Michael D. Monico is a principal in the firm of Monico, Pavich & Spevack, Chicago, IL. He has represented clients in all aspects of federal criminal law, and has been involved in many white-collar investigations nationwide. He is a frequent lecturer on criminal law. A former Assistant United States Attorney and a Past President of the Illinois Attorneys for Criminal Justice (IACJ), he is a former member of the NACDL Board of Directors.
Jacqueline S. Jacobson is an associate with the Chicago office of Monico, Pavich & Spevack concentrating in white-collar criminal defense and defense of securities and commodities enforcement proceedings. She was formerly a senior enforcement attorney at the Midwest Regional Office of the Securities and Exchange Commission (SEC) and a judicial clerk at the U.S. Court of Appeals for the Seventh Circuit.
On June 25, 1997, the United States Supreme Court handed government prosecutors generally, and the Securities and Exchange Commission (SEC) in particular, another weapon with which to prosecute insider trading cases against lawyers, accountants, investment bankers, securities brokers, and other individuals who may be exposed to material non-public information. Reversing a decision by the Eighth Circuit Court of Appeals, the High Court in United States v. O'Hagan1 approved the "misappropriation theory" as a prosecutorial tool against insider trading in criminal and civil insider trading cases.2
The misappropriation theory subjects individuals who trade on material, non-public information to prosecution, regardless of whether they worked for the company whose stock was being traded or otherwise owed the corporation's shareholders a fiduciary duty. Thus, the misappropriation theory turns the concept of insider trading inside out: "outsiders" now stand an equal chance of prosecution. O'Hagan, in other words, sweeps an entirely new segment of the populace within reach of the insider trading net.
O'Hagan Decision
James O'Hagan was a partner at the Minneapolis, Minnesota law firm of Dorsey & Whitney, which represented Grand Metropolitan PLC, a British company, in its tender offer for the common stock of Pillsbury Company. O'Hagan did not work on the deal, but he learned about it prior to the public from a Dorsey partner that participated in Grand Met's takeover bid. Armed with this confidential information, O'Hagan purchased Pillsbury options and common stock. When the tender offer hit, O'Hagan realized a profit of over $4.3 million dollars.3Because O'Hagan was not an insider of Pillsbury, however, the government could not charge him with insider trading under the classical theory of insider trading, which only reaches those individuals who owe a fiduciary obligation to the shareholders of the corporation whose shares are traded.4 Undaunted, the government brought a 57-count indictment against O'Hagan for mail fraud, wire fraud, and securities fraud using the misappropriation theory.5 The government theorized that O'Hagan had misappropriated confidential information about the tender offer from his law firm and its client, and then traded on that information to his own benefit.
A jury convicted O'Hagan on all 57 counts, but the Eighth Circuit reversed. It found that the misappropriation theory was inconsistent with the plain language of 10(b) and Rule 10b-56 of the Securities Act of 1934.7 The Eighth Circuit held that the theory improperly "permits liability for a breach of duty owed to individuals who are unconnected to and perhaps uninterested in a securities transaction. . . ."8 The court reasoned that such a reading would render meaningless 10(b)'s statutory language that the fraud be in connection with a securities transaction. It also was inconsistent with prior Supreme Court precedent which held that a mere breach of a fiduciary duty, without misrepresentation or a nondisclosure of material information, is not deception prohibited under 10(b).9
The Supreme Court disagreed.10 It found that "deceptive nondisclosure" satisfied the requirement of a deceptive device.11 More importantly, the Court held that the Eighth Circuit had misread prior Supreme Court precedent when it ruled that the 10(b) liability is limited to a breach of duty involving parties to a securities transaction.12 Concluding that the language of the misappropriation theory was consistent with the language of 10(b), the Supreme Court upheld the validity of the misappropriation theory in criminal as well as civil insider trading cases.13
Misappropriation Theory Development
Under the classical theory of insider trading, insiders of the corporation, such as its officers and directors, violate 10(b) and Rule 10b-5 when they buy or sell stock in their own company on the basis of material, non-public information.14 These individuals owe a fiduciary duty to the corporation in whose stock they trade, and to its shareholders. The insider breaches this duty when he trades on the corporation's confidential information for his own benefit.15Classical insider trading amounts to a "deceptive device" under 10(b) because the insider's relationship of trust to the shareholders triggers a duty to disclose or refrain from trading.16 Under certain limited circumstances, the classical insider trading theory also applies to some non-insiders. For example, people who are tipped off by insiders about confidential information who know or should have known that the information was given to them improperly violate the securities laws under the classical theory if they trade on that information.17 In addition, lawyers, accountants, and other professionals who temporarily owe a fiduciary duty to the corporation in whose stock they trade may be prosecuted under the classical theory.18
During the "merger mania" of the 1980s, the SEC became frustrated over its inability to prosecute outsiders who relied on confidential takeover information that they were inevitably exposed to during the merger process. The SEC did not like the idea that outsiders often made large profits by trading on non-public information, yet could not be prosecuted because they did not owe any legal duty to the corporation in whose stock they traded. It was out of this frustration that the misappropriation theory was born.
The Supreme Court first confronted the misappropriation theory in United States v. Chiarella.19 Chiarella was the employee of a financial printer which produced announcements for corporate takeover bids. By virtue of his position at the printer, Chiarella obtained tender offer information in advance of it becoming public. He bought stock in the target companies based on this advance information and then sold the stock at a profit after the tender offer occurred.20 Because he owed no legal duty to the companies in whose stock he traded, Chiarella could not be prosecuted under the classical theory of insider trading. The government trotted out the misappropriation theory, arguing Chiarella committed fraud on his employer's clients when he misappropriated confidential information belonging to his employer and then used it to trade.21
Although the Supreme Court ultimately reversed Chiarella's convictions, it did not reject the government's new theory. Rather, it declined to rule on the validity of the misappropriation theory because it had not been presented to the jury.22
Chief Justice Burger's strong dissent in support of the misappropriation theory and the dictum of four other Justices emboldened the SEC to accelerate use of this new prosecutorial weapon.23 The Chief Justice believed that Chiarella had clearly violated 10(b) when he "stole" the printer's information and used it for his own personal benefit. According to the Chief Justice, any individual, not just an insider, who misappropriates confidential information, should be obligated to disclose his intentions to trade on that information or abstain from trading.24
Since Chiarella, the SEC has relied heavily on the misappropriation theory and used it to support numerous prosecutions, including some of its most highly publicized insider trading cases, such as Drexel Burnham Lambert Inc,.25 Ivan Boesky,26 and Martin Siegal.27 Several circuits embraced the misappropriation theory, including the Second,28 Seventh,29 and Ninth.30 It had been rejected in the Fourth31 and with O'Hagan in the Eighth.
As refined in O'Hagan, under the misappropriation theory an individual violates 10(b) and Rule 10b-5 when he or she obtains material, confidential information, and then uses it in a subsequent securities transaction in breach of a fiduciary duty or similar relationship of confidence owed to the source of the information.32 The Court held that 10(b)'s "in connection with" language was satisfied by this subsequent securities transaction.33
Under the misappropriation theory, individuals may be prosecuted for securities fraud regardless of whether they owe any legal duty to the corporation or its shareholders in whose stock they trade. The misappropriation being scrutinized focuses on the individual's breach of duty to the owner or source of the information. Moreover, the owner or source does not have to be a purchaser or seller of securities or have any interest in the securities transaction. According to the Supreme Court, the deception element of 10(b) is met when the "fiduciary-turned-trader" secretly converts the source's confidential information for personal profit.34
The misappropriation theory is not aimed at all thefts, conversions, or misappropriations.35 It targets a fiduciary's use of stolen or misappropriated information only in connection with a subsequent securities transaction. Accordingly, 10(b) fraud under the misappropriation theory is not considered complete until the fiduciary actually uses the misappropriated information in a subsequent securities transaction.36
Misappropriation Theory Implications
The explicit language of 10(b) only prohibits conduct involving deception "in connection with the purchase or sale of [a] security."37 The classical theory of insider trading logically reads the "in connection with" requirement to reach fraud which is perpetrated on the corporation whose stock is being traded, or its shareholders.In effect, the misappropriation theory circumvents the "in connection with" requirement. It focuses on the breach of duty to the source of the information without regard to whether the source is a purchaser or seller of securities. In doing so, the theory extends liability to any and all breaches of confidence or trust, thus going well beyond the primary purpose of 10(b), to protect market participants. Despite the Supreme Court's caution to the contrary, O'Hagan seems to make 10(b) an "all-purpose breach of fiduciary duty ban."38
In O'Hagan the Supreme Court accepted without limitation the government's contention that the "in connection with" requirement is met when the "fiduciary- turned-trader" secretly uses the confidential information in a securities transaction.39 Read literally, O'Hagan enables the government to prosecute any person who receives confidential information and subsequently trades on that information, regardless of whether the source of that information had any connection to, or even a remote interest in the securities transaction.
One hopes that future cases will define and limit both what constitutes a fiduciary or confidential relationship in the context of the misappropriation theory, and what sources of information are legal or illegal to trade upon. O'Hagan, at least, was a lawyer working for a law firm actively involved in securities activity. Yet even before O'Hagan, the government signalled its intent to prosecute outsiders who obtained non-public information through relationships completely unrelated to the securities markets. For example, in United States v. Willis, the government used the misappropriation theory to charge a psychiatrist with insider trading when he traded Bank America shares based on confidential information that he learned from a patient, the wife of the president of American Express, during a counseling session.40 The government has taken Willis even further by applying the misappropriation theory to familial relationships, such as husband and wife,41 and parent and child.42 Unchecked, the government may try to apply its misappropriation theory to any breach of confidence or trust.
Turning almost any breach of any confidential or fiduciary relationship into securities fraud, regardless of whether there is any connection to the securities market, could lead to inconsistent and unfair prosecutions. A twist on the facts of the Willis case illustrates this point. If the same woman in Willis gave the identical information that she gave to her psychiatrist instead to her manicurist, and the manicurist then traded on the information, under the misappropriation theory, no liability would attach. Likewise, had the psychiatrist received the same information from his barber instead of his patient, again no liability would attach. In both instances, neither trader would be liable because they received the same information without breaching a duty of trust or confidence.43
Even more quixotic would be the reverse situation in Willis -- suppose it was the patient who received confidential information from his psychiatrist. Like many confidential relationships, the privilege belongs to the patient, not the psychiatrist, or in the attorney-client context, to the client, not to the lawyer. In theory then, the patient (or the client) may use the information to trade because there has been no breach of confidence -- the patient has "waived" the privilege. Basing the securities violation on the breach of a fiduciary relationship may create such anomalous results.
Despite its expansive scope, O'Hagan did place some parameters on the government's ability to criminally prosecute individuals under the misappropriation theory.44 First, the government must prove that the defendant "willfully" violated 10(b) and Rule 10b-5 thereunder.45 Second, the government must prove that the defendant had knowledge of the rule. These two scienter requirements may be used in the defense of a 10(b) misappropriation prosecution. If a defendant establishes that he had no knowledge of the rule, or that he did not willfully violate it, he may not be held criminally liable for violating 10(b). This may afford a defense to the manicurist or psychiatrist, but it is unlikely to protect from prosecution lawyers, accountants, and other professionals who might be presumed to know insider trading law.
Of course, as under the classical theory, proof that the information traded upon was not confidential or material also provides a defense to insider trading under the misappropriation theory.46 For example, one could argue that the information was not the kind of information that would be considered important by a reasonable investor.47 In addition, one could argue, as O'Hagan did,48 that the information traded upon had already reached the relevant trading market.49
Since liability under 10(b) hinges on the element of deception, "full disclosure" to the source of the confidential information by the fiduciary of his intent to trade defeats liability also.50 Thus, if the defendant tells the source that he intends to trade on the confidential information there is no "deceptive device" as required for liability under 10(b).51 That analysis changes, however, if the source itself owed a duty to the corporation or its shareholders, the so called "tippee" situation.52 Thus, full disclosure to an outsider source defeats 10(b) liability, while full disclosure to an insider source does not, though each scenario might be said to have the same adverse impact on the securities markets.
It is now clear that the misappropriation theory supports criminal and civil liability for insider trading under 10(b). Left unanswered is the question of what relationships, when breached, will give rise to liability under the securities laws. Lawyers will be particularly vulnerable to prosecution under the misappropriation theory because of their frequent exposure to confidential information arising out of inherently fiduciary relationships and their presumed knowledge of the rules governing securities transactions.
Clear Understanding
The Supreme Court's decision in O'Hagan was hardly unanimous -- three Justices took exception to stretching the language of 10(b) to accommodate the misappropriation theory. Consequently, though the era of misappropriation prosecutions seems to be upon us, significant wiggle room for interpretation and discussion remains.One hopes that courts will limit application of the misappropriation theory to relationships which implicate the securities markets or, at least, confine it as closely as possible to the factual circumstances unique to the case. Anything less could lead to broad and inconsistent results.
O'Hagan requires criminal defense counsel to adjust their views of an area of law that was once described generically as "insider trading." Insider trading is no longer confined to the conduct of insiders: it encompasses "outsider trading" as well. Consequently, a clear understanding of the origins of this theory and how it reached its present incarnation is essential for any defense counsel who would like to chase the concept of "insider trading" back inside. N
Notes
1. United States v. O'Hagan, 117 S. Ct. 2199 (1997).2. The Court's ruling will likely have a more significant impact on the SEC than the Department of Justice, as the DOJ relies on the wire and mail fraud statutes to prosecute insider trading, regardless of the status of the trader.
3. O'Hagan, 117 S. Ct. at 2204-2205.
4. The classical theory also reaches tippees or individuals who are improperly given material non-public information by an insider of the corporation. See infra. Misappropriation Theory Development (discussing the elements of the classical theory of insider trading).
5. Interestingly, O'Hagan used his $4.3 million profit to replace money he had allegedly embezzled from client trust funds. The embezzlement was unrelated to the securities violations, though a possible explanation for the prosecution's aggressive attitude in this case. For the embezzlement, O'Hagan was convicted of theft in a Minnesota state court prosecution and sentenced to 30 months' imprisonment. State v. O'Hagan, 474 N.W.2d 613 (Minn. App. 1991).
6. Rule 10b-5 of the Securities and Exchange Act of 1934, codified at 17 C.F.R. 240-10b-5, states:
It shall be unlawful for any person, directly, or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange, (1) to employ any device, scheme, or artifice to defraud, (2) 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 (3) to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of a security.
7. United States v. O'Hagan, 92 F.3d 612, 622 (8th Cir. 1996).
8. Id. at 617.
9. Id.
10. O'Hagan, 117 S. Ct. at 2204.
11. Id. at 2208.
12. Id. at 2208-2212.
13. Id. at 2213. The Supreme Court also upheld the validity of Rule 14e-3 of the Securities Act of 1934, which prohibits trading on non-public information in connection with a tender offer, unless there is full disclosure. Rule 14e-3 is a "disclose or abstain from trading" rule that does not require breach of a fiduciary duty. However, the breadth of the Supreme Court's ruling is unclear as it appears to limit 14e-3's validity to "prevent the type of misappropriation charged against O'Hagan." Id. at 2219.
14. United States v. Chiarella, 445 U.S. 222 (1980); In the Matter of Cady, Roberts & Co., 40 S.E.C. 907 (1961).
15. Chiarella, 445 U.S. at 228-29.
16. Id. at 445 U.S. at 228-229.
17. Dirks v. Sec, 463 U.S. 646, 659 (1983). Tippees owe a derivative fiduciary duty to the shareholders of the corporation. A "tippee assumes a fiduciary duty to the shareholders of the corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders of the corporation by disclosing the information to the tippee and the tippee knows or should have known that there has been a breach." Id. at 659.
18. Id. at 654 ("Under some circumstances, such as where corporate information is revealed legitimately to an underwriter, accountant, lawyer, or other consultant working for the corporation, these outsiders may become fiduciaries of the shareholders"). See, e.g. SEC v. Thomas Blair, No. 94 Civ 27 (W.D.N.C.) (February 3, 1994) (SEC charged an accountant hired by corporation to review its books with insider trading when he asked his fiancee to purchase the corporation's stock based on confidential information he learned during his review of its books); SEC v. Brenner, No. 97 CIV 0607 (N.D. G.A.) (March 19, 1997) (SEC charged the general counsel of a corporation with securities fraud when she disclosed confidential information about an FBI investigation into the corporation to her mother, who then promptly sold her stock).
19. Chiarella, 445 U.S. at 222.
20. Id. at 224.
21. Id. at 235-36.
22. Id. at 222.
23. Id. at 240 (Burger, J. dissenting). See also, Id. at 238 (Stevens, J. concurring); Id. at 239 (Brennan, J. concurring); and Id. at 251 (Blackmun, J. dissenting).
24. Id. at 240 (Burger, J. dissenting).
25. SEC v. Drexel Burnham Lambert Inc., No. 88 Civ. 7209 (S.D.N.Y. June 20, 1989).
26. SEC. v. Ivan Boesky, No. 86 Civ. 8767 (S.D.N.Y. Nov. 14, 1986).
27. SEC v. Martin Siegel, No. 87 Civ. 0963 (S.D.N.Y. Feb 13, 1987). See also SEC v. Levine, No. 86 Civ. 3726 (S.D.N.Y. May 12, 1986).
28. United States v. Newman, 664 F.2d 12 (2nd Cir. 1981), cert. denied, 464 U.S. 683 (1983) (two employees of an investment banking company charged with securities fraud for "misappropriating" and trading upon their employer's confidential financial information); SEC v. Materia, 745 F.2d 197 (2nd Cir. 1984), cert. denied, 471 U.S. 1053 (1985) (employee of a financial printer violated 10(b) and Rule 10b-5 by misappropriating and trading upon confidential tender offer information regarding the printer's clients); United States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986), aff'd by an equally divided court, 108 S. Ct. 316 (1987) (financial newspaper columnist convicted of insider trading under the misappropriation theory when he entered into a trading scheme with two brokers whereby he agreed to provide them with advance information of the contents of his column in exchange for profits derived from trading on that information).
29. SEC v. Cherif, 933 F.2d 403 (7th Cir. 1991)(Seventh Circuit affirmed SEC sanctions against a former bank employee for trading on confidential financial information he misappropriated from the bank regarding its corporate clients' future deals, even though the defendant was no longer employed at the bank when he obtained the confidential information).
30. SEC v. Clark, 915 F.2d 439 (9th Cir. 1990) (defendant convicted of insider trading for misappropriating and trading upon his employer's confidential information regarding the proposed acquisition of another company).
31. United States v. Bryan, 58 F.3d 933, 949-50 (4th Cir. 1995) (rejecting the misappropriation theory as inconsistent with the language of 10(b)).
32. O'Hagan, 117 S. Ct. at 2199.
33. Id. at 2207.
34. Id. at 2207-08. For example, according to the government, O'Hagan deceived his law firm by pretending to be loyal while secretly trading for personal profit on information that the firm had entrusted to him. Id.
35. Id. at 2209.
36. Id. at 2208-2209.
37.Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 114 S. Ct. 1439, 1445 (1994); Santa Fe Industries Inc. v. Green, 430 U.S. 462 (1977).
38. O'Hagan, 117 S. Ct. at 2208.
39. Id. at 2208-10. The "in connection with" requirement is satisfied because "the fiduciary's fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities." Id.
40. United States v. Willis, 737 F.Supp. 269 (S.D.N.Y. 1990)(in sustaining the conviction, the district court held that the psychiatrist used his position of trust to fraudulently induce his patient to provide secret information to him and then used that information to profit on the stock market).
41. United States v. Chestman, 947 F.2d 551 (2nd Cir. 1991) (en banc) (The government used the misappropriation theory to charge a stock broker with aiding and abetting a husband's "misappropriation" of confidential tender offer information he received from his wife. Although the Second Circuit reversed the broker's convictions, it did not foreclose the possibility that liability could arise out of breach of trust between a husband and wife. Instead, it ruled that the government had failed to present sufficient evidence of a fiduciary relationship).
42. United States v. Reed, 601 F.Supp 685 (S.D.N.Y.), rev'd on other grounds, 773 F.2d 477 (2nd. Cir. 1985) (court held that a son breached the duty of confidence to his father when he traded on confidential information he received from his father).
43. Although it is unlikely, given the lack of precise definition as to what constitutes a confidential relationship under the misappropriation theory, a breach of trust even in these relationships could be considered securities fraud.
44. There is some question as to whether the Court's holding that the trader must willfully misappropriate the information in order to be criminally liable under 10(b) can also be read to apply to civil insider trading prosecutions, thus increasing the SEC's scienter burden from recklessness to willfulness.
45. O'Hagan, 117 S. Ct. at 2213.
46. Id. at 2207.
47. In Basic v. Levinson, 108 S. Ct. 978 (1988), the Supreme Court established that the test for determining whether the information is "material" is whether there is a substantial likelihood that a reasonable investor would consider the information significant.
48. O'Hagan attacked his convictions on the ground, inter alia, that there was insufficient evidence to prove that he obtained confidential information from his law firm or its client. The government relied on a conversation between O'Hagan and a partner at his law firm who worked on Grand Met's bid for Pillsbury to prove that O'Hagan misappropriated information about the upcoming tender offer. O'Hagan responded that he received the information about the tender offer from newspaper reports which speculated about a Grand Met bid for Pillsbury. The Supreme Court specifically left this argument open for consideration on remand to the Eighth Circuit. O'Hagan, 117 S. Ct. at 2205 (n. 2).
49. Whether the information traded upon is considered public depends on whether it has been disseminated in a manner such that it has reached the relevant trading market and enough time has elapsed to allow the market to absorb the information. SEC. v. Texas Gulf Sulphor Co., 401 F.2d 833, 853-54 (2nd Cir. 1968).
50. O'Hagan, at 2208.
51. Id. However, if the trader owes a duty to more than one person and only discloses his intentto trade to one of those persons, he may still be liable under the misappropriation theory. Id. (n. 7).
52. Dirks, 463 U.S. at 659 (discussing tippee liability).