SEC v Texas Gulf Sulphur Co., 401 F.2d 83 I(2d Cir. 1968), cert denied 594 U.S. 976 (1969)

Defendants: Named in the suit was TGS director Thomas S. Lamont, a director and former vice chairman of Morgan Guaranty Trust, who was alleged to have tipped others to the knowledge, but not to have personally profited from the insider trades. The SEC suit also named Herbert W. Klotz, an Assistant Secretary of Commerce in the Johnson Administration, as a defendant; he resigned a few days later.

FACTS (lifted from casebriefs.com and I added a couple of facts) Defendants were officers, employees or were closely tied to employees of Texas Gulf. Texas Gulf, utilizing a geological survey, was conducting mining exploration in Canada. One area, called Kidd 55, was deemed promising by the survey, and a hole was drilled with the resulting core analyzed. The analysis showed that the minerals present in the area were extremely rich in minerals. Several other samples verified the findings. (Nov. 12, 1963) Defendants did not disclose the results of the analysis to outsiders, including other officers of Texas Gulf. Defendants did proceed to purchase shares and calls once they knew about the results. Prior to these transactions these persons had owned 1135 shares of TGS stock and possessed no calls; thereafter they owned a total of 8235 shares and possessed 12,300 calls. The trading activity and sample drilling did prompt rumors in the industry of a significant find by Texas Gulf. On April 12, 1964 (but was published April 13) Defendants sent out a misleading press release to calm the speculation. The press release misrepresented the actual results of the samples. The statement said: xxx These reports exaggerate the scale of operations, and mention plans and statistics of size and grade of ore that are without factual basis and have evidently originated by speculation of people not connected with TGS. xxx The work done to date has not been sufficient to reach definite conclusions and any statement as to size and grade of ore would be premature and possibly misleading. When we have progressed to the point where reasonable and logical conclusions can be made, TGS will issue a definite statement to its stockholders and to the public in order to clarify the Timmins project. Defendants decided to announce the results on April 15, although the news did not reach the public until April 16. Defendants still traded between April 12 and the April 16 announcement. Defendants claimed that the information was not material to the value of the company and therefore did not feel obligated to publicly disclose the information. They also argued that any trading after they released the news at midnight of April 16 was legitimate because technically the news was disseminated to the public. From November 8, 1963 to May 15, 1964, Texas Gulf stock rose from a close of 17 3/8 to 58 1/4. SEC brought a suit for violation of Rule 10b-5 of the Securities Exchange Act which provides:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange,(1) to employ any device, scheme, or artifice to defraud,(2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or(3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,in connection with the purchase or sale of any security.

The SEC argued that the company's press releases about the discovery were "materially false and misleading" and known to be so by TGS officer and employees. TGS contended that the SEC's position requiring disclosure before trading would "not have been in the best interest of the public, the company and its stockholders" because disclosing the find prematurely would have made it impossible to secure the mineral rights. The District Court dismissed the complaint against the corporation and all but two of the individual defendants.

ISSUEWON defendants violated Rule 10b-5.

HELDYes. All transactions in TGS stock or calls by individuals apprised of the drilling result of K-55-1 were made in violation of Rule 10b-5. The Rule is based in policy on the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information. 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 meaning of Sec. 16(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 inside 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.

An insider's duty to disclose information or his duty to abstain from dealing in his company's securities arises only in "those situations which are essentially extraordinary in nature and which are reasonably certain to have a substantial effect on the market price of the security if [the extraordinary situation is] disclosed."

The only regulatory objective is that access to material information be enjoyed equally, but this objective requires nothing more than the disclosure of basic facts so that outsiders may draw upon their own evaluative expertise in reaching their own investment decisions with knowledge equal to that of the insiders.

The basic test of materiality is whether areasonableman 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 contemplationmightaffect 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. 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.

A major factor in determining whether the K-55-1 discovery was a material fact is the importance attached to the drilling results by those who knew about it. In view of other unrelated recent developments favorably affecting TGS, participation by an informed person in a regular stock-purchase program, or even sporadic trading by an informed person, might lend only nominal support to the inference of the materiality of the K-55-1 discovery; nevertheless, the timing by those who knew of it of their stock purchases and their purchases ofshort-termcalls purchases in some cases by individuals who had never before purchased calls or even TGS stock virtually compels the inference that the insiders were influenced by the drilling results. This insider trading activity, which surely constitutes highly pertinent evidence and the only truly objective evidence of the materiality of the K-55-1 discovery, was apparently disregarded by the court below in favor of the testimony of defendants' expert witnesses, all of whom "agreed that one drill core does not establish an ore body, much less a mine.

The core of Rule 10b-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 results14 of K-55-1 were made in violation of Rule 10b-5.15 Inasmuch as the visual evaluation of that drill core (a generally reliable estimate though less accurate than a chemical assay) constituted material information, those advised of the results of the visual evaluation as well as those informed of the chemical assay traded in violation of law.