    Issue.

    (1) May individual employees and directors of a corporation be held to have violated § 10(b) and Rule 10b-5 by purchasing securities and accepting options to purchase securities in their corporation while in possession of information that could affect the price of those securities, which is not available to the public?  (2) Can a corporation be held liable to the investing public for issuing a report that misstates a material fact about an activity of the corporation?

    Held.

    (Waterman, J.)  Yes.  The court laid a foundation for its decision by examining the purpose and intent of congress and the Securities Exchange Commission in enacting the Securities Exchange Act of 1934 and the promulgation of Rule 10b-5 pursuant to the Act.  The basic thrust of the Act was to promote fairness in securities transactions generally and to prevent specific unfair and inequitable practices in securities transactions.  The regulations and controls therefore imposed were to apply to all transactions, where face-to-face or in the impersonal markets of the organized exchanges and the over-the-counter market.  Rule 10b-5 was designed to insure that all investors trading in the impersonal securities markets should have relatively equal access to material information which is not, nor intended to be, publicly known from making use of that information for his personal benefit by trading in corporate securities.

     

    Regarding the individual defendants, the court examined their individual conduct as it related to the circumstances as they developed over the period involved.  Since the major thrust of the trial court’s dismissal of most charges was a finding that no material information existed before April 9, 1964, this court dealt with that issue first.  The court stated that the test for a determination of materiality is whether a reasonable man would consider the information important in forming a decision in relation to transacting in the security involved.  Rule 10b-5 does not require a corporate insider to make any information within his knowledge public that would be expected to affect the shares of his corporation.  There are many circumstances in which such information may rightfully be withheld.  However, if a legitimate decision to withhold is made, the insider may not transact in the securities of the corporation unless and until it is effectively made known to the public.  An insider is not to be expected to make public disclosure of his predictions or educated guesses based on his expert analytical abilities or superior financial expertise.  What he must reveal is the factual basis for his analysis results.  In determining whether facts are material, there must be a balancing of the indicated probability of the occurrence against the magnitude of the occurrence in relation to the size of the corporate enterprise.

     

    An application of this principle to the results of the analysis of the core sample obtained from Kidd 55-1 indicates that this was material information.  Various experts described the results of that core sample analysis as “most impressive†and “beyond your wildest expectation.â€Â  But perhaps the most significant objective indicator of the material nature of the initial core sample was that four employees who had direct knowledge invested over $100,000 in the stock of TGS (Defendant).  Some of these individuals had never invested before.  It should be clearly evident that outside investors, if they had been in possession of the core analysis information, would have taken that information to be a significant factor in determining their investment course.  The point is not that the information must have been made public, only that the insiders could not trade on that information for their benefit without first disclosing it.  TGS (Defendant) and the individuals had a valid reason for withholding the information, since they had not yet acquired the Kidd tract or the surrounding tracts which they desired.  Still, they chose to purchase the stock and, in Darke’s (Defendant) case, pass along tips to associates who purchased while the information was suppressed.  Also, the corporate employee who directed the land acquisition program while also buying TGS (Defendant) stock must be considered to have had sufficient knowledge that the find was valuable to subject him to liability as well.

     

    The purchases of Crawford (Defendant) and Coates (Defendant) presented a different situation.  Crawford’s (Defendant) purchases were ordered on April 15 and April 16.  Coate’s (Defendant) purchases were made on April 16 immediately following the reading of the complete public statement issued by TGS (Defendant).  Both argue that their purchases were made following the public disclosure of the material information.  However, public disclosure means effective public disclosure, not just technical disclosure.  When their purchases were made, there had been no wide dissemination of the TGS (Defendant) statement.  Both purchases were made before even the Dow Jones wire service had published the contents of the statement.  Both defendants still argue that they honestly believed the information had been effectively disclosed.  A finding of liability under the federal securities laws and, in particular, Rule 10b-5 does not require proof of a specific intent to defraud.  While the standard to be applied must contain some measure of scienter, this requirement will be met by a showing of negligent conduct, lack of diligence, or unreasonable conduct.  We find that it cannot be said that either Crawford (Defendant) or Coates (Defendant) could have reasonably believed that the material information had been fully and effectively disseminated to the public at the time their purchases were made.

     

    The third type of conduct that must be examined was the acceptance of the stock options by the corporate officers and directors.  No reasonable distinction can be made between this type of transaction and a transaction involving an actual purchase of sale.  When the board of directors granted the options in February 1964, the defendants had withheld from the granting directors the information about the Timmins discovery that previously was determined to have been material.  The defendants were under a duty to disclose the material information before accepting the proffered options.  The fact that they did not disclose subjects the options to a remedy of rescission under Rule 10b-5.  Because the trial court determined that no liability attached to the acceptance of the options by two employees who were not considered top management personnel, and the SEC (Plaintiff) did not see fit to appeal that judgment, rendering an opinion as to their liability is unnecessary.

     

    (2) The court’s decision then moved to a determination of the liability, if any, to TGS (Defendant) itself for violation of Rule 10b-5.  The determination of liability would be made on the basis of an examination of the statement issued, in the form of a press release, on April 12, 1964.

     

    TGS (Defendant) contended that no liability could be found based on four defenses.  First, there was no showing that the statement produced any significant market action, and therefore, second, there was no showing of intent to affect the market price for the benefit of TGS (Defendant) or to TGS (Defendant) insiders.  Third, the lack of a showing of intent to benefit TGS (Defendant) or insiders established that the release was not issued in connection with any purchases or sales by TGS (Defendant) or the insiders.  Finally, the company argued that even if the statement were found to be issued in connection with the security transactions, there was no showing that it was false, deceptive, or misleading.

     

    The court, in determining the proper meaning and application of the term “in connection with the purchase or sale of any security†clause of § 10b and Rule 10b-5, made an extensive examination of the legislative history of the statute.  Their conclusion was that the thrust of the legislation was to prevent false, misleading, or deceptive devices or information from affecting the securities market.  By examining other legislation (e.g., the Securities Act of 1933), the court found that if Congress intended to limit 10b and Rule 10b-5 to transactions made by the parties charged, different, more specific language to that effect would have been used.  The court determine the legislative intent to be the protection of the investing public and that the broad language of § 10b did not limit its application to situations in which the perpetrator had engaged in transactions.  To find liability, therefore, the SEC need only establish that the statement was false or misleading and that the issuer knew, or should have known, that the statement was of such nature.  There need not be a finding that the statement was issued with a wrongful purpose, that is, to benefit the corporation or the insiders.  To apply that standard could possibly allow the wrongdoer to gamble a little in the issuance of the statement.  If the statement is issued but does not have the desired effect, then no liability would be found.  However, if the desired effect does result, then the wrongdoer can hope he is not discovered and escape liability.  The fact that the April 12 release did not produce any significant market activity only indicates that its desired purpose may not have been achieved.  This interpretation imposes a duty on corporate management to ascertain that any proposed pubic statement fairly and accurately represents the whole truth in regard to the subject matter of the release.  Where statements are made that are calculated to influence the market in a corporate security, if those statements are false or misleading, then Rule 10b-5 has been violated if the officers of the corporation cannot establish that every reasonable effort was made to ascertain the statement’s accuracy and completeness.  The court applied these standards and considered the effect of the April 19 release.  It found the statements in the release were less than truthful and complete, and certainly did not describe the actual state of the facts, which were apparently known to its authors.  If the company felt compelled to make a statement on April 12, then that statement should have consisted of the details of what was actually known at that time, therefore allowing the individual investor to form his own conclusions.  Since the point was not fully developed by the trial court, this court remanded the case back to the trial court for a determination of whether the statement was, in fact, misleading and whether discretion should be exercised in the favor of the SEC’s request for an injunction against future violations.  Affirmed in part, reversed in part, and remanded.

    Concurrence.

    (Friendly, J.)  The junior officers, Holyk (Defendant) and Mollison (Defendant), were entitled to a dismissal, as it is unreasonable to expect a minor officer to reject an option such as was offered here.  Stephens (Defendant), Fogarty (Defendant), and Kline (Defendant), as senior officers, had a duty to inform that this was not the right time to grant the option.

    Discussion.

    The Texas Gulf Sulphur case is one of the most important decisions to date on judicial interpretation of rule 10b-5.  It provided some indication of the all-inclusive nature of the rule.  Corporate officers may not take advantage of undisclosed material information to trade in the securities of their corporation.  Even if the insiders do not transact, they cannot reveal the information to outsiders who may then trade to their advantage.  A person who learns of inside information, even though an outsider, may not trade if he knows or has reason to know the information has not been effectively disseminated to the public.  In Texas Gulf Sulphur alone, the remedies granted included money damages, rescission (of the options), and injunction.  While the plaintiff in Texas Gulf Sulphur was the SEC, prior decisions found an implied right of private action under 10b-5.  Therefore, the scope of 10b-5 is enormous.  Both private plaintiffs and the government may hold liable corporate insiders, persons they tip, persons who independently learn of the inside information, and the corporation itself.  The concept of privity is abandoned and the requirement of scienter greatly limited.  And, based on the opinion of a New York State court, violations of 10b-5 can be asserted in a state action.  Many authorities have expressed alarm at the potential scope of Rule 10b-5.  They fear that the evils of the marketplace sought to be corrected may be replaced by another equally damaging evil—that is, that conduct by individuals and corporations that would not have gotten by the complaint stage in a traditional lawsuit will subject the individuals and corporations to staggering penalties.


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