Fed. Sec. L. Rep. P 95,723 Jerry D. Fridrich v. J. C. Bradford

CELEBREZZE, Circuit Judge

(concurring):

I concur in the result reached by the Court. However, because of the importance of defining the scope of. civil liability under rule 10b-5 in an open market context and the apparent divergence of today’s decision and that of the Second Circuit in Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228 (2d Cir. 1974); aff’g, 353 F.Supp. 264 (S.D.N.Y.1972), I feel compelled to explain my reasons for joining in the Court’s decision.

There is no doubt that Appellants, J. C. Bradford and J. C. Bradford, Jr., actively engaged in trading for their own account on the basis of material inside information which had not been disclosed to the trading public. This was a patent violation of the “disclose or abstain” rule announced in SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2nd Cir. 1968). In Shapiro the Second Circuit extended the rule to provide a basis for recovery in private actions for damages. 495 F.2d at 236 . I do not read today’s decision as a repudiation of the “disclose or abstain” rule in private damage actions. Rather, I see the Court’s opinion as imposmg a rational limitation on the scope of civil liability under rule 10b-5 for insiders trading in the open market.

■There is an obvious need to restrict the scope of civil liability of insiders trading in the open market. If an insider trades in a widely-held stock which is actively traded on a national market, the number of potential plaintiffs could be astronomical and the possible award of damages may be grossly disproportionate to the volume of the insider trading. The Supreme Court in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 , 745 — 47, 95 S.Ct. 1917 , 44 L.Ed.2d 539 (1975), recently addressed the problem of limiting the class of 'potential plaintiffs in 10b-5 civil actions. The majority, in affirming the purchaser-seller requirement of Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2d Cir. 1951), expressed alarm at the potentially vast number of persons who could conceivably bring civil suits under rule 10b-5 absent meaningful restrictions .on the scope of the judicially-created cause of action. The Supreme Court exhorted federal courts to consider the practical im- , plications of extending civil remedies to those who bear only a tangential relationship to the transactions giving rise to violations of rule 10b-5. 421 U.S. at 749 , 95 S.Ct. 1917 .

The limitations this Court places on the scope of an insider’s liability in damages to traders on the open market is consistent with the directive of Blue Chip Stamps . An insider who breaches the “disclose or abstain” rule by trading in the open market should not become a virtual insurer for losses sustained by those who happen to trade in the same stock weeks after the insider has ceased his trading activities. 1 There must be some causative link between breach of the insider’s duty to disclose the withheld information before trading and the losses incurred by would-be plaintiffs. 2 On the other hand, an insider should not *324 escape civil liability for conduct which would clearly violate rule 10b-5 in a face-to-face transaction, by the simple expedient of restricting his trading to the open market where the mechanics of the marketplace make it difficult, if not impossible, to trace particular transactions. 3

It was fear of creating a loophole in the “disclose or abstain” rule which led the Second Circuit in Shapiro to reject the argument that the rule should be restricted to SEC injunctive actions or to private suits where the actual purchasers of the stock could be identified. 495 F.2d at 236-37 . To do so, the Court reasoned, would be to circumvent the strong policy considerations supporting the rule and “make a mockery” of an insider’s duty to disclose or abstain from trading. 4 Id. Indeed, the “disclose or abstain” rule was devised to cope with the difficulty in tracing transactions in an impersonal market. Since the mechanics of the marketplace make it virtually impossible to identify the actual investors with whom an insider is trading, the duty of disclosure is owned to investors as a class who trade on the market during the period of insider trading. 5 As the Court stated in SEC v. Texas Gulf Sulphur Co., 401 F.2d at 848:

[T]he Rule is based in policy on the justifiable expectations of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information. .

The essence of the “disclose or abstain” rule is the inherent unfairness in allowing an insider to enter the open market and trade for his own account in the securities of a corporation on the basis of material inside information “ ‘knowing [such information] is unavailable to those with whom he is dealing,’ i. e., the investing public.” SEC v. Texas Gulf Sulphur Co., 401 F.2d at 848, quoting Matter of Cady, Roberts & Co., 40 SEC 907, 912 (1961). “It is, in fact, the insider’s advantage over others in trading the corporation’s securities which gives rise to the duty of disclosure.” Painter, 65 Colum.L.Rev. at 1384. The “disclose or abstain” rule accomplishes two salutory purposes of rule 10b-5: it insures the integrity of the marketplace and it compensates for the inequity of trading with a corporate insider who has superior access to material inside information. 6 See 401 F.2d at 848.

*325 Given the availability of the “disclose or abstain” rule to private litigants, the problem of identifying those entitled to recover for breach of that duty remains. At common law, recovery for deceit was limited to these who could show “reliance” and “privity”. See generally W. Prosser, Law of Torts § 105 at 685-86, 700-02 (4th ed. 1971). Due to the impersonal nature of trading on the open market and the remedial purpose of rule 10b-5, “privity” and “reliance” as means for limiting the plaintiff class havégenerally fallen into disfavor. See generally Painter at 1370, 1372. Since there is no practical method for matching purchases and sales in the open market, requiring privity in the common law sense as an element of rule 10b-5 would create an insurmountable obstacle for plaintiffs. 7 Reliance also has little relevance to trading in the open market where there are no face-to-face negotiations as a rule, and where non-disclosure of a material fact is often the gravamen of the complaint. See e. g., Blackie v. Barrack, 524 F.2d 891, 905-06 (9th Cir. 1975). See also Note, The Reliance Requirement In Private Actions Under SEC Rule 10b-5, 88 Harv.L.Rev. 584, 589-600 (1975).

Without reliance, however, there is no causative link between defendants’ conduct and plaintiffs’ investment decisions. And without at least a “semblance of privity” defendants’ liability could extend to complete strangers. See Joseph v. Farnsworth Radio and Television Corp., 99 F.Supp. 701, 706 (S.D.N.Y.1951), aff’d, 198 F.2d 883 (2d Cir. 1952). Cf. Globus v. Law Research Service, Inc., 418 F.2d 1276, 1292 (2d Cir. 1969). In Affiliated Ute Citizens v. United States, 406 U.S. 128, 153-54 , 92 S.Ct. 1456 , 31 L.Ed.2d 741 (1972), the Supreme Court dispensed with the requirement of showing actual reliance where liability was grounded on the non-disclosure of a material fact by individuals in a fiduciary relationship to the plaintiffs. Where there is such a relationship, the Court indicated that all that need be shown to prove causation is “causation-in-fact” — an affirmative obligation of disclosure and the withholding of material information. 406 U.S. at 153-54 , 92 S.Ct. 1456 . Because of the materiality of the information, the Court was willing to presume that disclosure would have affected plaintiffs’ investment decisions. 8 See gen *326 erally Note, Reliance Under Rule 10b-5, 24 Case W.Res.L.Rev. 363, 385-88 (1973). In' Shapiro the Second Circuit found Affiliated Ute controlling on the causation issue. 495 F.2d at 238 . The Court reasoned that the duty of disclosure imposed on an insider who chooses to sell or recommend selling a certain stock on the basis of material inside information establishes the requisite element of causation-in-fact for those who purchased that stock during the same period. 495 F.2d at 240-41 .

In the présent case, the Court holds that persons who trade on an open market weeks after an insider has concluded his trading activity must establish more than the materiality of the undisclosed information to demonstrate that their losses were caused by defendants’ trading. 9 As the-Court notes, the “disclose or abstain” rule is stated in the alternative. Trading is the gravamen of the offense. 10 The public has no absolute right to the undisclosed information. It is only when the insider enters the market and creates an informational imbalance that a duty to disclose is imposed to protect the anonymous investors trading with the insider. See SEC v. Texas Gulf Sulphur Co., supra at 848. The duty of disclosure is owed to the class of investors trading contemporaneously with the insider and it is only this group who are the proper beneficiaries of the relaxed causation standard of Affiliated Ute. These investors as a class are disadvantaged by the superior knowledge of the insider. The stocks they traded generate the insider’s profits. 11

There was admittedly no connection between Appellants’ trading and Appellees’ decision to sell their Old Line stock. Appellees are in precisely the same situation they would have been in if Appellants had chosen to abstain from trading. Since they entered the market weeks after Appellants had ceased trading, none of the shares they sold could possibly have been purchased by Appellants. When Appellees entered the market, the information available to investors had returned to equilibrium. Non-contemporaneous traders do not require the special protection of the “disclose or abstain” rule because they do not suffer the disadvantage of trading with someone who has superior access to information. Parties on both sides of the transaction have equal access to information. Of course, as a practical matter, if the insider had made full public disclosure before trading subsequent traders would have been aware of the information and able to gauge its effect on the market. In this sense, whatever losses they suffered were “caused” by the insider’s fail *327 ure to disclose. But, as the Court points out, that presupposes that the insider’s duty of disclosure runs to investors who have no possible connection to the insider trading. I also am unwilling to extend the “disclose or abstain” rule beyond the class of investors it was designed to protect — those trading contemporaneously with the insiders.

On remand from the Second Circuit, the District Court in Shapiro rejected the argument that recovery should be limited to those who purchased Douglas common stock during the period when defendants were actively trading in or recommending trading in the stock. Shapiro v. Merrill Lynch, Pierce, tenner & Smith, Inc., CCH Sec.L. Rep. 1(95,377 at 98,874, 98,877-78 (1976 Transfer Binder) (S.D.N.Y. Dec. 9, 1975). Instead, the District Court held that the duty of disclosure extends “to all purchasers trading contemporaneously with defendants’ wrongdoing, that is, ‘while such information remains undisclosed.’ ” Id. at 98,-878. Under this view, Appellees would be able to recover their losses from Appellants even though there was no possible connection between their trading and that of the insiders. Recovery would simply be based on their sale of Old Line Stock sometime before effective public disclosure of the planned merger. While I agree with the District Court in Shapiro that “liability should be coterminous with the duty breached by the wrongdoer,” id., I feel that the District Court has misinterpreted the breadth of the “disclose or abstain” rule in a straight insider trading situation. To repeat, the wrong which gives rise to the duty to “disclose or abstain” is the act of trading without disclosure. Neither an insider’s trading when he is not in possession of material inside information, nor the decision to abstain from trading when he does possess such information, gives rise to a duty of disclosure. That duty arises only when necessary to equalize the information available to outside investors who are actively trading with an insider who is privy to undisclosed material facts. When the insider ceases trading, the informational imbalance ends and the market returns to its normal state. However, where there is tipping in conjunction with insider trading the circumstances are significantly altered. When an insider tips material information to selected traders he is perpetuating the informational imbalance in the market and breaching a separate duty to treat all persons in the market alike. By tipping, the' insider has set off a chain of events which perhaps may only be remedied by full public disclosure. 12 Shapiro was not a case of straight insider trading but involved tipping on a mass scale. The complaint was essentially aimed at Merrill Lynch’s policy of selective leakage of information about Douglas’ financial straits to favored customers who in turn unloaded their shares in the market to unwary purchasers. Under these circumstances, the District Court in Shapiro may have correctly defined the class of potential plaintiffs to include those in the market up to the point of effective public disclosure.

In this ease, by contrast, the Bradfords engaged in a straight scheme of insider trading. 13 While I have no doubt that they knowingly violated rule 10b-5, I believe that recovery should be limited to those who sold Old Line shares between April 21st and 27th, 1972, the period when the Bradfords were actively purchasing Old Line Stock in the over-the-counter market. Since Appellees did not sell their shares during that period, I join in the Court’s reversal of the decision below.

. [T]he aim of the rule [10b-5] in cases such as this is to qualify, as between insiders and outsiders, the doctrine of caveat emptor —not to establish' a scheme of investors’ insurance.

List v. Fashion Park, Inc., 340 F.2d 457, 463 (2d Cir. 1965).

. Causation, as an element of 10b-5, must be proved in some form or “else defendants could *324 be held liable to all the world.” Globus v. Law Research Service, Inc., 418 F.2d 1276, 1292 (2d Cir. 1969).

. The mechanics of trading in the over-the-counter market are detailed in the Court’s opinion. Transactions are negotiated through broker-dealers who match buy and sell orders at random. Traders in the market have no way of identifying the ultimate sellers or purchasers of shares traded. No matter how an insider trade is accomplished, however, there are certain to be investors on the opposite side of the transaction who are deserving of rule 10b-5 protection. It would be anomalous if the impersonal nature of trading on the open market was to defeat civil liability for insiders trading in violation of rule 10b-5 since the trading markets were the original targets of Congress in 1934. See A. Bromberg, Securities Law: Fraud — SEC Rule 10b-5 § 817(1) at 217 (1971).

. In this case the defendants purchased the bulk of their shares from the inventory of their own brokerage house, J. C. Bradford & Co. They were, in effect, trading with themselves. If recovery were limited to those who actually sold Old Line stock to defendants, their own company would be the principal plaintiff. This would be an absurdity. An insider should not be immunized from liability simply because he trades through intermediaries. See Strong v. Repide, 213 U.S. 419 , 29 S.Ct. 521 , 53 L.Ed. 853 (1909). The real persons requiring protection are the anonymous investors whose Old Line shares were funneled to defendants through various broker-dealers.

. Since in any active market disclosure to a particular individual is not feasible, the duty to disclose, if such a duty exists, must be owed to all members of that ill-defined class of stockholders who, with the benefit of inside information, would alter their intention to sell. Thus, it must be concluded that all those who sold while the defendant was purchasing should be accorded equal rights of recovery.

Painter, Inside Information: Growing Pains for the Development of Federal Corporation Law, 65 Colum.L.Rev. 1361, 1378 (1965).

. One commentator has suggested that compensatory remedies are inappropriate where . trading in the open market is concerned. Note, Limiting the Plaintiff Class: Rule 10b-5 and the Federal Securities Code, 72 Mich.L.Rev. 1398, 1492 .(1974). He states that deterrence *325 should be the goal of 10b-5 in the open market and that curbing an insider’s “abuse of the market” is better left to SEC investigations and criminal sanctions. One problem with the author’s suggestion is that SEC manpower is limited and the time necessary to investigate and prosecute cases which now are processed through the civil courts would, in many cases, be prohibitive. Another is the limitation on the scope of remedies available to the SEC. Although courts have ordered disgorgement of profits as “ancillary relief” in SEC injunctive actions, there is no such remedy if the Commis.sion chooses to proceed through administrative actions against investment advisors or broker-dealers. See Ratner, Federal and State Roles in the Regulation of Insider Trading, 31 Bus.Law 947, 954-55 (Feb. 1976). Also, merely requiring an insider to disgorge the profits he made through his illegal trading may not satisfy either the deterrent or compensatory goals of rule 10b-5. Criminal sanctions are an inadequate substitute for civil proceedings because of the different standard of proof and other factors unrelated to securities regulation which make a conviction for criminal charges much more difficult to procure than a finding of civil liability. Civil liability serves both the deterrent and the compensatory functions of rule 10b-5. The prospect of a substantial money judgment is likely to cause an insider to pause and reflect before entering the market to trade on the basis of confidential information and, at the same time, bolster the confidence of investors that they need not accept the financial “risk” of trading with individuals who have superior access to inside information.

. Plaintiffs should not be required to prove that it was their particular stock certificates which passed through various brokerage houses and came to rest in an insider’s portfolio. As the Second Circuit said in Shapiro, 495 F.2d at 239 : “It would make a mockery of the ‘disclose or abstain’ rule if we were to permit the fortuitous matching of buy and sell orders to determine whether a duty of disclosure were violated.” See also Painter, 65 Colum.L.Rev. at 1372, 1377-78. One commentator has suggested that 'courts have dismissed cases for “lack of privity” when their real concern was over the absence of causation between the insider’s trading and the plaintiffs losses. Bromberg § 8.7(1) at 215 n. 68.

. The presumption of causation is rebuttable. Chelsea Assoc. v. Rapanos, 527 F.2d 1266, 1271-72 (6th Cir. 1975).

. Although the Court specifically does not address the question of market manipulation, if an insider’s trading affects the market price to the extent of creating an artificial market in a security, subsequent investors who were induced to trade on the basis of the price change could logically establish transactional causation without reference to an insider’s duty to “disclose or abstain.” See Cochran v. Channing, 211 F.Supp. 239 (S.D.N.Y.1962). See generally 88 Harv.L.Rev. at 592-96.

. Trading triggers the duty to “disclose or abstain” in a straight insider trading case — a case where insiders were trading solely on their own account. Texas Gulf Sulphur' also involved tipping and the Court held that recommending a trade based on material undisclosed information also gives rise to a duty to disclose. ' 401 F.2d at 848. The distinction between pure insider trading and tipping has relevance to the breadth of the duty of disclosure owed investors in the market. See discussion infra -at 327. -

. As noted above, the mechanics of the market necessitate designation of the class of contemporaneous investors as surrogate plaintiffs for those who actually traded with the insiders. This class must include investors who were in no way involved in the insider transactions, and except for the time of their trading, are indiscernible from subsequent traders. However, to accomplish the deterrent and compensatory purposes of 10b-5, it is better to be overinclusive in the definition of the plaintiff class than underinclusive.

Of course, limiting the plaintiff class to contemporaneous traders does not remove the spectre of “Draconian” damages. . The number of persons trading contemporaneously with an insider in the open market could still be enormous. However one may limit liability, the prospect of a ruinous recovery remains until some realistic measure of damages is devised. But this question is better left to the remedy stage where a court can employ its equitable powers in shaping an award or until such time as the Congress chooses to act on this problem.

. Tipping because it involves a more widespread imbalance of information presents an even greater threat to the integrity of the marketplace than simple insider trading. Tipping, by its very nature, is a more open-ended violation than that of the insider who enters the market, trades on his own account and withdraws.

. The record shows that the Bradfords purchased Old Line Stock for their own account and for accounts under their control. The District Court made no finding that they also engaged in tipping information about the merger to other investors.