Securities and Exchange Commission v. Capital Gains Research Bureau Inc/Opinion of the Court

We are called upon in this case to decide whether under the Investment Advisers Act of 1940 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. 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.

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 Report'-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. 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 *  *  * .'

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. 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.

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. It was preceded by the Securities Act of 1933, the Securities Exchange Act of 1934, the Public Utility Holding Company Act of 1935, the Trust Indenture Act of 1939, and the Investment Company Act of 1940. 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. 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 * *  * .' Pursuant to this mandate, the Commission made an exhaustive study and report which included consideration of investment counsel and investment advisory services. 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.' The report stressed that affiliations by investment advisers with investment bankers or corporations might be 'an impediment to a disinterested, objective, or critical attitude toward an investment by clients * *  * .'

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 * *  * .' The report quoted one leading investment adviser who said that he 'would put the emphasis *  *  * on subconscious' motivation in such situations. 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. 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.' (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'; that the adviser should devote his time 'exclusively to the performance' of his advisory function; that he should not 'share in profits' of his clients; and that he should not 'directly or indirectly engage in any activity which may jeopardize (his) ability to render unbiased investment advice.' 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.'

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 * *  * .'

This study and report-authorized and directed by statute culminated in the preparation and introduction by Senator Wagner of the bill which, with some changes, became the Investment Advisers Act of 1940. 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 Exchange Commission *  *  * it is hereby      declared that the national public interest and the interest      of investors are adversely affected- *  *  * (4) when the      business of investment advisers is so conducted as to defraud      or mislead investors, or to enable such advisers to relieve      themselves of their fiduciary obligations to their clients.

'It is hereby declared that the policy and purposes of  this title, in accordance with which the provisions of   this title shall be interpreted, are to mitigate and, so   far as is presently practicable to eliminate the abuses   enumerated in this section.' S. 3580, 76th Cong., 3d   Sess., § 202.

Hearings were then held before Committees of both Houses of Congress. In describing their profession, leading investment advisers emphasized their relationship of 'trust and confidence' with their clients and the importance of 'strict limitation of (their right) to buy and sell securities in the normal way if there is any chance at all that to do so might seem to operate against the interests of clients and the public.' The president of the Investment Counsel Association of America, the leading investment counsel association, testified that the

'two fundamental principles upon which the pioneers in this     new profession undertook to meet the growing need for      unbiased investment information and guidance were, first,      that they would limit their efforts and activities to the      study of investment problems from the investor's standpoint,      not engaging in any other activity, such as security selling      or brokerage, which might directly or indirectly bias their      investment judgment; and, second, that their remuneration for      this work would consist solely of definite, professional fees      fully disclosed in advance.'

Although certain changes were made in the bill following the hearings, there is nothing to indicate an intent to alter the fundamental purposes of the legislation. The broad proscription against 'any * *  * practice *  *  * which operates *  *  * as a fraud or deceit upon any client or prospective client' remained in the bill from beginning to end. And the Committee Reports indicate a desire to preserve 'the personalized character of the services of investment advisers,' and to eliminate conflicts of interest between the investment adviser and the clients as safeguards both to 'unsophisticated investors' and to 'bona fide investment counsel.' The Investment Advisers Act of 1940 thus reflects a congressional recognition 'of the delicate fiduciary nature of an investment advisory relationship,' as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline as investment adviser- consciously or unconsciously-to render advice which was not disinterested. It would defeat the manifest purpose of the Investment Advisers Act of 1940 for us to hold, therefore, that Congress, in empowering the courts to enjoin any practice which operates 'as a fraud or deceit,' intended to require proof of intent to injure and actual injury to clients.

This conclusion moreover, is not in derogation of the common law of fraud, as the District Court and the majority of the Court of Appeals suggested. To the contrary, it finds support in the process by which the courts have adapted the common law of fraud to the commercial transactions of our society. It is true that at common law intent and injury have been deemed essential elements in a damage suit between parties to an arm's-length transaction. But this it not such an action. This is a suit for a preliminary injunction in which the relief sought is, as the dissenting judges below characterized it, the 'mild prophylactic,' 306 F.2d, at 613, of requiring a fiduciary to disclose to his clients, not all his security holdings, but only his dealings in recommended securities just before and after the issuance of his recommendations.

The content of common-law fraud has not remained static as the courts below seem to have assumed. It has varied, for example, with the nature of the relief sought, the relationship between the parties, and the merchandise in issue. It is not necessary in a suit for equitable or prophylactic relief to establish all the elements required in a suit for monetary damages.

'Law had come to regard fraud * *  * as primarily a tort, and      hedged about with stringent requirements, the chief of which      was a strong moral, or rather immoral element, while equity      regarded it, as it had all along regarded it, as a      conveniently comprehensive word for the expression of a lapse      from the high standard of conscientiousness that it exacted      from any party occupying a certain contractual or fiduciary      relation towards another party.'

'Fraud has a broader meaning in equity (than at law) and     intention to defraud or to misrepresent is not a necessary      element.'

'Fraud, indeed, in the sense of a court of equity  properly includes all acts, omissions and concealments   which involve a breach of legal or equitable duty,   trust, or confidence, justly reposed, and are injurious   to another, or by which an undue and unconscientious   advantage is taken of another.'

Nor is it necessary in a suit against a fiduciary, which Congress recognized the investment adviser to be, to establish all the elements required in a suit against a party to an arm's-length transaction. Courts have imposed on a fiduciary an affirmative duty of 'utmost good faith, and full and fair disclosure of all material facts,' as well as an affirmative obligation 'to employ reasonable care to avoid misleading' his clients. There has also been a growing recognition by common-law courts that the doctrines of fraud and deceit which developed around transactions involving land and other tangible items of wealth are ill-suited to the sale of such intangibles as advice and securities, and that, accordingly, the doctrines must be adapted to the merchandise in issue. The 1909 New York case of Ridgely v. Keene, 134 App.Div. 647, 119 N.Y.S. 451, illustrates this continuing development. An investment adviser who, like respondents, published an investment advisory service, agreed, for compensation, to influence his clients to buy shares in a certain security. He did not disclose the agreement to his client but sought 'to excuse his conduct by assertin that *  *  * he honestly believed, that his subscribers would profit by his advice *  *  * .' The court, holding that 'his belief in the soundness of his advice is wholly immaterial,' declared the act in question 'a palpable fraud.'

We cannot assume that Congress, in enacting legislation to prevent fraudulent practices by investment advisers, was unaware of these developments in the common law of fraud. Thus, even if we were to agree with the courts below that Congress had intended, in effect, to codify the common law of fraud in the Investment Advisers Act of 1940, it would be logical to conclude that Congress codified the common law 'remedially' as the courts had adapted it to the prevention of fraudulent securities transactions by fiduciaries, not 'technically' as it has traditionally been applied in damage suits between parties to arm's-length transactions involving land and ordinary chattels.

The foregoing analysis of the judicial treatment of common-law fraud reinforces our conclusion that Congress, in empowering the courts to enjoin any practice which operates 'as a fraud or deceit' upon a client, did not intend to require proof of intent to injure and actual injury to the client. Congress intended the Investment Advisers Act of 1940 to be construed like other securities legislation 'enacted for the purpose of avoiding frauds,' not technically and restrictively, but flexibly to effectuate its remedial purposes.

We turn now to a consideration of whether the specific conduct here in issue was the type which Congress intended to reach in the Investment Advisers Act of 1940. It is arguable-indeed it was argued by 'some investment counsel representatives' who testified before the Commission-that any 'trading by investment counselors for their own account in securities in which their clients were interested * *  * ' creates a potential conflict of interest which must be eliminated. We need not go that far in this case, since here the Commission seeks only disclosure of a conflict of interests with significantly greater potential for abuse than in the situation described above. An adviser who, like respondents, secretly trades on the market effect of his own recommendation may be motivated-consciously or unconsciously-to recommend a given security not because of its potential for long-run price increase (which would profit the client), but because of its potential for short-run price increase in response to anticipated activity from the recommendation (which would profit the adviser). An investor seeking the advice of a registered investment adviser must, if the legislative purpose is to be served, be permitted to evaluate such overlapping motivations, through appropriate disclosure, in deciding whether an adviser is serving 'two masters' or only one, 'especially * *  * if one of the masters happens to be economic self-interest.' United States v. Mississippi Valley Generating Co., 364 U.S. 520, 549, 81 S.Ct. 294, 308, 309, 5 L.Ed.2d 268. Accordingly, we hold that the Investment Advisers Act of 1940 empowers the courts, upon a showing such as that made here, to require an adviser to make full and frank disclosure of his practice of trading on the effect of his recommendations.

Respondents offer three basic arguments against this conclusion. They argue first that Congress could have made, but did not make, failure to disclose material facts unlawful in the Investment Advisers Act of 1940, as it did in the Securities Act of 1933, and that absent specific language, it should not be assumed that Congress intended to include failure to disclose in its general proscription of any practice which operates as a fraud or deceit. But considering the history and chronology of the statutes, this omission does not seem significant. The Securities Act of 1933 was the first experiment in federal regulation of the securities industry. It was understandable, therefore, for Congress, in declaring certain practices unlawful, to include both a general proscription against fraudulent and deceptive practices and, out of an abundance of caution, a specific proscription against nondisclosure. It soon became clear, however, that the courts, aware of the previously outlined developments in the common law of fraud, were merging the proscription against nondisclosure into the general proscription against fraud, treating the former, in effect, as one variety of the latter. For example, in Securities & Exchange Comm'n v. Torr, 15 F.Supp. 315 (D.C.S.D.N.Y.1936), rev'd on other grounds, 2 Cir., 87 F.2d 446, Judge Patterson held that suppression of information material to an evaluation of the disinterestedness of investment advice 'operated as a deceit on purchasers,' 15 F.Supp., at 317. Later cases also treated nondisclosure as one variety of fraud or deceit. In light of this, and in light of the evident purpose of the Investment Advisers Act of 1940 to substitute a philosophy of disclosure for the philosophy of caveat emptor, we cannot assume that the omission in the 1940 Act of a specific proscription against nondisclosure was intended to limit the application of the antifraud and antideceit provisions of the Act so as to render the Commission impotent to enjoin suppression of material facts. The more reasonable assumption, considering what had transpired between 1933 and 1940, is that Congress, in enacting the Investment Advisers Act of 1940 and proscribing any practice which operates 'as a fraud or deceit,' deemed a specific proscription against nondisclosure surplusage.

Respondents also argue that the 1960 amendment to the Investment Advisers Act of 1940 justifies a narrow interpretation of the original enactment. The amendment made two significant changes which are relevant here. 'Manipulative' practices were added to the list of those specifically proscribed. There is nothing to suggest, however, that with respect to a requirement of disclosure, 'manipulative' is any broader than fraudulent or deceptive. Nor is there any indication that by adding the new proscription Congress intended to narrow the scope of the original proscription. The new amendment also authorizes the Commission 'by rules and regulations (to) define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.' The legislative history offers no indication, however, that Congress intended such rules to substitute for the 'general and flexible' antifraud provisions which have long been considered necessary to control 'the versatile inventions of fraud-doers.' Moreover, the intent of Congress must be culled from the events surrounding the passage of the 1940 legislation. '(O)pinions attributed to a Congress twenty years after the event cannot be considered evidence of the intent of the Congress of 1940.' Securities & Exchange Comm'n v. Capital Gains Research Bureau, Inc., 306 F.2d 606, 615 (dissenting opinion). See United States v. Philadelphia Nat. Bank, 374 U.S. 321, 348-349, 83 S.Ct. 1715, 1733-1734, 10 L.Ed.2d 915.

Respondents argue, finally, that their advice was 'honest' in the sense that they believed it was sound and did not offer it for the purpose of furthering personal pecuniary objectives. This, of course, is but another way of putting the rejected argument that the elements of technical common-law fraud-particularly intent must be established before an injunction requiring disclosure may be ordered. It is the practice itself, however, with its potential for abuse, which 'operates as a fraud or deceit' within the meaning of the Act when relevant information is suppressed. The Investment Advisers Act of 1940 was 'directed not only at dischonor, but also at conduct that tempts dishonor.' United States v. Mississippi Valley Generating Co., 364 U.S. 520, 549, 81 S.Ct. 294, 308, 309, 5 L.Ed.2d 268. Failure to disclose material facts must be deemed fraud or deceit within its intended meaning, for, as the experience of the 1920's and 1930's amply reveals, the darkness and ignorance of commercial secrecy are the conditions upon which predatory practices best thrive. To impose upon the Securities and Exchange Commission the burden of showing deliberate dishonesty a a condition precedent to protecting investors through the prophylaxis of disclosure would effectively nullify the protective purposes of the statute. Reading the Act in light of its background we find no such requirement commanded. Neither the Commission nor the courts should be required 'to separate the mental urges,' Peterson v. Greenville, 373 U.S. 244, 248, 83 S.Ct. 1119, 1121, 10 L.Ed.2d 323, of an investment adviser, for '(t)he motives of man are too complex * *  * to separate *  *  * .' Mosser v. Darrow, 341 U.S. 267, 271, 71 S.Ct. 680, 682, 95 L.Ed. 927. The statute, in recognition of the adviser's fiduciary relationship to his clients, requires that his advice be disinterested. To insure this it empowers the courts to require disclosure of material facts. It misconceives the purpose of the statute to confine its application to 'dishonest' as opposed to 'honest' motives. As Dean Shulman said in discussing the nature of securities transactions, what is required is 'a picture not simply of the show window, but of the entire store * *  * not simply truth in the statements volunteered, but disclosure.' The high standards of business morality exacted by our laws regulating the securities industry do not permit an investment adviser to trade on the market effect of his own recommendations without fully and fairly revealing his personal interests in these recommendations to his clients.

Experience has shown that disclosure in such situations, while not onerous to the adviser, is needed to preserve the climate of fair dealing which is so essential to maintain public confidence in the securities industry and to preserve the economic health of the country.

The judgment of the Court of Appeals is reversed and the case is remanded to the District Court for proceedings consistent with this opinion.

Reversed and remanded.

Mr. Justice DOUGLAS took no part in the consideration or decision of this case.

On none occasion respondents sold short some shares of a security immediately before stating in their Report that the security was overpriced. After the publication of the Report, respondents covered their short sales.

Respondents' transactions are summarized by the Commission as follows:

Stock Purchased       Purchase Recommended    Sold Sale    Profit

price  price

Continental  47 3/4 -

Insurance Co.3/15/60 47 7/8  3/18/60  3/29/60  50 1/8    $1,125.

United Fruit 5/13, 16,       21 1/4 -  6/6, 7,   23 5/8    10,725.

Co. 19, 20/60,      22 1/8   5/27/60 9, 10, 60 - 24 1/

Corp 7/5,   25 1/4 - 7/15/60  7/20, 21,  27 1/8      1,762.

14/60   28 3/4    22/60   -

Hart, Schaffner & Marx 8/8/60 23       8/12/60  8/18,    24 7/8837.

Union Pacific 10/28,  25 3/8 - 11/1/60  11/7/60    27    1,757.

Frank G. Shattuck Co 10/11/6016.83 (2.53  10/14/60    10/25/60     19 1/2 - 695.

(purchased     call cost,(exercised 20 1/

calls) plus 14.30 calls and

option price)     sold)

Chock Full O'Nuts    10/14/60 68 3/4 - 69  10/14/60   10/24/60      62 -    2,772.

(sold short). (sale price). (disparaged).

(covered     62 1/

short sale)(purchase

price)

Although some of the above figures relating to profits are disput ed, respondents do not substantially contest the remaining figures.

Mr. Justice HARLAN, dissenting.