On June 25 1997, the US Supreme Court held in United States v O'Hagan, 117 S Ct 2199 (1997), that it is a violation of the US securities laws for corporate outsiders to trade in securities for personal profit using material, non-public information in breach of a fiduciary duty owed to the source of the information. The Court thus ratified the misappropriation theory of liability, which has been used in nearly half the insider trading cases brought by the Securities and Exchange Commission (SEC) in recent years.
Following the stock market crash of 1929, Congress enacted legislation to curb perceived abuses in the securities markets. The Securities Act of 1933 regulates the process by which securities are offered and sold to the public, and the Securities Exchange Act of 1934 (the Exchange Act) regulates the structure of the securities markets and the conduct of market participants. Both laws rely on mandatory disclosure as the primary means of ensuring integrity and fairness in the marketplace. Consistent with this bedrock principle of disclosure, the anti-fraud provisions of the Exchange Act prohibit insider trading.
Under the classical theory of insider trading liability, a violation occurs when a corporate insider trades in his or her corporation's securities on the basis of material, non-public information and thereby breaches a duty to his or her trading parties arising from the relationship of trust and confidence between the shareholders and the insider. The misappropriation theory, by contrast, is premised not on the fiduciary duty owed by a company insider to a purchaser or seller of the company's stock, but rather on the fiduciary duty owed by a company outsider to the source of the information, which is breached when the outsider misappropriates and then trades on the confidential information.
Under this theory, a fiduciary's undisclosed use of a principal's information to purchase or sell securities, in breach of a duty of loyalty or confidentiality, defrauds the principal of the exclusive use of that information. The misappropriation theory, therefore, premises liability on a fiduciary-turned-trader's deception of those who entrusted him or her with access to confidential information, rather than his or her trading party.
The misappropriation theory was developed in response to the highly publicized Wall Street scandals of the 1980s involving stockbrokers and investment bankers. The new theory represented an attempt to bring the suspect trading activities of these individuals, who were not corporate insiders, within the purview of the securities laws.
James O'Hagan was a partner of Dorsey & Whitney, a Minneapolis law firm retained by Grand Metropolitan in connection with a potential tender offer for the common stock of Pillsbury Company. Although O'Hagan did not participate in Dorsey & Whitney's representation of Grand Metropolitan, he used information obtained from his law firm to purchase Pillsbury call options and common stock. After Grand Metropolitan announced its tender offer, the price of Pillsbury stock rose sharply and O'Hagan sold his options and stock at a profit of more than US$4.3 million. The SEC investigated O'Hagan's transactions, and the investigation resulted in an indictment alleging securities fraud under Section 10(b) of the Exchange Act and SEC Rule 10b-5, fraudulent trading in connection with a tender offer in violation of Section 14(e) of the Exchange Act and SEC Rule 14e-3(a), mail fraud, and money-laundering. O'Hagan was convicted on all of these counts and sentenced to a 41-month prison term. The Court of Appeals for the Eighth Circuit reversed O'Hagan's conviction, holding, among other things, that liability under Section 10(b) and Rule 10b-5 could not be based on the misappropriation theory of securities fraud.
The Supreme Court found that the allegations against O'Hagan satisfied the misappropriation theory because O'Hagan, in breach of a duty of trust and confidence he owed to his law firm and to its client, traded on the basis of non-public information regarding Grand Metropolitan's planned tender offer for Pillsbury common stock. Acknowledging that the government could not have prosecuted O'Hagan under the classical theory because he was not an insider of Pillsbury, the Court reasoned that O'Hagan should not escape liability simply because the source of the confidential information was the bidder in the tender offer rather than the target. The Court viewed the misappropriation theory as complimentary to the traditional theory and found that it satisfied each of the requirements of Section 10(b).
One controversial aspect of the O'Hagan decision is the Court's holding that full disclosure by the fiduciary to the source of an intention to trade would foreclose liability under Section 10(b) because there is no deception through non-disclosure, a central requirement of the misappropriation theory. The Court noted, however, that the fiduciary-turned-trader would continue to face potential liability under state law.
The O'Hagan decision also upheld the validity of SEC Rule 14e-3(a), a so-called 'disclose or abstain from trading' rule, which prohibits trading based on material, non-public information in the tender offer context where full disclosure is absent. Rule 14e-3(a) is a prophylactic measure which does not require a trader's breach of fiduciary duty in order to impose liability.
The O'Hagan decision is one of the most significant securities fraud decisions in recent years. It resolved a division of opinion among the federal Courts of Appeals about whether the misappropriation theory, which the SEC uses as a significant part of its enforcement programme, is a proper basis of liability under the securities laws.
John Kerr and Jennifer Dominitz
Simpson Thacher & Bartlett