INTRODUCTION 372 I. INSIDER TRADING IN THE SIXTIES 378 A. Section 16(b)'s Technical Regulation of Insider Trading 378 B. Rule 10b-5 Takes the Stage: Cady, Roberts and the Modern Law of Insider Trading 381 C. Would the Toehold Support a Paradigm Shift? Capital Gains as the Inflection Point 383 D. Rule 10b-5 Occupies the Field: Texas Gulf Sulphur 396 E. Insider Trading Retrenchment and Renewal 402 II. PRIVATE RIGHTS OF ACTION 403 A. The Second Circuit Lays the Foundation 404 B. The Supreme Court's Casual Embrace 407 C. Defining the Elements: Reliance, Materiality, and Scienter 408 D. Pruning the Judicial Oak: Rule 10b-5 Restrained 415 III. RULE 10B-5 AND CORPORATE MISMANAGEMENT 418 A. The Second Circuit Tackles Corporate Mismanagement 419 B. Mismanagement Cases Under Rule 10b-5 420 C. The Apogee of Rule 10b-5 and Corporate Mismanagement: Bankers Life 422 D. The Demise of Federal Corporate Law 425 CONCLUSION 429 INTRODUCTION
The popularity of securities law rises and falls in the Supreme Court. The New Deal Court consistently provided expansive interpretations to federal securities statutes first enacted in the 1930s, while also extending substantial deference to the Securities and Exchange Commission (SEC), the watchdog agency created to administer those laws. (1) In the 1970s and 1980s, the Court just as consistently provided restrictive interpretations of the securities laws with little deference to the SEC (2) This Article bridges the gap between the New Deal Court's enthusiastic embrace of the fledgling securities laws and the skepticism of the later era. It develops the key doctrinal contributions of the Sixties Court for securities law--a new approach to insider trading and its embrace of private causes of actions. Both survived the counterrevolution and still frame core parts of contemporary securities law.
The Sixties were volatile for securities law as they were for other aspects of American life. New Justices appointed by Presidents Kennedy and Johnson (3) along with New Deal holdover Justice William O. Douglas (previously chairman of the SEC), and support from liberal Eisenhower appointees Chief Justice Earl Warren (4) and Justice William Brennan, would push the Court's securities jurisprudence on a more interventionist path. What the Justices shared was a willingness to emphasize purpose over text in statutory interpretation. The Sixties Court was not content with simply upholding the work of Congress, as the New Deal Court had been, but instead joined as a partner in defining the securities laws to achieve their ultimate purpose. The Supreme Court, with the assistance of the SEC and the Second Circuit, produced a dramatic expansion of the law of securities fraud. The regulation of insider trading, previously cabined in a technical regime, simultaneously over and underinclusive, was reinvented as the comprehensive antifraud provision applicable today. For the first time, fraud took in pure omission in impersonal markets, a doctrinal development that had not seemed possible to litigants, jurists, and regulators in the three decades after the enactment of the federal securities laws. The Court's willingness to imply private rights of action from statutes transformed enforcement of securities laws, allowing class actions to flourish. In addition, the Court took an expansive view of fiduciary duty, creating a blueprint for a "federal corporation law," (5) a goal long sought by progressives to address perceived weaknesses in the prevailing state law, but never enacted by Congress. (6)
We focus on five key Supreme Court cases of the period: SEC v. Capital Gains Research Bureau, Inc.; (7) J.I. Case Co. v. Borak; (8) Mills v. Electric Auto-Lite Co.; (9) Superintendent of Insurance v. Bankers Life & Casualty Co.; (10) and Affiliated Ute Citizens of Utah v. United States, (11) looking not only at the published opinions but also the correspondence the Justices exchanged as those opinions were being drafted. (12) We also highlight the important role played by the Second Circuit in the development of the securities laws. (13) The Supreme Court paid scant attention to the securities laws during the 1950s, deciding only four cases between 1947 and 1962, none of which produced notable changes. (14) The Court's small securities docket during that time was matched by a slowdown in the work and budget of the SEC and little attention from Congress or the President. (15) The Agency had been exiled to Philadelphia in early 1942 to make more space for the war effort. During its first year there, the SEC produced two of the most influential rules in the Agency's history: Rule 10b-5, which today covers a broad space of shareholder antifraud litigation; (16) and Rule 14a-8, which allows shareholders to include proposals in a company's proxy. (17) But soon the Agency's output slowed. (18) In the midst of this slowdown for the Agency, as well as for the other branches of government and the Supreme Court, the Second Circuit was hard at work, particularly on the three areas that would flourish in the 1960s.
The postwar Second Circuit was well situated to take a leading role in securities law. Geographically, its location in New York City, the nation's leading commercial center and home of its largest securities markets, provided a steady source of securities cases. Location also provided its judges recurring exposure to financial innovation in securities and a sophisticated legal market on both the plaintiffs' and defendants' sides of securities litigation. The court's personnel magnified its impact. Through the 1940s, the Second Circuit had a stable bench of six long-serving members (two Roosevelt appointees joining four named by Coolidge), providing familiarity and an opportunity to develop expertise on securities cases. (19) The Second Circuit was generally recognized as distinctive. (20) It included: Judge Learned Hand, described as the best judge of the twentieth century; his cousin Judge Augustus Hand, who possessed a strong commercial background; two former deans of the Yale Law School--Judge T.W. Swan and Judge Charles Clark, the latter with strong New Deal ties and a sharply progressive attitude toward the securities laws; Judge Jerome Frank, who succeeded Douglas as SEC chair and shared his liberal instincts; and Judge Harrie Chase. (21) Even after Eisenhower started to appoint judges, this initial group, often continuing to hear cases after taking senior status, dominated the circuit's securities output. Two colleagues appointed to the Second Circuit in the 1950s and 1960s went on to the Supreme Court. (22) This strong cohort of jurists helped cement the Second Circuit's status as the "Mother Court" of securities law. (23)
The Supreme Court's activist turn in the 1960s ratified the earlier approach of the Second Circuit. Encouraged by the Supreme Court--in particular the expansive mode of statutory interpretation validated by the high court in Capital Gains--the Second Circuit pursued an even more ambitious agenda during the Sixties. During the 1960s, that appellate court unveiled new causes of action that ultimately transformed the enforcement of the securities law, both public and private. The Second Circuit's role would shift as it was called on to interpret this new Supreme Court precedent. The key players at the appellate court would also shift with Clark's death in 1963; Judge Henry Friendly would take the lead in the Second Circuit's development of securities law. Friendly, who joined the court in 1959, was a natural successor to Clark based on his background, although he fell short of Clark's commitment to purposive interpretation. Friendly's legal career began at Harvard Law School in the 1920s, which provided key players in the development of the securities laws of the New Deal. (24) He met Justice Felix Frankfurter even before starting law school, and Friendly's top-of-the-class record at Harvard Law School led Frankfurter to recommend him to clerk for Supreme Court Justice Louis Brandeis. (25) Friendly resisted opportunities to teach at Harvard, turning back entreaties from Brandeis and Landis and eventually an offer from Dean Roscoe Pound. (26) Instead, he went to the Root firm (27) and then to Cleary Gottlieb and Pan American Airways, until his appointment to the Second Circuit brought him into the orbit of securities law. (28) In the midst of the change in securities law chronicled here, Friendly attended an American Bar Association (ABA) sponsored meeting to discuss the possible codification of federal securities law; he was the only participant there who was not a member of the relevant ABA committee. (29) When the American Law Institute, on which Friendly served as a member of the council and the executive committee, decided to take on a project to rewrite federal securities law, Friendly was one of two federal judges on the advisory committee. (30) Friendly became a dominant player in securities law over the next two decades. (31) His opinions on scienter in Rule 10b-5 and 14a-9 and extraterritoriality continued to be cited decades after they were written. (32)
We proceed as follows. Part I shows how the Supreme Court and Second Circuit expanded the scope of securities fraud in the 1960s, relying on fiduciary duty to create a new law of insider trading. We also highlight the critical role played by William Cary, Kennedy's appointee as chairman of the SEC. Part II turns to the recognition of implied private rights of action in the Sixties and the work of the Supreme Court and Second Circuit in fleshing out the elements of those new causes of action. Part III looks at the creation of federal corporations law. Shareholder claims against their directors were brought under the umbrella of federal law in response to longstanding worries about the adequacy of remedies under state corporate law. Along the way, we trace how the foundation laid in the 1950s in the Second Circuit manifested...