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The Unusual Administrative History of Rule 10b-5

The Supreme Court has in two recent decisions (Janus and Stoneridge) all but indicated that, were the issue to arise ab initio, there would be no private right of action under Rule 10b-5.  17 CFR 240.240.10b-5.  The rule, of course, is the primary vehicle for class actions against public companies based upon allegations of false disclosure and the legal source for the prohibition on insider trading.  The securities laws without a private right of action under Rule 10b-5 would project a very different landscape.  

But a private right of action aside, the creation of the rule itself was a result of bureaucratic serendipity that is often forgotten in the discussion over the provision.  The rule was written by Milton Freeman, one of the early greats in the securities area in 1942.   Other than the text of the rule itself, the adopting release had only this to say about the new provision:

  • The Securities and Exchange Commission today announced the adoption of a rule prohibiting fraud by any person in connection with the purchase of securities. The previously existing rules against fraud in the purchase of securities applied only to brokers and dealers. The new rule closes a loophole in the protections against fraud administered by the Commission by prohibiting individuals or companies from buying securities if they engage in fraud in their purchase.

Exchange Act Release No. 3230 (May 21, 1942). 

The actual process of writing and adopting the rule was described by Mr. Freeman himself back in 1967.  Here is what he had to say about it:

  • It was one day in the year 1943, I believe.  I was sitting in my office in the S.E.C.  building in Philadelphia and I received a call from Jim Treanor who was then the Director of the Trading and Exchange Division.  He said, "I have just  been on the telephone with Paul Rowen," who was then   the S.E.C. Regional Administrator in Boston, "and he has told me about the president of some company  in Boston who is going around buying up the stock of his company from his own shareholders at $4.00  a share, and he has been telling them that the company is doing very badly, whereas, in fact, the earnings are going to be quadrupled and will be $2.00 a share for this coming year.  Is there any thing  we can do about it?"  So he came upstairs and I called in my secretary and I looked at Section 10(b)   and I looked at Section 17, and I put them together,  and the only discussion we had there was where "in  connection with the purchase  or sale" should be, and we decided it should be at the end.

That was the administrative process.  It still had to be submitted to the Commission for approval.

  • We called the Commission and we got on the calendar, and I don't remember whether we got there that  morning or after lunch.   We passed a piece of paper around to all the commissioners.  All the commissioners read the rule and they tossed it on the table, indicating  approval.  Nobody said anything  except Sumner Pike who said, "Well," he said, "we are against fraud, aren't we?" That is how it happened.  Louis [Loss] is absolutely right that I never thought that twenty-odd years later it would be  the biggest thing that had ever happened.   

Conference on Codification of the Federal Securities Laws, 22 BUS. LAW. 793, 921-23 (1967). 

This was truly another era, when rulemaking was not the impossible affair it is today.  See Business Roundtable v. SEC,  No. 10-1305, July 22, 2011.

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