Securities and Exchange Commission v. Capital Gains Research Bureau, Inc, 42

• Decision Date: 09 December 1963
• Docket Number: No. 42,42
• Citation: 84 S.Ct. 275,11 L.Ed.2d 237,375 U.S. 180
• Parties: SECURITIES AND EXCHANGE COMMISSION, Petitioner, v. CAPITAL GAINS RESEARCH BUREAU, INC., et al
• Court: U.S. Supreme Court

375 U.S. 180

84 S.Ct. 275

11 L.Ed.2d 237

SECURITIES AND EXCHANGE COMMISSION, Petitioner,

v CAPITAL GAINS RESEARCH BUREAU, INC., et al.

No. 42.

Argued Oct. 21, 1963.

Decided Dec. 9, 1963.

David Ferber, Washington, D.C., for petitioner.

Leo C. Fennelly, New York City, for respondents.

Mr. Justice GOLDBERG delivered the opinion of the Court.

We are called upon in this case to decide whether under the Investment Advisers Act of 1940¹ the Securities and Exchange Commission may obtain an injunction compelling a registered investment adviser to disclose to his clients a practice of purchasing shares of a security for his own account shortly before recommending that security for long-term investment and then immediately selling the shares at a profit upon the rise in the market price following the recommendation. The answer to this question turns on whether the practice—known in the trade as 'scalping'—'operates as a fraud or deceit upon any client or prospective client' within the meaning of the Act.² We hold that it does and that the Commission may 'enforce compliance' with the Act by obtaining an injunction requiring the adviser to make full disclosure of the practice to his clients.³

The Commission brought this action against respondents in the United States District Court for the Southern District of New York. At the hearing on the application for a preliminary injunction, the following facts were established. Respondents publish two investment advisory services, one of which—'a Capital Gains Re- port'—is the subject of this proceeding. The Report is mailed monthly to approximately 5,000 subscribers who each pay an annual subscription price of $18. It carries the following description:

'An Investment Service devoted exclusively to (1) The protection of investment capital. (2) The realization of a steady and attrative income therefrom. (3) The accumulation of CAPITAL GAINS thru the timely purchase of corporate equities that are proved to be undervalued.'

Between March 15, 1960, and November 7, 1960, respondents, on six different occasions, purchased shares of a particular security shortly before recommending it in the Report for long-term investment. On each occasion, there was an increase in the market price and the volume of trading of the recommended security within a few days after the distribution of the Report. Immediately thereafter, respondents sold their shares of these securities at a profit.⁴ They did not disclose any aspect of these transactions to their clients or prospective clients.

On the basis of the above facts, the Commission requested a preliminary injunction as necessary to effectuate the purposes of the Investment Advisers Act of 1940. The injunction would have required respondents, in any future Report, to disclose the material facts concerning, inter alia, any purchase of recommended securities 'within a very short period prior to the distribution of a recommendation * * *,' and '(t)he intent to sell and the sale of said securities * * * within a very short period after distribution of said recommendation * * *.'⁵

The District Court denied the request for a preliminary injunction, holding that the words 'fraud' and 'deceit' are used in the Investment Advisers Act of 1940 'in their technical sense' and that the Commission had failed to show an intent to injure clients or an actual loss of money to clients. D.C., 191 F.Supp. 897. The Court of Appeals for the Second Circuit, sitting en banc, by a 5-to-4 vote accepted the District Court's limited construction of 'fraud' and 'deceit' and affirmed the denial of injunctive relief.⁶ 2 Cir., 306 F.2d 606. The majority concluded that no violation of the Act could be found absent proof that 'any misstatements or false figures were contained in any of the bulletins'; or that 'the investment advice was unsound'; or that 'defendants were being bribed or paid to tout a stock contrary to their own beliefs'; or that 'these bulletins were a scheme to get rid of worthless stock'; or that the recommendations were made 'for the purpose of endeavoring artificially to raise the market so that (respondents) might unload (their) holdings at a profit.' Id., 306 F.2d at 608—609. The four dissenting judges pointed out that '(t)he common-law doctrines of fraud and deceit grew up in a business climate very different from that involved in the sale of securities,' and urged a broad remedial construction of the statute which would encompass respondents' conduct. Id., 306 F.2d at 614. We granted certiorari to consider the question of statutory construction because of its importance to the investing public and the financial community. 371 U.S. 967, 83 S.Ct. 550, 9 L.Ed.2d 538.

The decision in this case turns on whether Congress, in empowering the courts to enjoin any practice which operates 'as a fraud or deceit upon any client or prospective client,' intended to require the Commission to establish fraud and deceit 'in their technical sense,' including intent to injure and actual injury to clients, or whether Congress intended a broad remedial construction of the Act which would encompass nondisclosure of material facts. For resolution of this issue we consider the history and purpose of the Investment Advisers Act of 1940.

I.

The Investment Advisers Act of 1940 was the last in a series of Acts designed to eliminate certain abuses in the securities industry, abuses which were found to have contributed to the stock market crash of 1929 and the depression of the 1930's.⁷ It was preceded by the Securities Act of 1933,⁸ the Securities Exchange Act of 1934,⁹ the Public Utility Holding Company Act of 1935,¹⁰ the Trust Indenture Act of 1939,¹¹ and the Investment Company Act of 1940.¹² A fundamental purpose, common to these statutes, was to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry.¹³ As we recently said in a related context, 'It requires but little appreciation * * * of what happened in this country during the 1920's and 1930's to realize how essential it is that the highest ethical standards prevail' in every facet of the securities industry. Silver v. New York Stock Exchange, 373 U.S. 341, 366, 83 S.Ct. 1246, 1262, 10 L.Ed.2d 389.

The Public Utility Holding Company Act of 1935 'authorized and directed' the Securities and Exchange Commission 'to make a study of the functions and activities of investment trusts and investment companies * * *.'¹⁴ Pursuant to this mandate, the Commission made an exhaustive study and report which included consideration of investment counsel and investment advisory services. ¹⁵ This aspect of the study and report culminated in the Investment Advisers Act of 1940.

The report reflects the attitude—shared by investment advisers and the Commission—that investment advisers could not 'completely perform their basic function—furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments—unless all conflicts of interest between the investment counsel and the client were removed.'¹⁶ The report stressed that affiliations by invest- ment advisers with investment bankers or corporations might be 'an impediment to a disinterested, objective, or critical attitude toward an investment by clients * * *.'¹⁷

This concern was not limited to deliberate or conscious impediments to objectivity. Both the advisers and the Commission were well aware that whenever advice to a client might result in financial benefit to the adviser—other than the fee for his advice 'that advice to a client might in some way be tinged with that pecuniary interest (whether consciously or) subconsciously motivated * * *.'¹⁸ The report quoted one leading investment adviser who said that he 'would put the emphasis * * * on subconscious' motivation in such situations.¹⁹ It quoted a member of the Commission staff who suggested that a significant part of the problem was not the existence of a 'deliberate intent' to obtain a financial advantage, but rather the existence 'subconsciously (of) a prejudice' in favor of one's own financial interests. ²⁰ The report incorporated the Code of Ethics and Standards of Practice of one of the leading investment counsel associations, which contained the following canon:

'(An investment adviser) should continuously occupy an impartial and disinterested position, as free as humanly possible from the subtle influence of prejudice, conscious or nconscious; he should scrupulously avoid any affiliation, or any act, which subjects his position to challenge in this respect.'²¹ (Emphasis added.)

Other canons appended to the report announced the following guiding principles: that compensation for investment advice 'should consist exclusively of direct charges to clients for services rendered';²² that the adviser should devote his time 'exclusively to the performance' of his advisory function;²³ that he should not 'share in profits' of his clients;²⁴ and that he should not 'directly or indirectly engage in any activity which may jeopardize (his) ability to render unbiased investment advice.'²⁵ These canons were adopted 'to the end that the quality of services to be rendered by investment counselors may measure up to the high standards which the public has a right to expect and to demand.'²⁶

One activity specifically mentioned and condemned by investment advisers who testified before the Commission was 'trading by investment counselors for their own account in securities in which their clients were interested * * *.'²⁷

This study and report—authorized and directed by statute²⁸ culminated in the preparation and introduction by Senator Wagner of the bill which, with some changes, became the Investment Advisers Act of 1940.²⁹ In its 'declaration of policy' the original bill stated that

'Upon the basis of facts disclosed by the record and report of the Securities and...