Chapter 16 - § 16.13 • CASES IMPOSING LIABILITY UNDER RULE 10b-5

• Jurisdiction: Colorado

§ 16.13 • CASES IMPOSING LIABILITY UNDER RULE 10b-5

Cases imposing liability under Rule 10b-5 best demonstrate the Rule's broad scope. Mitchell v. Texas Gulf Sulphur Co.²⁸⁸ is the seminal case in this area. Texas Gulf Sulphur was a large mining company that was drilling in Canada for various minerals. Rumors in the press indicated that it may have found a large ore body. On April 12, 1964, the company issued a press release denying any such discovery. On April 16, Texas Gulf issued another press release confirming a large discovery of zinc, copper, and silver. As can be imagined, the price of the stock increased greatly over the next few weeks.

Before, and then shortly after, April 16, several people who had inside information regarding the discovery bought stock in Texas Gulf at the pre-announcement prices. The plaintiffs in this case had sold stock. The court held that this "insider" trading on non-public information was violative of § 10(b) and Rule 10b-5 of the 1934 Act. The court also held that the damages should be based on the highest value of the Texas Gulf stock between the date the investors learned of the fraud and a reasonable time afterwards. This, the court felt, would have allowed the plaintiffs to reinvest in Texas Gulf had they decided to do so.

In prior litigation brought by the SEC and based on the same incidents, the court imposed the following duty on all persons with access to non-public information: anyone in possession of material inside information must either disclose it to the investing public or, if he or she is disabled from disclosing it in order to protect corporate confidence or chooses not to do so, he or she must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed. It is now accepted that to trade in stock based on undisclosed, non-public information is a violation of § 10(b) and Rule 10b-5.

In Texas Gulf Sulphur, the insider who recommended Texas Gulf stock to others (the tipper) was also held liable for the tippee's profits. The tippee, if acting with the requisite intent, would also be liable for his or her profits from trading on the basis of inside information. The Second Circuit affirmed the liability of the tipper for profits made by the tippees in SEC v. Contorinis.²⁸⁹ Note that in the tipper/tippee cases, it is not material whether the tipper knew that the tippee might trade on the inside information. The requisite mens rea for a criminal conviction derives from the tipper's knowledge that he or she is breaching a duty to the owner of the information, according to United States v. Libera.²⁹⁰ In this case, the tipper stole pre-publication information of Business Week magazine from the tipper's employer, a financial printer, and passed the information on to others who traded on that information.

It is not necessarily material whether the tippees trade on the basis of the material non-public information. Mere possession of the information at the time of trading is sufficient.²⁹¹

A 1998 case, SEC v. Warde,²⁹² also addressed the potential liability of a tippee. That court stated that, to find liability of a tippee under § 10(b), the court must find sufficient evidence to permit a reasonable finding that:

1) The tipper possessed material nonpublic information about the issuer.
2) The tipper disclosed the information to the tippee.
3) The tipper traded in securities of the issuer while in possession of the information.
4) The tippee "knew or should have known that [the tipper] violated a relationship of trust [such as being an officer or director of the issuer] by relaying" the information to the tippee.²⁹³
5) The tippee "benefitted by the disclosure to [the tippee]." According to the court, the benefit need not be monetary; the benefit element can be satisfied when the tipper "intend[s] to benefit the . . . recipient" or "makes a gift of confidential information to a trading relative or friend."²⁹⁴

When the transaction occurs in connection with a tender offer, liability under § 14(e) may exist when a "substantial step ha[s] been taken toward a tender offer at the time of the inside trading."²⁹⁵

§ 16.13.1—Unsuitability

There have been many other cases defining other fraudulent or deceptive practices. Customers have brought actions against brokers for steering them into unsuitable investments. The Tenth Circuit has established a three-part test necessary to establish unsuitability, which it refers to as "fraud by conduct rather than fraud by omission":

1) The broker must recommend (or in the case of a discretionary account, purchase) securities that were unsuitable in light of the investor's objectives.
2) The broker must recommend or purchase securities with an intent to defraud, or with reckless disregard for the investor's interests (scienter).
3) The broker must exercise control over the investor's account. This latter "control" element is necessary to satisfy the causation/reliance requirement of § 10(b). See O'Connor v. R. F. Lafferty & Co.;²⁹⁶ in that case, the court did not find the existence of the required scienter.

§ 16.13.2—Churning

Churning of a customer's account by a broker has been held to be a fraudulent practice.²⁹⁷

"Churning" is considered to be excessive trading in a customer's account, and depends on the facts and circumstances of each case. There is a lower threshold for "excessiveness" in an account for an unsophisticated investor or in a discretionary account as compared with an account for a more sophisticated investor. There are generally three tests:

1) Calculate the turnover rate, a ratio of the total cost of a customer's purchases during a given time period to the average monthly investment. In In re Shearson, Hammill & Co.,²⁹⁸ one account was turned over 70 times during a nine-month period and another 35 times during a 4½-month period. (Both represented turnover rates of 90 percent or better.) In Jenny v. Shearson, Hammill & Co., Inc.,²⁹⁹ the court denied the defendant's motion for summary judgment, holding that in some cases a turnover rate of 1.84 could be considered excessive. In Fischbach,³⁰⁰ the SEC found turnover ratios ranging from 2.99 to 6.00 in 30 accounts and greater than 6.00 in 11 accounts to "suggest excessive trading." The administrative law judge found other indications of churning to include: a substantial amount of transactions on the margin; commissions were charged at 150 percent of the standard commission; many short-sale transactions; high volume of commissions earned; and the individual investors originally had directed the account executive to maintain a "buy blue chip and hold" strategy. Generally, a turnover rate of six times a year is considered de facto excessive.
2) Determine whether there has been a pattern of in-and-out trading, where a substantial portion of the customer's portfolio is invested in securities for only a short term, sold, and then reinvested in other securities for a short term. In Norris & Hirschberg, Inc. v. SEC,³⁰¹ the court found that the brokerage house made 266 purchases and 191 sales over a four-year period, including 117 purchases and 67 sales in five over-the-counter securities in which the broker made a market.
3) Compare the dealer's profits with the size of the customer's investment. In Hecht v. Harris, Upham & Co., Inc.,³⁰² over a span of seven years, a $533,000 account engaged in over 10,000 trades, generating 4.7 percent of the total income of the San Francisco office of Harris, Upham, even though the account only represented less than 0.1 percent of all accounts in the office.

Broker-dealers have a duty to use reasonable efforts to maximize the economic benefit to their clients in each transaction. That duty may include looking beyond the brokerage community's "national best bid and offer" price available on NASDAQ. The Third Circuit held that the brokers' duty to execute a trade order at the best available price is well-established and is not "ambiguous" as a panel had held.³⁰³

It should be noted that Rule 10b-5 imposes liability for fraud in the purchase or sale of securities regardless of whether there is an exemption available for the transaction, and regardless of whether the stock has been registered or represents restricted shares of a privately held company. See Jordan v. Duff & Phelps, Inc.,³⁰⁴ where the court held that a close corporation repurchasing its stock from a shareholder is under a duty to disclose all material facts in connection with the repurchase.

Rule 10b-5 is not, however, intended to give a plaintiff a federal cause of action for what is, effectively, a claim for relief under state law. In Santa Fe Industries, Inc. v. Green,³⁰⁵ the plaintiff, a minority stockholder in Kirby Lumber Company, sued to set aside a merger between Kirby and its parent, Santa Fe, alleging that the absence of a justifiable business purpose for the merger, together with a low price offered, constituted a device or scheme to defraud in violation of § 10(b) and Rule 10b-5. The court held that, since there was full and honest disclosure of the transaction, Santa Fe's actions were not in violation of § 10(b) or Rule 10b-5.

At the time, this Supreme Court decision constituted a reversal of a developing line of cases called the "new fraud" by some commentators. This has been recently reaffirmed. See In re Chaus Securities Litigation³⁰⁶ and cases cited therein. See also Matignon Finance, Inc. v. Ameritel Communications Corp.,³⁰⁷ where the federal district court dismissed the plaintiffs' securities fraud claims, finding that any damages stemmed from breach of contract.

Even in SEC enforcement actions, federal courts have found that the securities laws do not provide a remedy for all wrongs. In SEC v. Zandford,³⁰⁸ the SEC brought a civil fraud action against a broker who allegedly misappropriated clients' funds. The Fourth Circuit concluded that, while the allegations might be actionable as fraud or conversion under state...