UNITED STATES COURT OF APPEALS FOR THE SECOND CIRCUIT
decided: April 3, 1974.
MAURICE SHAPIRO, ISADORE SHAPIRO, WILLIAM H. NAIGLES, CHAYLIE SAXE AND THOMAS F. GIBSON, JR., PLAINTIFFS-APPELLEES,
MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., WINTHROP LENZ, JULIUS H. SEDLMAYER, GILLETTE K. MARTIN, DEAN S. WOODMAN, EDWARD N. MCMILLAN, PHILLIP F. BILBAO, NORMAN H. HEINDEL, JR., LEE W. IDLEMAN, LAWRENCE ZICKLIN, JAMES A. MCCARTHY, ELIAS A. LAZOR, CHESTER T. SMITH, JR., INVESTORS MANAGEMENT CO., INC., ANCHOR CORPORATION, MADISON FUND, INC., J. M. HARTWELL & CO., J. M. HARTWELL & CO., INC., HARTWELL ASSOCIATES, PARK WESTLAKE ASSOCIATES, VAN STRUM & TOWNE, INC., FLESCHNER BECKER ASSOCIATES, A. W. JONES & CO., A. W. JONES ASSOCIATES, CITY ASSOCIATES, FAIRFIELD PARTNERS, BURDEN INVESTORS SERVICES, INC. AND WILLIAM A. M. BURDEN & CO., DEFENDANTS-APPELLANTS
Appeal from interlocutory order entered in the Southern District of New York, Charles H. Tenney, District Judge, denying defendants' motion for judgment on the pleadings in a civil action brought to recover damages for alleged violations of the antifraud provisions of the federal securities laws in connection with sales in 1966 of common stock of Douglas Aircraft Company, Inc., the chief issue being the liability of non-trading "tippers" and trading "tippees" under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. Affirmed.
Danaher,*fn* Lumbard and Timbers, Circuit Judges.
TIMBERS, Circuit Judge:
This appeal presents important questions, some of first impression, involving the scope of the antifraud provisions of the federal securities laws in their application to transactions on a national securities exchange when material inside information has not been disclosed.
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. In short, this case involves the liability of non-trading "tippers" and trading "tippees" under Section 10(b) and Rule 10b-5.
Defendants appeal, pursuant to 28 U.S.C. § 1292(b) (1970), from an order entered in the Southern District of New York, Charles H. Tenney, District Judge, 353 F. Supp. 264 (S.D.N.Y. 1972), denying their motion for judgment on the pleadings on the ground that the complaint failed to state a claim upon which relief can be granted.
The action was brought to recover damages claimed to have been sustained as the result of defendants' trading or recommending trading of common stock of Douglas Aircraft Company, Inc. (Douglas) on the New York Stock Exchange (NYSE) in 1966. Such acts or transactions are alleged to have violated Sections 10(b) and 15(c) (1) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b) and 78o(c) (1) (1970); Rules 10b-5 and 15c-1 and 2, 17 C.F.R. §§ 240.10b-5 and 240.15c-1 and 2 (1973), promulgated by the Securities and Exchange Commission (SEC); and Section 17(a) of the Securities Act of 1933, 15 U.S.C. § 77q(a) (1970).*fn1
Applying to the admitted facts before us what we believe to be controlling principles of law as enunciated by the Supreme Court and by our Court, we affirm.
In summarizing here the facts necessary to a determination of the legal issues raised on this appeal, we must take as admitted the well-pleaded material facts alleged in the complaint, as the district court did, 353 F. Supp. at 268, since the order under review denied defendants' motion for judgment on the pleadings pursuant to Fed. R. Civ. P. 12(c).*fn2
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.*fn3 This statement indicated that Douglas had earned 85 cents per share on its common stock during that period.
During the period June 17 through June 22, Merrill Lynch and certain of its officers, directors and employees (the individual defendants)*fn4 were advised by Douglas' management of certain material adverse inside information regarding Douglas' earnings.*fn5 This information was essentially that (a) Douglas would report substantially lower earnings for the entire first six months than it had reported for the first five months of its 1966 fiscal year; (b) Douglas had sharply lowered its estimate of earnings for its full 1966 fiscal year in that it now expected to have little or no profit for that year; and (c) Douglas had substantially reduced its projection of earnings for its 1967 fiscal year. This information was given to Merrill Lynch solely because of its position as the prospective underwriter for the Douglas debenture issue. The individual defendants and Merrill Lynch knew or should have known that the information had not yet been publicly announced.
During the period June 20 through June 24, Merrill Lynch and the individual defendants disclosed this confidential information to the following Merrill Lynch customers (the selling defendants), most of whom were institutional investors: Investors Management Co., Inc. (a wholly owned subsidiary of Anchor Corporation), Madison Fund, Inc., J. M. Hartwell & Co. (predecessor of J. M. Hartwell & Co., Inc.), Hartwell Associates, Park Westlake Associates, Van Strum & Towne, Inc., Fleschner Becker Associates, A. W. Jones & Co., A. W. Jones Associates, City Associates, Fairfield Partners, Burden Investors Services, Inc. and William A. M. Burden & Co. The selling defendants knew or should have known that this information had not yet been publicly announced.
During the period June 20 through June 23, the selling defendants either sold from existing positions or made short sales of more than 165,000 shares of Douglas common on the NYSE. This was approximately one-half of the total number of Douglas shares sold on the NYSE during this period. These sales were made prior to Douglas' public disclosure of the revised earnings information on June 24*fn6 and without the sellers having disclosed this information to the investing public, including plaintiffs. As a result of these sales, the individual defendants and Merrill Lynch received commissions from the execution of the selling defendants' orders and also received compensation in the form of customer directed "give ups" -- i.e. division of commissions earned by other brokers who executed orders for the selling defendants.
On June 23, plaintiff Gibson purchased an unspecified number of shares of Douglas common on the NYSE; his purchase was prior to the public release on June 24 of Douglas' revised earnings report. The other four plaintiffs -- Maurice Shapiro, Isadore Shapiro, Naigles and Saxe -- purchased an unspecified number of shares of Douglas common on the NYSE on June 24; their purchases were made without knowledge of the material adverse earnings information released by Douglas that day.*fn7
Beginning about June 22 or 23, the market price of Douglas common on the NYSE took a sudden and substantial drop.*fn8 This coincided with and, according to the complaint, was caused by the substantial sales by the selling defendants on the basis of material inside information, the disclosure of which after plaintiffs' purchases precipitated a further severe drop in the market price of Douglas common.
On August 21, 1970, plaintiffs commenced the instant action in the Southern District of New York. They sued on behalf of themselves and all others similarly situated who purchased Douglas common during the period June 21 through June 24, 1966. Essentially the complaint alleges that defendants were under a duty to disclose to the general investing public, including plaintiffs, the material inside information regarding Douglas' earnings; that defendants defrauded plaintiffs by not disclosing such information, in violation of the antifraud provisions of the securities laws; that plaintiffs would not have purchased Douglas stock if they had known of the information withheld by defendants; and that plaintiffs sustained substantial damages as a result of the acts of defendants. Plaintiffs do not claim to have purchased specific shares of Douglas stock sold by any of the selling defendants. The complaint demands damages sustained by plaintiffs and an accounting of profits realized by defendants.*fn9
After the pleadings were closed and certain limited discovery proceedings had taken place, both sides brought on motions before Judge Tenney. Plaintiffs moved, pursuant to Fed. R. Civ. P. 23(c), for an order declaring that the action be maintained as a class action. Defendants moved for judgment on the pleadings on the ground that the complaint failed to state a claim upon which relief can be granted. In support of their motion, defendants contended that plaintiffs lacked standing to sue; that the information defendants withheld was not material; that there was no privity between plaintiffs and defendants; that scienter was absent; and that plaintiffs had failed to allege facts sufficient to establish causation and reliance.
On December 26, 1972, Judge Tenney filed a well reasoned opinion, 353 F. Supp. 264, denying the motions by both sides.*fn10 In denying defendants' motion for judgment on the pleadings, the judge carefully considered but rejected each of defendants' contentions. He held in substance that Merrill Lynch and the individual defendants violated a duty which they owed to plaintiffs when these defendants disclosed material inside information to the selling defendants; that the selling defendants in turn violated a duty which they owed to plaintiffs when they sold the Douglas stock without disclosing the material inside information which had been divulged to them; that the conduct of all defendants had caused plaintiffs to sustain damages; and that accordingly the complaint stated a claim upon which relief could be granted against all defendants under Section 10(b) and Rule 10b-5.
Since there was no issue before Judge Tenney on defendants' motion for judgment on the pleadings with respect to the measure of damages to which plaintiffs would be entitled or other appropriate relief to be fashioned in the event plaintiffs were successful after trial on the merits, he made no determination on that issue.
On February 22, 1973, upon motion by defendants, Judge Tenney amended his earlier order by adding the certification*fn11 required by 28 U.S.C. § 1292(b) (1970) to permit appeal from an interlocutory order. On March 27, 1973, we granted leave to appeal.
Upon the basis of the foregoing summary of the facts and prior proceedings, we turn directly to the legal questions presented. They are essentially whether defendants violated Section 10(b) and Rule 10b-5 and, if so, whether they are liable in damages to plaintiffs for such violations. The district court held as a matter of pleading that both questions must be answered in the affirmative. We agree.
Our starting point is the statute and the implementing rule. 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 . . . ."
As we have stated time and again, the purpose behind Section 10(b) and Rule 10b-5 is to protect the investing public and to secure fair dealing in the securities markets by promoting full disclosure of inside information so that an informed judgment can be made by all investors who trade in such markets. E.g., Crane Co. v. Westinghouse Air Brake Co., 419 F.2d 787, 793 (2 Cir. 1969), cert. denied, 400 U.S. 822, 27 L. Ed. 2d 50, 91 S. Ct. 41 (1970); SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848 (2 Cir. 1968), cert. denied sub nom. Kline v. SEC, 394 U.S. 976, 89 S. Ct. 1454, 22 L. Ed. 2d 756 (1969). We recently held in Radiation Dynamics, Inc. v. Goldmuntz, 464 F.2d 876, 890 (2 Cir. 1972), that "the essential purpose of Rule 10b-5 . . . is to prevent corporate insiders and their tippees from taking unfair advantage of the uninformed outsiders."
Moreover, in applying the antifraud provisions of the securities laws to the facts of this case, it is important to bear in mind that "Congress intended securities legislation enacted for the purpose of avoiding frauds to be construed 'not technically and restrictively, but flexibly to effectuate its remedial purposes. '" Affiliated Ute Citizens v. United States, 406 U.S. 128, 151, 31 L. Ed. 2d 741, 92 S. Ct. 1456 (1972), quoting from SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 195, 11 L. Ed. 2d 237, 84 S. Ct. 275 (1963). This policy of flexible, non-technical construction of the securities laws has provided the underpinning for the results in recent cases involving specific violations of the antifraud provisions of the securities laws. E.g., Superintendent of Insurance v. Bankers Life & Casualty Co., 404 U.S. 6, 12, 30 L. Ed. 2d 128, 92 S. Ct. 165 (1971); SEC v. Glen-Arden Commodities, Inc., 493 F.2d 1027, slip op. at 2175, 2186 (2d Cir. 1974); International Controls Corp. v. Vesco, 490 F.2d 1334, slip op. at 1399, 1416 (2 Cir. 1974). See Chris-Craft Industries, Inc. v. Piper Aircraft Corp., 480 F.2d 341, 357, 363 (2 Cir.), cert. denied, 414 U.S. 910, 94 S. Ct. 231, 38 L. Ed. 2d 148 (1973).*fn12
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.
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." 401 F.2d at 848.
Defendants argue, however, that Texas Gulf is inapplicable here because, first, that was an SEC injunction action and not a private damage action and, second, Rule 10b-5 does not impose upon these defendants a duty to disclose the material inside information in question to these plaintiffs who did not purchase the actual stock sold by defendants.
Although Texas Gulf was an SEC injunction action, the strong public policy considerations behind our "disclose or abstain" rule there are equally applicable here. In short, whether invoked in an SEC injunction action or in a private damage action, "the Rule is based in policy on the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information . . ." SEC v. Texas Gulf Sulphur Co., supra, 401 F.2d at 848.*fn13 See Crane Co. v. Westinghouse Air Brake Co., supra, 419 F.2d at 796. Since one of the primary goals of the antifraud provisions of the securities laws would be frustrated if our "disclose or abstain" rule enunciated in Texas Gulf were to be limited to SEC injunction actions and held inapplicable to private damage actions, we reject such ground of distinction.
We also reject defendants' second asserted ground for distinguishing Texas Gulf -- that our "disclose or abstain" rule is not applicable here because the only duty owed by defendants was to purchasers of the specific shares of Douglas stock sold by defendants and the transactions here involved were not face-to-face sales to plaintiffs. This argument totally misconstrues our Texas Gulf rule. 401 F.2d at 848. It also ignores the fact that these transactions occurred on an anonymous national securities exchange where as a practical matter it would be impossible to identify a particular defendant's sale with a particular plaintiff's purchase. And 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 to disclose had been violated. See Painter, Inside Information: Growing Pains For The Development Of Federal Corporation Law Under Rule 10b-5, 65 Colum. L. Rev. 1361, 1372, 1377-78 (1965).*fn14 On this very point, we stated in Radiation Dynamics, Inc. v. Goldmuntz, supra, that our "disclose or abstain" rule enunciated in Texas Gulf "applies whether the securities are traded on a public stock exchange or sold through private placement." 464 F.2d at 887. To hold that Section 10(b) and Rule 10b-5 impose a duty to disclose material inside information only in face-to-face transactions or to the actual purchasers or sellers on an anonymous public stock exchange, would be to frustrate a major purpose of the antifraud provisions of the securities laws: to insure the integrity and efficiency of the securities markets. Chris-Craft Industries, Inc. v. Piper Aircraft Corp., supra, 480 F.2d at 357. We decline defendants' invitation to sanction a result which Section 10(b) and Rule 10b-5 clearly were intended to foreclose. See Astor v. Texas Gulf Sulphur Co., 306 F. Supp. 1333, 1340-42 (S.D.N.Y. 1969). We hold that defendants owed a duty -- for the breach of which they may be held liable in this private action for damages -- not only to the purchasers of the actual shares sold by defendants (in the unlikely event they can be identified) but to all persons who during the same period purchased Douglas stock in the open market without knowledge of the material inside information which was in the possession of defendants.
We find untenable the contentions of the respective defendants that, upon the issue of whether they violated the antifraud provisions of the securities laws, a distinction should be drawn between their roles as non-trading "tippers" and trading "tippees".
With respect to Merrill Lynch and the individual defendants (the non-trading "tippers"), their divulging of confidential material inside information to their customers who sold Douglas stock on the basis of such information clearly violated Section 10(b) and Rule 10b-5. In SEC v. Texas Gulf Sulphur Co., supra, 401 F.2d at 852, 856, we held that two "tippers" violated the antifraud provisions of the securities laws by disclosing material inside information to individuals who subsequently entered into transactions on the basis of that information, and we remanded to the district court for determination of an appropriate remedy. Upon remand, the district court held one of these "tippers" liable for "tipping" and awarded appropriate relief. SEC v. Texas Gulf Sulphur Co., 312 F. Supp. 77, 95 (S.D.N.Y. 1970), modified on other grounds, 446 F.2d 1301, 1307-08 (2 Cir.), cert. denied, 404 U.S. 1005, 92 S. Ct. 561, 30 L. Ed. 2d 558 (1971). We find Texas Gulf controlling with respect to the liability of the non-trading "tippers" here.
With respect to the selling defendants (the trading "tippees"), Texas Gulf strongly suggests that the same duty to "abstain or disclose" should be imposed upon them. Although the issue of "tippee" liability was not squarely before us in Texas Gulf, we did say:
"As Darke's 'tippees' are not defendants in this action, we need not decide whether, if they acted with actual or constructive knowledge that the material information was undisclosed, their conduct is as equally violative of the Rule as the conduct of their insider source, though we note that it certainly could be equally reprehensible." 401 F.2d at 852-53.
In Ross v. Licht, 263 F. Supp. 395, 410 (S.D.N.Y. 1967), the court observed, "If [defendants] were not insiders, they would seem to have been 'tippees ' . . . and subject to the same duty as insiders." See Radiation Dynamics, Inc. v. Goldmuntz, supra, 464 F.2d at 887, 890; Cady Roberts & Co., 40 S.E.C. 907, 912-13 (1961). Cf. Kuehnert v. Texstar Corp., 412 F.2d 700, 702-05 (5 Cir. 1969). We are not persuaded by the selling defendants' argument that as tippees they were not able to make effective public disclosure of information about a company with which they were not associated; for the duty imposed is not a naked one to disclose, but a duty to abstain from trading unless they do disclose. Since upon the admitted facts before us the selling defendants knew or should have known of the confidential corporate source of the revised earnings information and they knew of its nonpublic nature, they were under a duty not to trade in Douglas stock without publicly disclosing such information.
In short, for the reasons set forth above, we hold that all defendants violated Section 10(b) and Rule 10b-5.
We turn next to the remaining major legal question presented: assuming that defendants did violate the antifraud provisions of the securities laws by trading in or recommending trading in Douglas common stock (as we have held above), whether they are liable in a private action for damages to plaintiffs who during the same period purchased Douglas stock in the open market without knowledge of the material inside information which was in the possession of defendants.
The essential argument of defendants on this question is that, even if they did violate Section 10(b) and Rule 10b-5, their conduct did not "cause" damage to plaintiffs;*fn15 that it was Douglas' precarious financial condition, not defendants' securities law violations, which precipitated the sudden, substantial drop in the market price of Douglas stock and hence the losses sustained by plaintiffs; that, since plaintiffs had no prior or contemporaneous knowledge of defendants' actions, they would have purchased Douglas stock regardless of defendants' securities law violations; and that, since defendants' sales were unrelated to plaintiffs' purchases and all transactions took place on anonymous public stock exchanges,*fn16 there is lacking the requisite connection between defendants' alleged violations and the alleged losses sustained by plaintiffs.
The short, and we believe conclusive, answer to defendants' assertion that their conduct did not "cause" damage to plaintiffs is the "causation in fact" holding by the Supreme Court in Affiliated Ute Citizens v. United States, 406 U.S. 128, 153-54, 31 L. Ed. 2d 741, 92 S. Ct. 1456 (1972), upon the authority of which we conclude that the requisite element of causation in fact has been established here by the uncontroverted facts that defendants traded in or recommended trading in Douglas stock without disclosing material inside information which plaintiffs as reasonable investors might have considered important in making their decision to purchase Douglas stock.
In order more fully to deal with the arguments which have been vigorously urged upon us by defendants' counsel, however, we believe it may be helpful to back up a bit from our conclusion based on Affiliated Ute and particularly to indicate briefly the decisional law regarding the requisite element of causation that preceded the Supreme Court's opinion in that case.
We consistently have held that causation is a necessary element of a private action for damages under Rule 10b-5. E.g., Chasins v. Smith, Barney & Co., 438 F.2d 1167, 1172 (2 Cir. 1970); Crane Co. v. Westinghouse Air Brake Co., 419 F.2d 787, 797 (2 Cir. 1969), cert. denied, 400 U.S. 822, 27 L. Ed. 2d 50, 91 S. Ct. 41 (1970). Indeed, we have refused "to facilitate outsiders' proof of insiders' fraud" by "reading out of [Rule 10b-5] so basic an element of tort law as the principle of causation in fact." List v. Fashion Park, Inc., 340 F.2d 457, 463 (2 Cir.), cert. denied, 382 U.S. 811, 86 S. Ct. 23, 15 L. Ed. 2d 60 (1965). This is consistent with "the basic concept that causation must be proved else defendants could be held liable to all the world." Globus v. Law Research Service, Inc., 418 F.2d 1276, 1292 (2 Cir. 1969), cert. denied, 397 U.S. 913, 25 L. Ed. 2d 93, 90 S. Ct. 913 (1970). And we have recognized that the aim of Rule 10b-5 "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., supra, 340 F.2d at 463.
As one branch of their absence of causation argument, defendants contend that there was no privity between themselves and plaintiffs. We hold here, as we have held before, that privity between plaintiffs and defendants is not a requisite element of a Rule 10b-5 cause of action for damages. For example, we have upheld Rule 10b-5 claims for relief where there have been no direct transactions between plaintiffs and defendants. Crane Co. v. Westinghouse Air Brake Co., supra, 419 F.2d at 796-98; Heit v. Weitzen, 402 F.2d 909, 913 (2 Cir. 1968), cert. denied, 395 U.S. 903, 23 L. Ed. 2d 217, 89 S. Ct. 1740 (1969). See Astor v. Texas Gulf Sulphur Co., 306 F. Supp. 1333, 1341-42 (S.D.N.Y. 1969). As the Tenth Circuit stated in Mitchell v. Texas Gulf Sulphur Co., 446 F.2d 90, 101 (10 Cir.), cert. denied, 404 U.S. 1004, 30 L. Ed. 2d 558, 92 S. Ct. 564 (1971), "perhaps the first step is to realize that the common law requirement of privity has all but vanished from 10b-5 proceedings while the distinguishable 'connection ' element is retained." And we recognized in Globus v. Law Research Service, Inc., supra, 418 F.2d at 1291, that "before there may be a violation of the securities acts there need not be present all of the same elements essential to a common law fraud. . . ." See Ruder, Texas Gulf Sulphur -- The Second Round: Privity and State of Mind in Rule 10b-5 Purchase and Sale Cases, 63 Nw. U.L. Rev. 423, 432-33 (1968). In short, causation as an element of a Rule 10b-5 cause of action can be established notwithstanding lack of privity.
As a further refinement of their absence of causation argument, defendants contend that, even if privity between plaintiffs and defendants is not required, it is still necessary to show a "connection" between defendants' non-disclosure conduct and plaintiffs' purchase of Douglas stock -- in the sense that the former induced the latter -- before a Rule 10b-5 claim can be established. It is true that prior to the Supreme Court decision in Affiliated Ute the so-called connection requirement was stated in terms of causation and reliance. For example, we have noted that the reason for the requirement of reliance "is to certify that the conduct of the defendant actually caused the plaintiff's injury", List v. Fashion Park, Inc., supra, 340 F.2d at 462, and we have held that "to the extent that reliance is necessary for a finding of a 10b-5 violation in a non-disclosure case . . .,the test is properly one of tort 'causation in fact. '" Chasins v. Smith, Barney & Co., supra, 438 F.2d at 1172. See Crane Co. v. Westinghouse Air Brake Co., supra, 419 F.2d at 797. Cf. SEC v. Texas Gulf Sulphur Co., supra, 401 F.2d at 860. While the concepts of reliance and causation have been used interchangeably in the context of a Rule 10b-5 claim, the proper test to determine whether causation in fact has been established in a non-disclosure case is "whether the plaintiff would have been influenced to act differently than he did act if the defendant had disclosed to him the undisclosed fact." List v. Fashion Park, Inc., supra, 340 F.2d at 463. See Chasins v. Smith, Barney & Co., supra, 438 F.2d at 1172. Cf. Chris-Craft Industries, Inc. v. Piper Aircraft Corp., 480 F.2d 341, 373-75 (2 Cir.), cert. denied, 414 U.S. 910, 94 S. Ct. 231, 38 L. Ed. 2d 148 (1973).
Even on the basis of the pre- Affiliated Ute decisions discussed above, therefore, we would reject defendants' essential causation argument, namely, that, absent an allegation that plaintiffs' purchase of Douglas stock was induced by defendants' non-disclosure of material inside information, the requisite element of causation is lacking. On the contrary, the Rule 10b-5 causation in fact requirement is satisfied by plaintiffs' allegation that they would not have purchased Douglas stock if they had known of the information withheld by defendants.
As must be apparent from our discussion above, we believe that the Supreme Court's decision in Affiliated Ute -- which we regard as controlling on the issue of causation in the instant case -- is a logical sequel to our prior decisions in such cases as List, Heit, Globus, Crane, and Chasins. Moreover, Affiliated Ute specifically applied to a Rule 10b-5 damage action the causation in fact standard enunciated by Mr. Justice Harlan in Mills v. Electric Auto-Lite Co., 396 U.S. 375, 385, 24 L. Ed. 2d 593, 90 S. Ct. 616 (1970), where, in a case involving a cognate provision of the 1934 Act (Section 14(a)), the Court approved dispensing with any requirement of proof of reliance as a prerequisite to recovery in a private damage action. See note 12, supra.
In Affiliated Ute, members of a large class of holders of stock deposited in a bank alleged that two employees of the bank in arranging for sales of this stock had failed to disclose to plaintiffs facts regarding the bank's and the employees' positions as market makers and facts regarding the true value of the stock, in violation of Rule 10b-5. The Supreme Court, in reversing the Court of Appeals which had held that there could be no recovery under Section 10(b) and Rule 10b-5 without a showing of reliance, stated:
"Under the circumstances of this case, involving primarily a failure to disclose, positive proof of reliance is not a prerequisite to recovery. All that is necessary is that the facts withheld be material in the sense that a reasonable investor might have considered them important in the making of this decision. . . . This obligation to disclose and this withholding of a material fact establish the requisite element of causation in fact." 406 U.S. at 153-54. (citations omitted) (emphasis added.)
As applied to the instant case, this holding in Affiliated Ute surely warrants our conclusion that the requisite element of causation in fact has been established by the admitted withholding by defendants of material inside information which they were under an obligation to disclose, such information being clearly material in the sense that plaintiffs as reasonable investors might have considered it important in making their decision to purchase Douglas stock.
Defendants argue that the Affiliated Ute rule of causation in fact should be confined to the facts of that case which involved face-to-face transactions. We disagree. That rule is dependent not upon the character of the transaction -- face-to-face versus national securities exchange -- but rather upon whether the defendant is obligated to disclose the inside information. Here, as we have held above, defendants were under a duty to the investing public, including plaintiffs, not to trade in or to recommend trading in Douglas stock without publicly disclosing the revised earnings information which was in their possession. They breached that duty. Causation in fact therefore has been established.
Our holding that causation in fact has been established despite the fact that all transactions took place on a national securities exchange is consistent with the underlying purpose of Section 10(b) and Rule 10b-5 "to prevent inequitable and unfair practices and to insure fairness in securities transactions generally, whether conducted face-to-face, over the counter, or on the exchanges. . . . The Act and the Rule apply to the transactions here, all of which were consummated on exchanges." SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 847-48 (2 Cir. 1968), cert. denied sub nom. Kline v. SEC, 394 U.S. 976, 89 S. Ct. 1454, 22 L. Ed. 2d 756 (1969) (citations omitted).*fn17
For the reasons set forth above, we hold that defendants are liable in this private action for damages to plaintiffs who, during the same period that defendants traded in or recommended trading in Douglas common stock, purchased Douglas stock in the open market without knowledge of the material inside information which was in the possession of defendants.*fn18
Finally, having held that all defendants violated Section 10(b) and Rule 10b-5 and that they are liable to plaintiffs in this private action for damages, we leave to the district court the appropriate form of relief to be granted, including the proper measure of damages. This comports with the procedure followed in other cases where appellate courts have determined issues of liability for violations of the securities laws. Mills v. Electric Auto-Lite Co., 396 U.S. 375, 386-89, 24 L. Ed. 2d 593, 90 S. Ct. 616 (1970); J. I. Case v. Borak, 377 U.S. 426, 433-35, 12 L. Ed. 2d 423, 84 S. Ct. 1555 (1964); Chris-Craft Industries, Inc. v. Piper Aircraft Corp., 480 F.2d 341, 379-80 (2 Cir.), cert. denied, 414 U.S. 910, 94 S. Ct. 231, 38 L. Ed. 2d 148 (1973); Crane Co. v. Westinghouse Air Brake Co., 419 F.2d 787, 803-04 (2 Cir. 1969), cert. denied, 400 U.S. 822, 27 L. Ed. 2d 50, 91 S. Ct. 41 (1970).
In the instant case there are especially compelling reasons for following this procedure. Since the appeal comes to us from an interlocutory order denying defendants' motion for judgment on the pleadings, there was no issue before the district court and of course no adjudication below on the form of relief to be granted. Among the questions to be determined which will have an important bearing on the form of relief is whether the action is to be maintained as a class action and, if so, the parameters of the class; as to this, the district court understandably was unable to make a determination on the facts presented by the pleadings. 353 F. Supp. at 280. See note 10, supra. Another closely related question bearing upon the relief to be granted as to which the district court had insufficient data upon which to make a determination, 353 F. Supp. at 279-80, is just when Douglas' news release regarding its revised earnings forecast on the morning of June 24, 1966 became effectively disseminated, especially in the light of SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 854 n. 18 (2 Cir. 1968), cert. denied sub nom. Kline v. SEC, 394 U.S. 976, 89 S. Ct. 1454, 22 L. Ed. 2d 756 (1969). Other questions bearing upon the appropriate form of relief which must await trial include the extent of the selling defendants' trading in Douglas stock, whether such trading effectively impaired the integrity of the market, what compensation if any was paid by the selling defendants to Merrill Lynch for the inside information, what profits or other benefits were realized by defendants, what expenses were incurred and what losses were sustained by plaintiffs, and what should be the difference, if any, in the extent of liability imposed on the individual defendants and the selling defendants, respectively. Moreover, we do not foreclose the possibility that an analysis by the district court of the nature and character of the Rule 10b-5 violations committed may require limiting the extent of liability imposed on either class of defendants.
In leaving to the district court the fashioning of appropriate relief, including the proper measure of damages, we are not unmindful of the arguments pressed upon us by all defendants that the resulting judgment for damages may be very substantial in amount -- in the words of defendants' counsel, a "Draconian liability". This is an additional reason for leaving to the district court the appropriate form of relief to be granted -- a determination that can best be made after an evidentiary hearing and on the basis of appropriate findings of fact.
In short, we decide today only those legal questions properly before us on this appeal from the interlocutory order denying defendants' motion for judgment on the pleadings. We leave all other issues to the district court, including the fashioning of appropriate relief.