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plaintiffdefendantdamages

plaintiffdefendantdamagesappealleaseregulationsustained

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Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228, Fed. Sec. L. Rep. P 94,473

Facts

The events leading to this action occurred between April and July 1966, when Merrill Lynch was the prospective managing underwriter for a new issue of debentures by Douglas Aircraft Company. During this time, Merrill Lynch received material inside information about Douglas' earnings, which was not publicly disclosed. Merrill Lynch and its employees shared this information with certain customers, who then sold a significant amount of Douglas stock on the NYSE without disclosing the information to the public. Plaintiffs, who purchased Douglas stock during this period without knowledge of the inside information, later suffered financial losses when the stock price dropped following the public announcement of the revised earnings.

The course of events which culminated in the instant action occurred during the period April 1966 through July 1966. During this period, Merrill Lynch, Pierce, Fenner & Smith Inc. (Merrill Lynch) was engaged as the prospective managing underwriter of a proposed Douglas offering of $75,000,000 principal amount of a new issue of 4 3/4% Convertible subordinated debentures. A registration statement for this offering was filed with the SEC on June 7; it became effective on July 12, with Merrill Lynch the managing underwriter. On June 7, Douglas had released an earnings statement which reported the results of operations for the first five months of its 1966 fiscal year, i.e. through April 30, 1966. During the period June 17 through June 22, Merrill Lynch and certain of its officers, directors and employees (the individual defendants) were advised by Douglas' management of certain material adverse inside information regarding Douglas' earnings. This information was given to Merrill Lynch solely because of its position as the prospective underwriter for the Douglas debenture issue.

Issue

The main legal issues are whether the defendants violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 by disclosing material inside information and whether they are liable for damages to those who purchased stock without knowledge of this information.

Specifically, the questions presented are (1) whether Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 were violated by a prospective managing underwriter of a debenture issue and the underwriter's officers, directors and employees when they divulged material inside information to the underwriter's customers for the purpose of protecting the latters' investments in the stock of the issuer; (2) whether the same antifraud provisions of the securities laws were violated by the underwriter's customers when they traded in the stock of the issuer without disclosing the material inside information which had been divulged to them by the underwriter; and (3) whether those referred to above, if they did violate the antifraud provisions of the securities laws, are liable in damages to those persons who during the same period purchased stock in the same company in the open market without knowledge of the material inside information.

Rule

Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 prohibit the use of manipulative or deceptive devices in connection with the purchase or sale of securities, requiring full disclosure of material information to ensure fair dealing in the securities markets.

Section 10(b) of the 1934 Act in relevant part makes it unlawful for any person, directly or indirectly, by the use of any facility of any national securities exchange ‘to use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission (SEC) may prescribe as necessary or appropriate in the public interest or for the protection of investors.’ One such prescription is Rule 10b-5 which provides in relevant part that ‘in connection with the purchase or sale of any security’, it shall be unlawful for any person, directly or indirectly, by the use of any facility of any national securities exchange ‘(a) to employ any device, scheme, or artifice to defraud, (b) 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 (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person . . ..’

Analysis

The court found that Merrill Lynch and its employees, as well as the customers who sold the stock, violated the antifraud provisions by failing to disclose the material inside information. The court emphasized that the duty to disclose applies to all investors trading on public exchanges, regardless of whether they were direct purchasers or sellers. The court also noted that the defendants' actions caused the plaintiffs' financial losses, as the plaintiffs purchased stock without the benefit of the undisclosed information.

Here, upon the question of whether Section 10(b) and Rule 10b-5 were violated, the critical facts— admitted for purposes of this appeal— are that Merrill Lynch, a prospective managing underwriter of a Douglas debenture issue, and some of the officers, directors and employees of Merrill Lynch, divulged to certain of its customers, the selling defendants, material adverse inside information regarding Douglas' earnings; the selling defendants, without disclosing to the investing public this inside information, sold Douglas common stock on a national securities exchange; and as a result of such trading Merrill Lynch and the individual defendants received commissions and other compensation, the selling defendants minimized their losses, but the investing public comprised of uninformed outsiders, including plaintiffs, who purchased Douglas stock during the same period sustained substantial losses.

Conclusion

The court affirmed the lower court's ruling, holding that the defendants violated the antifraud provisions and are liable for damages to the plaintiffs who purchased stock without knowledge of the material inside information.

Our holding that such conduct on the part of all defendants violated Section 10(b) and Rule 10b-5 is based chiefly on our decision in SEC v. Texas Gulf Sulphur Co., supra, where we stated that ‘anyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing it . . ., must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.’

Who won?

The plaintiffs prevailed in the case because the court found that the defendants had violated securities laws by failing to disclose material inside information, which directly caused the plaintiffs' financial losses.

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