Securities law - First Circuit limits scope of "safe harbor" disclosure loophole under misappropriation theory of insider trading.

• Author: Manning, Matthew R.

Securities Law--First Circuit Limits Scope of "Safe Harbor" Disclosure Loophole Under Misappropriation Theory of Insider Trading--SEC v. Rocklage, 470 F.3d 1 (1st Cir. 2006)

In Oliver Stone's film Wall Street, Gordon Gekko's philosophy that "greed is good" exposed the widespread corporate culture of excess and ruthlessness that defined the 1980s. (1) Decades before this era, Congress and the Securities and Exchange Commission (SEC) enacted [section] 10(b) of the 1934 Securities and Exchange Act ('34 Act) (2) and Rule 10b-5 (3) to limit the impact of greed in corporate America. (4) Despite Congress, the SEC, and the Supreme Court's regulatory frameworks, what constitutes insider trading, especially misappropriation-based insider trading, remains unclear. (5) Despite this ambiguity, the scope of insider trading prohibition has narrowed with time. (6) In SEC v. Rocklage, (7) the United States Court of Appeals for the First Circuit clarified what constitutes misappropriation-based insider trading by considering whether a pre-tip disclosure eliminated liability where an alleged misappropriator deceptively acquired information. (8) The court affirmed the district court's denial of the defendant's motion to dismiss for failure to state a claim and remanded the SEC's [section] 10(b) claim, explaining that a pre-tip disclosure does not always render the acquisition of information non-deceptive and eliminate liability, thus limiting the scope of the "safe harbor" loophole for misappropriation-based insider trading. (9)

On December 31, 2001, Mr. Rocklage, the Chairman and Chief Executive Officer (CEO) of Cubist Pharmaceuticals (Cubist) relayed private and material information to his wife. (10) He told her that one of Cubist's key drugs failed a clinical trial and that the company's stock price would drop upon public announcement of such news. (11) Mr. and Mrs. Rocklage had a mutual agreement to keep this information confidential, but Mrs. Rocklage also had a preexisting agreement to relay any negative news about Cubist to her brother, William M. Beaver (Beaver). (12) Shortly thereafter, Mrs. Rocklage told her husband that she intended to tip Beaver to sell his shares of Cubist stock. (13) Despite Mr. Rocklage's insistence that information regarding the clinical trial remain confidential, Mrs. Rocklage gave her brother a "wink and a nod," their prearranged indicator, signaling negative news about Cubist. (14) On January 2, 2002, Beaver sold all of his Cubist stock and also prompted his neighbor, David G. Jones (Jones), to do the same. (15)

Three years later, the SEC filed a civil complaint against Mrs. Rocklage, Beaver, and Jones in the United States District Court for the District of Massachusetts alleging [section] 10(b) and Rule 10b-5 violations under a misappropriation-based theory of insider trading. (16) The three defendants filed a Rule 12(b)(6) motion to dismiss for failure to state a claim, arguing that, pursuant to the Supreme Court's disclosure loophole in United States v. O'Hagan, (17) Mrs. Rocklage's pre-tip disclosure to her husband negated all liability under a misappropriation-based insider trading theory. (18) The district court held that although the defendants were not liable based on a classical theory of insider trading, because Mrs. Rocklage was not an insider of Cubist, they were, however, liable under a misappropriation theory, despite O'Hagan's disclosure loophole. (19) The defendants then moved for the district court to reconsider, arguing the district court misread O'Hagan; but the district court denied the motion despite its concession that it misapplied O'Hagan. (20) In the alternative, the defendants requested that the district court certify the issue for an interlocutory appeal, which the district court did after denying the defendant's motion for reconsideration. (21) The United States Court of Appeals for the First Circuit accepted the appeal and held that Mrs. Rocklage deceptively acquired nonpublic information from her husband and that her pre-tip disclosure to her husband did not preclude liability under a misappropriate-based insider trading theory. (22)

Congress enacted the '34 Act in response to the collapse of the stock market in 1929, the Great Depression, and the public's general distrust of greed-induced Wall Street businessmen. (23) Despite the absence of an explicit statutory reference, the origins of insider trading prohibition can be traced to [section] 10(b) of the '34 Act. (24) Eight years after the passage of the '34 Act, Congress enacted Rule 10b-5, the basis for modern federal insider trading prohibition. (25) Despite enacting [section] 10(b) of the '34 Act and Rule 10b-5, the plain text of these laws created more questions than answers in terms of what constitutes insider trading. (26) This ambiguity resulted in a long progeny of cases interpreting [section] 10(b) and Rule 10b-5's impact on insider trading. (27)

The rapid broadening and subsequent narrowing of the scope of insider trading prohibition has distinguished federal insider trading law since its enactment. (28) The scope of Rule 10b-5 expanded in 1961 when an SEC enforcement action stated that Rule 10b-5 applied to insider trading cases, thereby establishing the predicate for the "disclose or abstain" rule. (29) Insider trading prohibition continued to broaden in 1968 when the Second Circuit endorsed the SEC's "disclose or abstain rule." (30) The Supreme Court, however, limited Rule 10b-5's broad scope from 1975 until 1983. (31) Arguably the most influential case resulting from this progeny was Chiarella v. United States, (32) where the Supreme Court established the classical theory of insider trading by requiring a fiduciary duty in order for the "disclose or abstain" rule to yield insider trading liability. (33)

Nonetheless, the dissenting opinion in Chiarella illustrated that a minority of the Court's justices intended to reverse course and instead broaden the scope of federal insider trading prohibition. (34) Nearly two decades later, a majority of the Court adopted this minority view by endorsing a new theory of insider trading in United States v. O'Hagan, referred to as misappropriation-based insider trading. (35) Misappropriation-based insider trading applies when a person trades on material, nonpublic information in breach of a fiduciary duty owed to the source of the information, as opposed to the corporate shareholders. (36) Although the misappropriation theory broadened the scope of insider trading prohibition, it also provided a "safe harbor" loophole through which brazen misappropriators could escape liability by disclosing their deceptive trading plans to the source of the information prior to initiating the fraudulent trade. (37) The safe harbor loophole troubled legal scholars, including the lone dissenter in O'Hagan, Justice Thomas, who noted the lack of justification for the exception. (38) This loophole resulted in a debate as to when misappropriators can escape insider trading liability by making a pre-tip or pre-trade disclosure. (39)

In Rocklage, the First Circuit limited the scope of the "safe harbor loophole" by extending insider trading liability to Mrs. Rocklage despite her pre-tip disclosure. (40) The court acknowledged that Mrs. Rocklage communicated material, nonpublic information in breach of a fiduciary duty she owed her husband. (41) The First Circuit then turned to the "heart" of the [section] 10(b) cause of action and considered whether Mrs. Rocklage engaged in a "manipulative or deceptive device ... in connection with the purchase and sale of any security." (42) With regard to the "manipulative or deceptive device" element, the court explained that Mrs. Rocklage participated in two deceptive acts, acquiring confidential information from her husband and tipping Beaver to sell his Cubist stock. (43) Second, the court found that both devices were "in connection with" the sale of a security. (44) Accordingly, all of the defendants were liable under [section] 10(b) and Rule 10b-5, notwithstanding their argument that the "safe harbor" loophole, namely the pre-tip disclosure, precluded...