By Ignacio E. Salceda and Brett Rodda

By the end of September 1988, James O'Hagan owned more Pillsbury options than any other individual investor. O'Hagan was not a professional investor, however, he was a lawyer.

In July 1988, Grand Metropolitan PLC hired O'Hagan's Minneapolis law firm, Dorsey & Whitney, to represent it in a contemplated tender offer for Pillsbury. Although O'Hagan never personally worked on the deal, he started buying up Pillsbury stock and call options soon after Dorsey & Whitney began representing Grand Met. When Grand Met announced its tender offer for Pillsbury in early October, the value of O'Hagan's stock and options holdings skyrocketed. All told, O'Hagan pocketed more than $4 million in profits.

When O'Hagan's trading was discovered, he was indicted on 57 counts of mail fraud, securities fraud and money laundering. He was convicted on all counts and sentenced to 41 months in prison. On appeal to the Eighth Circuit, O'Hagan argued that he could not be liable for insider trading because, quite simply, he was not a Pillsbury insider and owed no fiduciary duty to the company or its shareholders. The Eighth Circuit agreed with O'Hagan and reversed his convictions, rejecting the SEC's theory that O'Hagan was nonetheless liable for "misappropriating" the information entrusted to his law firm. The Eighth Circuit's decision dealt a blow to one of the SEC's most powerful enforcement weapons and exacerbated a split among the Circuits, with two (the Eighth and Fourth Circuits) invalidating the "misappropriation theory" of insider trading and three (the Second, Seventh and Ninth Circuits) embracing the doctrine.

On June 25, 1997, by a six to three vote, the Supreme Court resolved the circuit split by upholding the misappropriation theory and reinstating O'Hagan's insider trading convictions. In doing so, the Court endorsed an expansive definition of "insider" which goes beyond traditional corporate insiders. Justice Ginsburg's opinion stressed that while O'Hagan had no duty to Pillsbury or its shareholders, he did have a duty to the source of his information. "It was O'Hagan's failure to disclose his personal trading to Grand Met and Dorsey, in breach of his duty to do so, that made his conduct 'deceptive' under § 10(b) [of the Securities Exchange Act of 1934]." United States v. O'Hagan, 97 C.D.O.S. 4931 (decided June 25, 1997).

Justice Ginsburg went on to say that the Eighth Circuit simply misread prior Supreme Court holdings in ruling that only a breach of a duty to a party in a securities transaction is enough to impose liability. Over a strong dissent by Justice Thomas, the Court held that liability is imposed not when the "fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities. The securities transaction and the breach of duty thus coincide." O'Hagan. The misappropriator "deceives the source of the information and simultaneously harms members of the investing public." Id. In short, it seems the duty can be owed to virtually anyone with confidential information, so long as the "tip" is then used "in connection with" a securities transaction.

The O'Hagan Court also held that the SEC did not exceed its rule making authority when it adopted Rule 14e-3(a) under the Securities Exchange Act of 1934. Rule 14e-3(a) prohibits trading in possession of material nonpublic information concerning a tender offer. The most notable aspect of the Rule is that unlike SEC Rule 10b-5, Rule 14e-3(a) does not require that the trading take place in breach of a fiduciary duty in order to impose liability. The Rule also gives the Commission prophylactic powers to prohibit otherwise legal actions that might lead to a violation of securities laws. The Eighth Circuit held that this rule exceeded the SEC's authority because the Commission's power to prevent fraudulent acts did not include the power to define fraud. According to the Eighth Circuit, that was a job for Congress. In reversing that decision, the Supreme Court adopted a very broad reading which allows the SEC to "prohibit acts, not themselves fraudulent under the common law or Sect. 10(b), if the prohibition is reasonably designed to prevent acts and practices [that] are fraudulent." O'Hagan.

The Supreme Court's decision in O'Hagan was certainly welcome news at the SEC. According to the Commission's enforcement chief, William McLucas, the Commission has relied on the misappropriation theory in about 40 percent of its recent insider trading cases. By upholding the misappropriation theory, however, the O'Hagan decision created almost as many questions as it answered.

First, the Court appears to have shifted from a fairly restrictive view of the insider trading laws to a relatively expansive one. The Court's reading of Rule 14e-3 is especially troublesome since it gives the Commission prophylactic powers to prohibit actions that are merely potentially fraudulent.

Second, the Court's decision appears to have been based not on the text of the applicable rules or on the Court's own precedent, but on a nebulous concern for maintaining public confidence in the securities markets. With this decision, the Court appears to be retreating from its earlier rejection of a parity of information theory of insider trading. Apart from the difficulty inherent in basing a decision on such a vague concept, it is difficult to see how a trader's duty to simply disclose that he has inside information to the source of the information furthers the Court's proffered goal of preserving public confidence in a fair securities marketplace.

Finally, the Court failed to provide a definition of "misappropriation," meaning the line between lawful independent research and unlawful deception will still have to be litigated.

I. A New View

A. The Misappropriation Theory

The misappropriation doctrine has been the more controversial of the two insider trading theories. Under the other, "classical" theory of insider trading, a person is liable under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 if he or she trades in a company's securities while in possession of material nonpublic information if: (1) he or she is an insider of the corporation and therefore owes a fiduciary duty to the corporation's shareholders, or (2) the person is a tippee in receipt of the nonpublic information from an insider, and the tippee knows, or has reason to know, that the insider breached a fiduciary duty to the corporation by disclosing the information to the tippee.

By contrast, liability under the misappropriation theory now appears to be premised on the trader's deception toward the source of the confidential information.

The misappropriation theory has its origin in Chief Justice Burger's dissenting opinion in Chiarella v. United States, 445 U.S. 222 (1980). In Chiarella, an employee of a financial printing company used the nonpublic information contained in documents sent to his print shop in order to buy stock in takeover targets. The Court's majority, applying the classical theory of insider trading, overturned the employee's Rule 10b-5 conviction because the employee had no direct fiduciary relationship with any of the target companies in which he traded.

Chief Justice Burger's dissent argued that the print shop employee should be liable because he misappropriated information entrusted to him in confidence by his employer. Under this theory, this misappropriation of information was sufficient to provide the basis for liability for insider trading. In rather sweeping language, Chief Justice Burger wrote that just as with insiders of a corporation, "a person who has misappropriated nonpublic information has an absolute duty to disclose that information or to refrain from trading." 445 U.S. at 240 (Burger, C.J., dissenting).

Despite the Chief Justice's dissent, the Supreme Court before O'Hagan seemed to heading toward a narrower interpretation of insider trading laws. That is why the O'Hagan decision may have come as a surprise to those who have followed the Supreme Court's recent opinions on insider trading.

In Chiarella, Justice Powell, writing for the majority, stated that "[n]ot every instance of financial unfairness constitutes fraudulent activity under 10(b)." 445 U.S. at 232. The Court held that as Chiarella had not received any information from the companies in which he bought stock and had no prior relationship with any seller of the target companies' securities, he therefore had no duty to tell the persons from whom he bought stock about the pending acquisition. Justice Powell found that Chiarella's conviction could not be upheld because doing so would impose a duty to disclose among all market participants who had some information that other traders might not have.

The Court again rejected this parity of information view of the securities markets in Dirks v. SEC, 463 U.S. 646 (1983). In that case, the Court reversed a court of appeals decision that imposed liability on investment analyst Raymond Dirks, who was told by an employee of an insurance company that the insurer was being fraudulently managed. The employee hoped Dirks could help expose the fraud, which he did, but only after telling his clients to sell their holdings in the insurer.

The Court held that Dirks could not be liable for insider trading because the information he received was not the result of a fiduciary breach and therefore, he had no duty to disclose it to the market. The decision in Dirks expanded the reach of Section 10(b) to include lawyers, accountants and other temporary insiders who become fiduciaries of the company while working on material deals, that is they become "temporary insiders," but the line was clearly drawn at that duty. Moreover, there was no expectation by the employee that Dirks would keep their information private. In fact, the employee wanted the fraud exposed. One important policy issue surrounding Dirks was the policy goal of encouraging market participants to work to ferret out information about companies. Obviously, it is better for the securities markets if an analyst makes efforts to investigate companies and then communicates that information to his investors.

Neither Chiarella nor Dirks specifically addressed the misappropriation doctrine. The SEC interpreted the Court's silence as a green light to pursue the theory, and it began using it aggressively in prosecuting insider trading cases. The Court tried to address the issue in Carpenter v. United States, 484 U.S. 19 (1987), one of the most celebrated insider trading prosecutions of the 1980s. The case involved Foster Winans, a reporter for The Wall Street Journal. Winans was one of the authors of the Journal's "Heard on the Street" column, a widely read commentary on the stock market. Winans told several acquaintances what companies would be profiled in upcoming columns and whether the coverage would be positive or negative.

After these activities were discovered, the government charged that Winans' breach of his duty to his employer, the newspaper, was sufficient to satisfy the duty requirement of Rule 10b-5. After the convictions of several members of the insider trading ring, the Second Circuit held that Winans' breach of the Journal's policy against using confidential information created a corollary duty to abstain from trading based on that information and affirmed the convictions. The Supreme Court granted certiorari in the case to determine the validity of the misappropriation theory, but was unable to come to a decision on those counts as it was split four to four. The Court did, however, affirm the convictions for mail and wire fraud.

The Second Circuit's decision in Carpenter represented a broad view of insider trading liability and ultimately presaged the O'Hagan decision by the Supreme Court. Nevertheless, many observers thought that the Court would overturn the misappropriation theory as the doctrine appeared to have become guided by ad hoc judgments of what constitutes fair play in the securities markets. After all, was it the job of the SEC to regulate the relationship between employees and employers and to penalize the breach of a duty to the employer with a charge of insider trading?

Nonetheless, the O'Hagan decision once again appears to have been guided more by an innate sense of what is "fair"--whether some participants in the securities markets are getting an "unfair" advantage because of the information they obtain--than a consideration of what is the proper scope of the federal securities laws. Unfortunately, it will often be difficult for courts, as well as market participants, to agree on what sources and types of information are "unfair."

Some of these concerns were voiced by Justice Thomas in his dissent. Justice Thomas (joined by Chief Justice Renquist) agreed with the premise that misappropriating information is "deceptive," but he argued that Rule 10b-5's requirement that a deception be "in connection with a securities transaction" was not met. "Where the relevant element of fraud has no impact on the integrity of the subsequent transaction as distinct from the nonfraudulent element of using nonpublic information, one can reasonably question whether the fraud was used in connection with a securities transaction." O'Hagan (Thomas, J., dissenting). Justice Thomas would not have impose liability where the source of information has no connection with the other participants in the securities transaction.

B. SEC Rule 14e-3

The O'Hagan Court's reading of Rule 14e-3 is even more expansive. It is safe to say that the SEC was more than a little worried about the fate of 14e-3, as it has traditionally been viewed as a broad interpretation of the Commission's powers. The rule, prohibiting insider trading in anticipation of a tender offer, was used in about half of the recent misappropriation cases brought by the SEC.

Under Rule 14e-3, anyone with material nonpublic information regarding a tender offer has a duty to disclose the information to the market or abstain from trading. This disclosure to the marketplace is fundamentally different from the duty in O'Hagan in which the trader must simply disclose to the source of his information that he plans to trade. Therefore, unlike Rule 10b-5, liability under the tender offer rule may not require the breach of any duty.

Just what it does require seems to be a unsettled question. Rule 14e-3(a) theoretically reaches all trading conducted while in possession of material nonpublic information if the trader knows or has reason to know that the information came from "the inside." Would this cover rumors as well? If there was a case in which there was no breach of duty, would that actually be considered a violation? O'Hagan seemed to leave that question open by including a footnote on "warehousing," a practice by which someone planning a tender offer "authorizes" others to load up on the company's stock before the announcement. Justice Ginsberg wrote that "warehousing" is a question "for another day." O'Hagan n.17.

II. Trust in the Market

Although the misappropriation doctrine theoretically protects sources of confidential information, Justice Ginsberg made it clear that she was also trying to protect the market as a whole. "Investors likely would hesitate to venture their capital in a market where trading based on misappropriated nonpublic information is unchecked by law." O'Hagan. Since anyone with a position of access has the potential to exploit his connections, he could impose on the marketplace a "disadvantage that cannot be overcome with research or skill." O'Hagan.

Unfortunately, the remedy proposed by the Supreme Court does not cure the ill. A mere "duty to disclose" to the source does not automatically protect the market. To get around liability, all a trader with inside information has to do is disclose the fact that he will trade. The counsel for the government testified at oral argument: "To satisfy the common law rule that a trustee may not use the property that [has] been entrusted [to] him, there would have to be consent. To satisfy the requirement of the Securities Act that there be no deception, there would only have to be disclosure." O'Hagan. Because the trader does not owe a duty to the market or to the people he trades with, he would not have to make any disclosure to them. The disclosure required is to the source of the information. In that case, all O'Hagan had to do to avoid liability was tell somebody (who it is isn't clear) at both Grand Met and Dorsey, his two sources, that he was trading. He was not required to obtain their blessing; he just had to inform them that he had material nonpublic information which he intended to use for his own personal gain. This type of "disclosure" barely protects the source, and does even less to protect the market.

Admittedly, given his position as an attorney in a law firm, O'Hagan would have been hard pressed to make such a disclosure without serious consequences to his career. Yet there are many instances where there would not be a similar deterrent.

An example from Justice Thomas' dissent is illustrative: "Indeed, were the source expressly to authorize its agents to trade on the confidential information--as a perk or bonus, perhaps--there would likewise be no §10(b) violation." O'Hagan. Whether the misuse is disclosed to the source, approved by the source or kept secret from the source, the impact on the market is the same. The misappropriator "would still be trading based on nonpublic information that the average investor has no hope of obtaining through his own diligence." O'Hagan.

This result is produced by the Court's interpretation of the "deception" requirement. "If the fiduciary discloses to the source that he plans to trade on the nonpublic information, there is no deceptive device and thus no 10(b) violation." O'Hagan.

Justice Ginsburg responded to Justice Thomas' dissent by raising the possibility that a principal who allows a tippee to trade on inside information about a tender offer may be in violation of Rule 14e-3. The next question, then, is whether a principal who does not consent, but also does not actively try to stop the trades, could be liable under this theory. That is yet another question left open by the decision.

III. Defining Misappropriated Information

In the movie Wall Street, Gordon Gecko tells his young protege Bud Fox to "tail" corporate raider Larry Wildman in order to find out where he goes and with whom he meets. When Bud sees Wildman board a plane for a meeting with executives at the mythical Anacott Steel in Erie, Pennsylvania, Gecko begins buying up Anacott stock. Is that misappropriation under the O'Hagan decision? What if Gecko sent out Bud after hearing a rumor from someone inside the company?

These kinds of questions are bound to arise in the post-O'Hagan world. The hypotheticals will make excellent law school examination questions, but it is not clear what they mean about the nature of insider trading enforcement. Uncertainty is likely to be the norm with many situations. The uncertainty is especially troubling because of the seriousness of the offense. Insider trading is a crime, punishable by prison and large fines, as well as a civil violation.

Suppose a waiter at a posh Manhattan restaurant overhears two executives discussing an unannounced reorganization plan at their company. May the waiter trade on the information? Arguably, trading by individuals who accidentally overhear material nonpublic news is not misappropriation because there is no duty to keep it secret.

The misappropriation theory is thought to rest on the assumption that some confidential information has been entrusted to the trader who then misuses it for personal profit. Only people with fiduciary duties to the source are obliged to honor the source's confidences. So, in what ways can this duty be acquired? It seems possible that a person could become a fiduciary without even realizing it. The boundaries of the duty not to use information are not clear. In the short run, the O'Hagan decision means that the SEC retains one of its most important weapons in the fight against insider trading. As of yet, though, the weapon's full capacity has not been tested. What's more, because O'Hagan offers little guidance, the uncertainty surrounding the misappropriation doctrine will continue. Some lower courts may limit the holding to factual situations substantially similar to those in O'Hagan. One thing is clear: it just became much more risky for "outsiders" to engage in trading when they are in trading when they are in possession of what they believe is nonpublic information.

** Ignacio Salceda is a litigation associate at Wilson, Sonsini, Goodrich & Rosati. Brett Rodda is a Stanford University Law School student who clerked at the firm during the summer of 1997.

This article is NOT legal advice.