O'hagan Revisited: Should a Fiduciary Duty Be Required Under the Misappropriation Theory?

• Citation: Vol. 22 No. 4
• Publication year: 2010

Georgia State University Law Review

Volume 22 , „

Article 9

Issue 4 Summer 2006

6-1-2006

O'Hagan Revisited: Should a Fiduciary Duty Be Required Under the Misappropriation Theory?

Rebecca S. Smith

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Recommended Citation

Smith, Rebecca S. (2005) "O'Hagan Revisited: Should a Fiduciary Duty Be Required Under the Misappropriation Theory?," Georgia State University Law Review: Vol. 22: Iss. 4, Article 9. Available at: http://digitalarchive.gsu.edu/gsulr/vol22/iss4/9

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O 'HAGAN REVISITED: SHOULD A FIDUCIARY DUTY BE

REQUIRED UNDER THE MISAPPROPRIATION THEORY?

Introduction

Although insider trading has been in the forefront of the news for the past decade, the Securities Exchange Act of 1934 fails to expressly prohibit insider trading, with the exception of section 16(b), which is not an antifraud measure.¹ But since the 1961 administrative proceeding by the Securities and Exchange Commission (SEC), courts have continuously interpreted the Securities Exchange Act to allow enforcement against insider trading based on its provisions. Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5 have become the most important weapons against insider trading.³ Rule 10b-5 states:

It shall be unlawful for any person, directly or indirectly, by use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) [t]o employ any device, scheme, or artifice to defraud, (b) [t]o 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 (c) [t]o engage in any act, practice, or course of business which operates or would operate as a fraud or deceit

1. See 15 U.S.C. § 78p(b) (2005); Randall W. Quinn, The Misappropriation Theory of Insider Trading in the Supreme Court: A (Brief) Response to the (Many) Critics o/United States v. O'Hagan, 8 fordham j. Corp. & Fin. l. 865,868 (2003).

2. Michael A. Snyder, United States v. O'Hagan, The Supreme Court and the Misappropriation Theory of Securities Fraud and Insider Trading: Clarification or Confusion?, 27 Cap. U. L. Rev. 419, 421 (1999).

3. Roberta S. Karmel, The Relationship Between Mandatory Disclosure and Prohibitions Against Insider Trading: Why a Property Rights Theory of Inside Information is Untenable, 59 brook. L. REV. 149,152-53 (1994).

1005

upon any person, in connection with the purchase or sale of any security.⁴

Two theories of liability for insider trading have emerged from this rule: the classical theory and the misappropriation theory.⁵ The classical theory imposes liability when a traditional corporate insider trades based on nonpublic information gathered in the course of the insider's duties.⁶ The misappropriation theory extends liability to those individuals who trade based on nonpublic, material information but are not corporate insiders and owe no duty to the shareholders of the corporation.⁷ The misappropriation theory focuses on individuals who trade based on confidential information in breach of a fiduciary relationship with the source of the information. Therefore, an analysis of fiduciary duty is key to determining a violation of Rule 10b-5 under the misappropriation theory.⁹

The validity of the misappropriation theory was the subject of debate among the circuits until 1997.¹⁰ In that year, the Supreme Court resolved the circuit split in United States v. O'Hagan, holding the misappropriation theory was a valid basis for enforcement under Rule lOb-5.¹¹ However, the decision in United States v. O'Hagan failed to resolve the controversy surrounding the misappropriation theory.¹² Part I of this Note discusses the history of the

4. 17 C.F.R. § 240.10b-5 (2005).

5. See Snyder, supra note 2, at 421-22; Bach Hang, Note, The SEC's Criminal Rulemaking in Rule 10b5-2: Incarceration Should be Made of Sterner Stuff, 41 washburn L.J. 629,635-36 (2002).

6. Hang, supra note 5, at 635-36.

7. See United States v. O'Hagan, 521 U.S. 642,652 (1997).

8. Id.

9. See generally Hang, supra note 5, at 636 (stating to find fraud under misappropriation theory, there must be a breach of a fiduciary duty).

10. See, e.g., United States v. O'Hagan, 92 F.3d 612,618 (8th Cir. 1996), rev'd, 521 U.S. 642 (1997) (rejecting the misappropriation theory); United States v. Bryan, 58 F.3d 933, 944 (4th Cir. 1995) (rejecting the misappropriation theory); SEC v. Cherif, 933 F.2d 403, 410 (7th Cir. 1991) (approving a variation of the misappropriation theory); United States v. Chestman, 947 F.2d 551, 566 (2d Cir. 1991) (approving a variation of the misappropriation theory); SEC v. Clark, 915 F.2d 439,449 (9th Cir. 1990) (approving a variation of the misappropriation theory); Rothberg v. Rosenbloom, 771 F.2d 818, 822-23 (3d Cir. 1985) (approving a variation of the misappropriation theory).

11. See O 'Hagan, 521 U.S. at 652-54.

12. See Richard W. Painter, Kimberly D. Krawiec, & Cynthia A. Williams, Don't Ask, Just Tell: Insider Trading After United States v. O'Hagan, 84 Va. L. Rev. 153, 191 (1998) (criticizing the lack of clarity of the scope of the fiduciary duty, beyond the classic insider trading relationship, needed to

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misappropriation theory prior to the O'Hagan decision.¹³ Part II analyzes United States v. O 'Hagan and the questions the decision left unanswered.¹⁴ Part III examines the evolution of the interpretation of the fiduciary duty requirement.¹⁵ Part IV analyzes Rule 10b5-2 and its effect on the enforcement of insider trading using the misappropriation theory.¹⁶ Finally, Part V discusses the parity of information theory as an alternative to the fiduciary duty requirement.¹⁷

I. Misappropriation Theory Before O 'Hagan

A. Chiarella v. United States⁷*

The Supreme Court first discussed the misappropriation theory in dicta in Chiarella v. United States}⁹ This case involved an employee of a printing company who obtained material, nonpublic information regarding a pending tender offer while performing his job. Chiarella used this information to purchase stock in the target company. The majority in Chiarella stated:

We cannot affirm petitioner's conviction without recognizing a general duty between all participants in market transactions to forgo actions based on material, nonpublic information. Formulation of such a broad duty, which departs radically from the established doctrine that duty arises from a specific

impose liability under the misappropriation theory); Quinn, supra note 1, at 889 (discussing the failure of the Supreme Court in O'Hagan to explain what types of relationships establish a duty under the misappropriation theory).

13. See discussion infra Part I.

14. See discussion infra Part II.

15. See discussion infra Part III.

16. See discussion infra Part IV.

17. See discussion infra Part V.

18. 445 U.S. 222 (1980).

19. Id. at 235-36.

20. Id. at 224.

21. Id.

relationship between two parties, should not be undertaken absent some explicit evidence of congressional intent.²²

In his dissent, Chief Justice Burger interpreted section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 "to mean that a person who has misappropriated nonpublic information has an absolute duty to disclose that information or to refrain from trading."²³ This dissent stressed the word choice used in the provisions, imposing liability on "any person engaged in any fraudulent scheme."²⁴ Chief Justice Burger stated the law should not require a fiduciary duty to the source of the information to impose liability because there will be an automatic breach of the duty owed to all investors in the market. He endorsed a fraud-on-the-investor approach to the misappropriation theory.²⁶ This approach, also known as fraud-on-the-market, allows a court to find Rule 10b-5 liability if the trading affected the integrity of the market.²⁷ The plaintiff does not show individual reliance on a particular misrepresentation but only shows reliance on the integrity of the security's market price. The materiality of the information is the key factor in determining whether there was an infraction under the fraud-on-the-market theory.²⁹

After Burger's strong dissent in Chiarella, the SEC began to use the misappropriation theory in its pursuit of insider trading claims but decided to use a fraud-on-the-source approach rather than the fraud-on-the-investor approach endorsed by Chief Justice Burger.³⁰ The fraud-on-the-source approach to insider trading provides "a person who has misappropriated nonpublic information has an absolute duty

22. Id. at 233 (footnote omitted).

23. Id. at 240 (Burger, C.j., dissenting).

24. Chiarella, 445 U.S. at 240.

25. See id. at 240-42.; see also Nelson S. Ebaugh, Insider Trading Liability for Tippers and Tippees: A Call for the Consistent Application of the Personal Benefit Test, 39 TEX. j. BUS. l. 265,274 (2003).

26. Ebaugh, supra note 25, at 274.

27. See William K.S. Wang & Marc I. Steinberg, Insider Trading 216 (1996).

28. Id.

29. See id.

30. Ebaugh, supra note 25, at 274-75.

2006] o 'ha gan REVISITED 1009

to disclose that information or to refrain from trading."³¹ This approach focuses on the relationship between the tipper and tippee.³² The SEC's basis for the decision to adopt a fraud-on-the-source approach rather than a fraud-on-the-market approach is unclear.³³

B. United States v. Newman⁵*

The fraud-on-the-investor application of the misappropriation theory was successful in United States v. Newman, which, like Chiarella, involved employees.³⁵ In Newman, investment...