By Booth, Richard A.
Regulation , Vol. 30, No. 4
It has been nearly 40 years since the Second Circuit handed down its landmark opinion in SEC v. Texas Gulf Sulfur Company. In that case, Texas Gulf Sulfur (TGS) had found an unusually rich deposit of ores near Timmins, Ontario. When rumors of the strike began to circulate, the company downplayed the event by issuing a pessimistic press release. In the meantime, several directors and officers purchased stock and call options. Several others received stock options as compensation. When the company issued a corrective press release, the price of TGS stock rose dramatically and the insiders who had acquired stock and options enjoyed a handsome profit.
The resulting litigation raised a mother lode of legal issues. It was both a classic false press release securities fraud case (complete with duty-to-correct issues arising from rumors originating in the company) and an insider trading case. It even raised intriguing issues about the legality of an insider accepting stock options while in mere possession of material nonpublic information. The Second Circuit found violations of federal securities law--in particular Rule 10b-5--in each of those transgressions. Although the court did not get the law right in every respect, the result would clearly be the same today. But the case may well have been decided differently if it had not involved both a false press release and insider trading. Standing alone, the false press release might have been excused as a mistake of business judgment--a good-faith effort to quell rumors while gathering facts.
The decision in TGS is largely silent as to the appropriate remedy in a private civil action. Because the decision came in an enforcement action, it was not necessary for the court to address that issue. But if the court had done so, there is a good chance that it would have concluded that those who traded on inside information should disgorge their gains to the issuer, TGS, because that is the statutory remedy for short swing trading specified in Section 16(b) of the Exchange Act.
In the meantime, securities fraud and insider trading have become well established as independent causes of action and the courts and Congress have struggled to devise appropriate remedies for each. But the connection between securities fraud and insider trading matters. A securities fraud class action should be dismissed for failure to state a claim unless it appears that insiders have used the occasion to misappropriate stockholder wealth. (By "misappropriation" I mean something broader than what constitutes insider trading under federal law.) There are two related reasons: First, rational investors diversify, making securities fraud without misappropriation a zero-sum game. Second, securities fraud class actions generate deadweight losses for diversified investors. In the aggregate and over time, diversified investors suffer reduced returns from securities fraud class actions--not from securities fraud. A rational investor would therefore prefer the abolition of such actions except where there is diversion of stockholder wealth by insiders.
The appropriate remedy for misappropriation is for the culprits to disgorge their ill-gotten gains to the issuer. Such actions should be characterized as derivative actions rather than class actions--that is, actions brought by shareholders on behalf of the corporation rather than on behalf of shareholders themselves. That in turn carries significant implications. A derivative action based on insider gain may be maintained in state court as well as federal court, thus avoiding the strictures of the Securities Litigation Uniform Sanctions Act (SLUSA). Indeed, most such actions likely would migrate to state court because they would be based primarily on allegations of breach of fiduciary duty (which is more expansive than insider trading as defined under federal law) and because state law remedies for breach of fiduciary duty are more generous than the strict out-of-pocket rule embodied in federal securities law. …