Rogue Missives Thursday, July 03, 1997

Last Wednesday, in a decision that surprised many defense attorneys, the U.S. Supreme Court voted 6-to-3 to reinstate the conviction of James H. O'Hagan. O'Hagan is an attorney who, in 1988, made $4.3 million trading on information that London-based Grand Metropolitan, his firm's client, was preparing to launch a tender offer for Pillsbury.

In reversing a lower court's decision, the Justices upheld important Securities and Exchange Commission (SEC) rulings designed to combat so-called "insider trading" and "fraud" in connection with tender offers. These provisions were hatched during the 1980s as a means of cracking down on perceived abuses associated with hostile takeovers. In her majority opinion, Justice Ruth Bader Ginsburg echoed regulators' oft-repeated rhetoric from that decade, characterizing the important misappropriation theory of insider trading as "well-tuned to an animating purpose of the Exchange Act: to insure honest securities markets and thereby promote investor confidence."

On the face of it, individual investors are likely to cheer this decision as another example of the SEC standing up for a fair marketplace. Yet it's not that simple. It's worth asking whether the SEC and the Court are actually doing us any favors here. Indeed, it's worth asking whether the provisions the Court affirmed even make sense.

Chief Justice William Rehnquist and Justice Clarence Thomas think not. In a legalistic but still quite damning dissent, Thomas deems the Commission's insider trading theory incoherent and charges the majority with engaging in the "'imaginative' exercise of constructing its own misappropriation theory" given that the SEC botched its argument for the one it was proposing. He also argues that the SEC's restrictions on activity surrounding a tender offer "exceed the Commission's authority" in part because "neither the majority nor the Commission identifies any relevant underlying fraud against which [this rule] reasonably provides prophylaxis."

Make no mistake, O'Hagan is a criminal. His trading was designed to pay back the $1 million he had already embezzled from an escrow account under his supervision. He has since been disbarred and sentenced to 30 months in jail. Still, it's not clear that his actions constitute or should constitute securities fraud.

O'Hagan was a partner at the law firm of Dorsey & Whitney in Minneapolis, Minnesota when, in July 1988, Grand Metropolitan retained the firm to represent it in a potential tender offer for Pillsbury. Though O'Hagan did not work on the team representing Grand Met, the prosecution argued he duped another lawyer who did into spilling the beans about the planned tender offer. On August 18, he began purchasing call options, and continued doing so until the end of September, when he owned 2,500 unexpired options. Around the same time, he purchased 5,000 shares of Pillsbury stock for about $39 a share. Meanwhile Dorsey & Whitney ended their representation of Grand Met on September 8. A month later, the tender offer was launched, sending Pillsbury shares to nearly $60 and allowing O'Hagan to cash out his investment for a handsome six-week profit.

The indictment charged that O'Hagan violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder because he had misappropriated material, nonpublic information from his firm and its client, breaching his fiduciary duty to the source of the information. O'Hagan was also charged with violating Section 14(e) of the Securities Act and Rule 14e-3, which makes it unlawful to engage in any fraudulent, deceptive, or manipulative acts or practices in connection with a tender offer. Specifically, Rule 14e-3 makes criminal "the purchase or sale of a security by one who is in possession of material information relating to [a] tender offer which information he knows or has reason to know is nonpublic and which he knows or has reason to know has been acquired directly or indirectly" from an acquirer or target, regardless of whether the trader has a fiduciary duty to either party.

The O'Hagan case is so important because the Court has never before ruled definitively on the validity of the misappropriation theory. The restrictions on trading surrounding a tender offer have been denounced by some as a case of the SEC exceeding its rulemaking authority by broadening the definition of securities fraud beyond the intentions of both Congress and the Supreme Court because it requires no breach of fiduciary duty.

The SEC's first attempt to regulate securities trading by corporate insiders in possession of material nonpublic information came in 1962, a right upheld by the courts in 1968. It wasn't until 1980 that Chiarella v. United States, the first criminal case of insider trading, clarified the terms of what has come to be known as the classical theory of insider trading. Vincent Chiarella was a printer who put together the coded packets used by companies preparing to launch a tender offer for other firms. Chiarella broke the code and bought shares of the target companies based on his knowledge of an imminent takeover bid. He was eventually caught, fired, and forced to hand over his profits. The Supreme Court, though, reversed his conviction on the grounds that the existing insider trading law only applied to people who had a fiduciary responsibility to the party on the other end of a transaction.

A corporation's permanent insiders (such as executives or directors), or temporary insiders (such as attorneys, accountants, or consultants), all might obtain confidential information about a company through their normal activities. To prevent such insiders from taking advantage of an unsuspecting shareholder, these fiduciaries are required either to disclose the material information before trading on it, or to abstain from trading. Since Chiarella had no such obligation of trust, his trading did not, in the court's view, constitute insider trading despite the fact that he clearly possessed advantageous nonpublic information. While Chiarella broke a duty to his employer, the Court said this was not grounds for prohibiting his trading because the prosecutors had not presented that argument to the jury.

A second case in 1983, Dirks v. SEC, highlighted the original limits the Court placed on the concept of insider trading. Raymond Dirks was a securities analyst who was informed by Ronald Secrist, a former employee of the insurance company Equity Funding Corp., that Equity was defrauding its policyholders and investors. Dirks checked on the story, persuaded himself of its accuracy, and then reported his findings to the press and the SEC. No one believed him. At that point, he simply told his institutional clients to sell their Equity shares. When Equity collapsed and it became clear that Dirks' clients had benefited from his advice, the SEC charged Dirks with insider trading since he had used Secrist's information. But the Court rejected the conviction, saying that Secrist had not been motivated by personal gain in telling Dirks this information and that Dirks had, in turn, acted properly.

The rules that were applied in the O'Hagan were New rules were drawn up by the SEC after the 1983 Dirks decision. In Ginsburg's majority opinion, the Court concludes that the Chiarellas of the world should be held accountable under the securities laws lest investors lose confidence in the marketplace. "Although informational disparity is inevitable in the securities markets, investors likely would hesitate to venture their capital in a market where trading based on misappropriated nonpublic information is unchecked by law." According to the Court, a "misappropriator who trades on the basis of material, nonpublic information, in short, gains his advantageous market position through deception: he deceives the source of the information and simultaneously harms members of the investing public."

The majority argues, in sum, that "it makes scant sense to hold a lawyer like O'Hagan a 10(b) violator if he works for a law firm representing the target of a tender offer, but not if he works for a law firm representing the bidder." Some districts have found that while someone working for a bidder in an acquisition can trade, someone working for the buyer cannot. At the very least, the O'Hagan case overturns this inconsistent provision. Unfortunately, the majority opinion went much farther.

In the Court's opinion, the misappropriation theory complements the classical theory of insider trading by premising liability "on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information." Where the classical theory protects against abuse by insiders, the misappropriation theory protects against abuse by "'outsiders' to a corporation who have access to confidential material information that will affect the corporation's security price when revealed, but who owe no fiduciary or other duty to that corporation's shareholders."

Justice Thomas's dissenting opinion persuasively attacks these conclusions from a number of angles that highlight how what the majority identifies as securities fraud has little if anything to do with the trading of securities. To flesh out its conception of the fraud behind the misappropriation of information, the majority turned to the original misappropriation case, the 1987 decision Carpenter v. United States. As a reporter for The Wall Street Journal, R. Foster Winans knew what companies would be covered in the upcoming "Heard on the Street" columns. He violated his confidentiality agreement with the Journal by tipping off co-conspirators (including David Carpenter) who then traded these stocks based on his information. Though the court at the time split 4-to-4 on the securities fraud charge, it did determine that a company's confidential information is property to which it deserves exclusive use. Winans's undisclosed misappropriation of this information constituted "fraud akin to embezzlement."

But is defrauding someone of the exclusive use of his or her information securities fraud? Thomas says no and that O'Hagan is actually guilty of two separate acts: the misappropriation of information and the use of that information to trade securities. O'Hagan could have taken his information about a possible tender offer and sold his story to a newsweekly, thereby depriving Grand Metropolitan of exclusive use but not dealing in securities at all. Though that would constitute misappropriation in the majority view, it clearly fails the test that requires that a "deceptive device" be used "in connection with" a securities transaction. Thomas transcribes the SEC's own oral argument, highlighting the incoherence of the misappropriation theory as a possible reading of Rule 10b-5. He then charges the majority with concocting a new theory "from whole cloth." O'Hagan, in his view, cannot have been expected to comply with this new theory "because, until today, the theory has never existed."

Thomas goes farther, clarifying the problem at the heart of the misappropriation theory. "The majority's approach is misleading in this case because it glosses over the fact that the supposed threat to fair and honest markets, investor confidence, and market integrity comes not from the supposed fraud in this case, but from the mere fact that the information used by O'Hagan was nonpublic." Rebutting the majority conviction that the deception of the information source and the harmful trading on nonpublic information are connected, Thomas argues that even if it's true that "trading on nonpublic information hurts the public, it is true whether or not there is any deception of the source of information."

This distinction becomes readily apparent in the majority's observation that "[d]eception through nondisclosure is central to the theory of liability" and that "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" (though the fiduciary may be liable for breach of duty under state law). But as Thomas writes, "No market transaction is made more or less dishonest by disclosure to a third party principal, rather than to the market as a whole...[T]hose on the other side of the trade remain in the dark."

Thomas also points out that the source of information could legally authorize its agents to trade on the non-public information. For example, Grand Met could have encouraged the partners of O'Hagan's firm to purchase Pillsbury prior to the tender offer, as a form of compensation, perhaps. Even with the type of disclosure that would avoid indictment under the misappropriation theory (but also get someone fired), the investing public would still face the same problem: trading against others in possession of nonpublic information. For similar reasons, Thomas dismisses the Rule 14(e)-3 restriction on trading based on knowledge of a tender offer; there's no unavoidable connection between the misappropriation of information and the use of it to trade securities. Since none of the actions Rule 14(e)-3 is designed to prevent are obviously cases of fraud, putting broad restrictions on trading that extend to non-fiduciaries cannot be justified.

Daniel Fischel, a financial consultant and widely-cited law professor at the University of Chicago, offers a similar critic of the SEC's insider trading regulations in his provocative re-reading of the 1980s, Payback: The Conspiracy to Destroy Michael Milken and His Financial Revolution (1995). He charges that the misappropriation theory "was tailor-made for regulatory overreaching." In his view, misappropriation is better left to civil and criminal laws, not securities laws. "The wrongdoing in Carpenter," he wrote, regarding the case involving the Journal reporter, "was a breach of an employment agreement that caused no direct economic injury to the employer and had little, if any, connection to the securities marketplace."

In a sense, part of what's missing from the SEC's two insider trading rules validated by the O'Hagan decision is an investor victim at the heart of the deception. When a corporate insider buys shares based on material nonpublic information that will soon drive a stock higher, it's clear that he's victimizing investors who sold them on the cheap because they didn't know what he knows. So he has a duty to either disclose that information or abstain from trading. But whom did O'Hagan victimize in this way?

One can even argue, as Fischel does, that leaks and rumors about a buy-out actually benefit the target company's shareholders. The heavy trading volume would have signaled Pillsbury shareholders that something might be up. Such run-ups prior to a formal tender offer also have the effect of giving investors an increasingly higher price for their shares whereas they otherwise might have received the lower pre-rumor price every day until the offer was announced.

Does the trading of an O'Hagan harm the acquiring company's shareholders by telling the market a takeover is afoot and thus make a Grand Met pay more for a Pillsbury? This is certainly plausible. Still, neither the SEC nor the Court has offered such an argument. As Fischel points out, much of the more public build-up to a tender offer (and the consequent opportunities for all these parties to run afoul of the SEC) is due to the requirement of the Williams Act of 1968 that investors who take a 5% stake in a firm report it to the SEC within 10 days. When a Bank of New York is forced because of the Williams Act to disclose it wants to increase its ownership of State Street Boston by a few percent, it is the actual disclosure forced by the Williams act that causes shares of State Street Boston to surge, not any misappropriate by those with or without fiduciary responsibility to the Bank of New York. Whatever troubles the government finds in these cases are the result of the laws already in place, not misappropriation.

For now, it's hard to know exactly how much harm the O'Hagan decision may cause. Despite the good intentions of the more liberal justices, it seems true that the information disparity among investors is not just unavoidable but mostly unrelated to matters of insider trading. The question is what kinds of disequilibriums in the flow of information are tolerable, and which must end? Cleaning up what the SEC calls securities fraud under the misappropriation theory or tender offer rule will ultimately do very little to address that persistent concern about investor confidence in the marketplace. What would really help is a concerted effort to make sure that U.S. companies are practicing fair and equitable corporate disclosure. It would be rewarding to see the SEC finally take that issue seriously.

Louis Corrigan ([email protected])

© Copyright 1995-2000, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool. The Motley Fool is a registered trademark and the "Fool" logo is a trademark of The Motley Fool, Inc. Contact Us