Securities Law in the Sixties: The Supreme Court, the Second Circuit, and the Triumph of Purpose Over Text

Adam C. Pritchard is the Frances and George Skestos Professor of Law at University of Michigan Law School and Robert B. Thompson is Peter P. Weidenbruch, Jr. Professor of Business Law at Georgetown University Law Center. This post is based on their recent paper.

Key pillars of modern securities law—insider trading regulation, implied private rights of action, and “federal corporation law”—were born in the 1960s, not as a result of legislative enactment, but rather, judicial pronouncement. In our paper, Securities Law in the Sixties: The Supreme Court, the Second Circuit, and the Triumph of Purpose over Text, we show how the judicial approach to securities law transformed in that decade. In our paper we focus on the key Supreme Court cases of the period, looking not only at the published opinions, but also at the papers of each of the justices. This archival research shows the exchange of ideas among the justice and how the opinions evolved in the drafting. The Supreme Court of the Sixties did not simply apply the text as enacted as a mere agent of Congress, but instead made itself a partner of Congress in shaping the securities laws. Under this approach, the purpose of the securities laws became the touchstone of interpretation. The interpretive space opened by the invocation of purpose allowed a dramatic expansion in the law of securities fraud.

We also highlight the important role the Second Circuit—the “Mother Court” for securities law—played in developing the securities laws in the Sixties. Geographically, the Second Circuit’s 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, with a sophisticated bar on both the plaintiffs’ and defendants’ side. Encouraged by the high court’s dynamic approach to statutory interpretation, the Second Circuit developed new causes of action that transformed both public and private enforcement of the securities laws. We show—again using the judges’ papers, letters and memos—how Judges Charles Clark, a former dean of the Yale Law School with strong New Deal ties and sharply progressive attitudes, and Henry Friendly, more cautious in his approach, helped shape securities law. Friendly would emerge as the dominant figure in securities cases in the 1960s and 1970s, until his influence was eclipsed by Lewis Powell, Jr. after Powell’s appointment to the Supreme Court.

Reinvention of Insider Trading Doctrine. Insider trading doctrine today bears scant resemblance to what it looked like in 1960. During the Sixties the legal focus shifted from § 16(b)’s mechanical disgorgement provision to a broadly defined fiduciary duty arising under Rule 10b-5’s “catch-all” antifraud provision. As the 1960s dawned there was still widespread agreement that fraud did not/could not encompass nondisclosure in trades occurring over the anonymous exchanges of modern securities markets. Affirmative lies and half-truths were covered, but the pure nondisclosure that would come to identify modern insider trading was not yet recognized as fraud. The SEC and the Second Circuit helped drive this shift to include pure omission, a doctrinal development that had not seemed possible to litigants, jurists and regulators in the three decades after the enactment of the securities laws. SEC Chair William Cary laid down a marker for the new approach using Rule 10b-5 fraud in the agency’s 1961 decision in Cady, Roberts & Co. Even so judicial acceptance remained in doubt. The Supreme Court’s willingness to give a broad purposive interpretation to fraud in 1962 in SEC v. Capital Gains Research Bureau emboldened the Second Circuit’s to adopt the broad fraud-based approach to insider trading in SEC v. Texas Gulf Sulphur that has remained the standard for the modern law of insider trading in the 50 years since. When the Supreme Court first addressed insider trading under Rule 10b-5 in 1980 it would take a step back from Texas Gulf Sulphur, but it would not repudiate the fiduciary duty framework that had been created in the Sixties.

Private Rights of Action. The revision of Rule 23 of the Federal Rules of Civil Procedure in 1966 created the procedural structure undergirding the modern securities class action, but of equal significance was the judicial discovery of implied private causes of action. Rule 10b-5 was promulgated by the SEC in 1942, but the Supreme Court did not take up the issue of implied rights of action under the securities laws until J.I. Case v. Borak in 1964 (recognizing a private cause of action under Rule 14a-9, the parallel antifraud provision under the proxy rules) and Superintendent of Ins. v. Bankers Life & Casualty Co. in 1971 (acknowledging, in a footnote, a private right of action under Rule 10b-5). The Supreme Court’s opening of the floodgates for securities class actions in the 1960s shares two characteristics with the development of insider trading law. First, the principal weapon was the open-ended language of Rule 10b-5, combined with an expansive understanding of Congressional purpose, only minimally constrained by reference to statutory text. Second, the Second Circuit would again play a critical role in fleshing out the details of these implied causes of action in the absence of statutory guideposts. As with insider trading, the Supreme Court would take a step back in the 1970s, but securities fraud class actions remain a thriving cottage industry.

Federal Corporation Law. The impetus to develop Rule 10b-5 and its implied cause of action was driven in part by perceived failures in state law. As Louis Loss explained to a 1966 American Bar Association conference on the proposed codification of the federal securities laws: “Like many people in this room, if not all of us, I am convinced that basically what we have from 10b-5 was overdue … the common law was strangely laggard in appreciating the fiduciary obligations of directors and other insiders to shareholders.” “Federal corporation law” was a goal long sought by progressives, fueled by longstanding worries about the ability of state corporate law to provide adequate remedies, but never enacted by Congress.

The Second Circuit’s 1952 decision in Birnbaum v. Newport Steel appeared to hobble the use of 10b-5 to expand fiduciary duty. Subsequent Second Circuit decisions during the 1960s, however, pushed the boundaries of Rule 10b-5 to cover mismanagement traditionally governed by state law. The Supreme Court’s 1971 decision in Bankers Life embraced a broad reach of the Rule, encouraging more Second Circuit opinions reading the Exchange Act broadly to effect its purpose. Soon thereafter, however, the Supreme Court would reverse course, more dramatically than it did in the fields of insider trading and implied rights of action. “Federal corporation law” is no longer produced by the courts; instead, Congress now takes the lead on corporate governance.

Securities law in the 1960s was marked by the three principal innovations that continue to shape contemporary securities law. The regulation of insider trading previously cabined in a technical regime under § 16(b), simultaneously over- and under-inclusive, was reinvented as the broad-reaching antifraud provision under Rule 10b-5 applicable today. The Court’s willingness to imply private rights of action from statutes transformed enforcement, allowing securities class actions to flourish. Finally, the Court took an expansive view of fiduciary duty, creating a blueprint for a “federal corporation law,” although that initiative would quickly be repudiated.

The complete paper is available here.

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