Texas Gulf Sulphur and the Genesis of Corporate Liability Under Rule 10b-5

Corporate liability for market misrepresentations under Rule 10b-5, the staple of today’s class actions, first took root in the 1960s. Our paper, Texas Gulf Sulphur and the Genesis of Corporate Liability under Rule 10b-5, shows the initial judicial efforts, occurring in the iconic Texas Gulf Sulphur case, to grapple with the extensive corporate liability for material misstatements affecting shares traded in public markets. Texas Gulf Sulphur is mostly known today for transforming insider trading law, but the judges of the Second Circuit hearing that case struggled more with the question of corporate liability.

We analyze not only the published opinions in Texas Gulf Sulphur, but also the judges’ internal memoranda. Henry Friendly identified corporate liability as “the most important issue in the case,” a surprising assertion given that the question of damages was not directly at issue in an SEC action for injunctive relief. The concern over corporate liability was heightened by the fact that the misleading press release at issue was not motivated by a malevolent purpose; the intent was to dampen over-exuberant speculation about an exceptionally rich ore find by the company. The press release was not connected to trading by either the corporation or its officers. A majority of the court shared Friendly’s concern. In an effort to narrow the corporation’s potential liability, the judges considered two options: 1) construing narrowly the “in connection with the purchase or sale of any security” language from §10(b) of the Exchange Act; and 2) the requisite state of mind required for violating Rule 10b-5.

The district court had concluded that the corporation’s benign intentions—and the fact that it was not trading in its own securities—defeated the “in connection with” element. SEC v. Texas Gulf Sulphur Co., 258 F.Supp. 262, 293 (SDNY 1966). The Second Circuit majority rejected that narrow construction, instead adopting a “reasonably calculated to influence the investing public” standard. Texas Gulf Sulphur, 401 F.2d at 862. The majority’s rationale? “[T]he court below used a standard that does not reflect the congressional purpose that prompted the passage of the Securities Exchange Act of 1934.” The purposes of the Exchange Act, according to the majority, were to “to protect the investing public and to secure fair dealing in the securities markets” which “would be seriously undermined” by a requirement that the defendants “engage[] in related securities transactions or otherwise act[] with wrongful motives.” Stated at that level of abstraction, statutory purpose could invoked to support virtually any measure against fraud.

Yet, even the judges who were wary of expanding corporate liability were unwilling to sign on to a more restrictive interpretation of “in connection with.” The “in connection with” requirement offered a textual basis for limiting corporate liability, but the language chosen by Congress hardly compelled a restrictive reading. More relevant for an intermediate appellate court, a narrow construction of the language would fly in the face of the Supreme Court’s instruction in Capital Gains—issued in a case reversing a narrow reading of the securities laws by the Second Circuit—that “securities legislation enacted for the purpose of avoiding frauds” was to be construed “not technically and restrictively, but flexibly to effectuate its remedial purposes.” 375 U.S. 180, 195 (citations and quotations omitted).

For Henry Friendly, the more promising avenue for limiting corporate liability was state of mind. In Friendly’s memo in the Great American case, written just a day after his Texas Gulf Sulphur memo, he commented “Once we decide that ‘in connection with’ is not a useful method for bringing some limits on Rule 10-b-5 but that the way to do this is to impose some kind of guilty action requirement, this case is not a hard one.” Memo of HJF, SEC v. Great American Industries (5/9/1968), at 3, Henry Friendly Collection, Box 135, Folder 6, Harvard Law School Library. Friendly was unable, however, to persuade a majority of his colleagues to cabin the developing 10b-5 remedy. The majority strongly sided with the SEC on both the “in connection with” and the scienter questions, rejecting the effort to “handicap unreasonably the Commission in its work” by imposing a more stringent standard. Texas Gulf Sulphur, 401 F.2d at 861. Capital Gains was invoked for the proposition that “[i]n an enforcement proceeding for equitable or prophylactic relief, the common law standard of deceptive conduct has been modified in the interests of broader protection for the investing public so that negligent insider conduct has become unlawful.” Negligence “comport[ed] with the administrative and legislative purposes underlying the Rule” and would “promote[] the deterrence objective of the Rule.” The only concession to concerns about corporate liability was to limit the negligence holding to injunctive actions brought by the SEC.

The Second Circuit’s TGS holdings on “in connection with” and state of mind shaped subsequent Supreme Court developments, but in divergent ways. The “in connection with” requirement got to the Supreme Court fairly quickly; Justice William O. Douglas’s opinion for the court in Bankers Life gave an even broader application to the phrase in the context of a private claims than Texas Gulf Sulphur had in an SEC enforcement action. Superintendent of Insurance v. Bankers Life and Casualty Co., 404 U.S. 6 (1971). The opinion was vintage Douglas, relying strongly on the purpose of the securities laws.

State of mind, by contrast, would not be decided by the Supreme Court for almost a decade. When the question reached the Supreme Court in Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), the SEC supported the plaintiff in seeking a negligence standard. Lewis F. Powell’s opinion for the Court rebuffed the SEC, holding that negligence could not satisfy the necessary state of mind in a private cause of action. Powell relied heavily on a textual exegesis of § 10(b) in his opinion; purpose received short shrift. Four years after Ernst & Ernst, the Supreme Court closed the door on the SEC’s attempt to gain injunctive relief on the basis of negligence in Aaron, again relying heavily on the text of § 10(b). 446 U.S. 680 (1980). Both private plaintiffs and the SEC would be required to prove scienter, a result closer to the position advocated by Henry Friendly.

The Texas Gulf Sulphur court’s holding on corporate liability was a classic 1960s result, relying on the purpose underlying the securities laws to give a broad reach to Rule 10b-5. The framework for addressing private damages liability anticipated by the Second Circuit judges in Texas Gulf Sulphur, was pruned a bit by the Supreme Court, but it is still reflected in Rule 10b-5 jurisprudence today. “In connection with” is not a meaningful constraint, but the scienter requirement has become the key element policing the scope of corporate liability under Rule 10b-5.

The complete paper is available here.