The misappropriation theory: a valid application of section 10(B) to protect property rights in information.

• Author: Simon, Keith Adam
• Position: Securities Exchange Act - Supreme Court Review - Case Note

United States v. O'Hagan, 117 S. Ct. 2199 (1997)

1. INTRODUCTION

   In United States v. Hagan,(1) the United States Supreme Court held that the misappropriation theory is a valid basis upon which to impose [sections] 10(b) and Rule 10b-5 liability for securities fraud.(2) The Court found that the misappropriation theory satisfies the statutory requirement of [sections] 10(b) that a deceptive device be used "in connection with" a securities transaction.(3) The Court reasoned that the misappropriation theory, by proscribing trading based on misappropriated confidential information, promotes market integrity and investor confidence.(4) This, in turn, advances the underlying purposes of [sections] 10(b) and Rule 10b-5.(5)

   In addition, the Supreme Court held that Rule 14e-3(a), which prohibits trading while in possession of material nonpublic information regarding a tender offer, is a valid exercise of the Securities and Exchange Commission's (SEC) rulemaking authority under [sections] 14(e).(6) The majority did not rule on the authority of the SEC to define fraud.: Rather, the Court found Rule 14e-3(a), "as applied to cases of this genre,(7) to be a means reasonably designed to prevent fraud in tender offers under [sections] 14(e).(8)

   This Note agrees with the Court's assessment that the misappropriation theory is a valid basis upon which to impose [sections] 10(b) and Rule 10b-5 liability.(9) First, this Note asserts that the misappropriation theory is consistent with Supreme Court precedent(10) interpreting the statutory language of [sections] 10(b).(11) Second, this Note argues that the misappropriation theory protects property rights in information and promotes investor confidence in the securities market, thereby increasing market efficiency and integrity.(12) Finally, this Note advances a solution to the "in connection with" dissent(13) of Justice Thomas.(14) This Note argues that the correct approach is to consider the gathering of information itself as part of the gatheror's securities transaction.(15)

2. BACKGROUND

   1. INTRODUCTION

      It is axiomatic that the operations of and the information used by the securities market is an area in "special need of regulation for the protection of investors."(16) Without such regulation, investors may worry that they are being deprived of the fair market value of their investments if others illegally use confidential information.(17) As a result, those same investors might choose alternatives to the stock market, thereby making it more difficult for corporate issuers to raise capital.(18) This, in turn, would adversely affect this nation's economic growth and stability.(19) As part of the inquiry regarding this potentially disastrous situation, courts have dealt with the following issue: When must a person who knows material nonpublic information(20) disclose such information before trading on it?(21) The answer to that g question has changed significantly over the years.(22) Consequently, to gain an adequate understanding of the issue, this Note examines three distinct time periods: (1) the years prior to the passage of [sections] 10(b)(23) and Rule 1013;(24) of the Securities Exchange Act of 1934;(25) (2) the years after the passage of [sections] 10(b) and Rule 10b-5 but before Chiarella v. United States(26) and Dirks v. SEC;(27) and (3) the years since the Chiarella and Dirks decisions.

   2. BEFORE [sections] 10(B) AND RULE 10B-5: THE COMMON LAW ERA

      Under the common law, a failure to disclose material information is fraudulent only when there is a duty to speak.(28) This duty to speak is created "when one party has information that the other [party] is entitled to know because of a fiduciary or other similar relation of trust and confidence between them."(29)

      In most jurisdictions, an insider(30) of a corporation has no duty to disclose material information before trading.(31) For example, in Goodwin v. Agassiz(32) the court ruled that the defendants,(33) both insiders of Cliff Mining Company (Cliff), did not defraud Goodwin, a shareholder of Cliff, when they bought his shares on the Boston Stock Exchange without disclosing their possession of material inside information.(34) The court held that insiders of a corporation have a fiduciary duty only to the corporation itself, not to individual shareholders.(35) Since there is no trust relationship between the insiders and the individual shareholders, insiders are neither under a duty to speak nor are they guilty of fraud if they trade securities based on material nonpublic information.(36) From a policy perspective, the court found it significant that the securities were traded on an impersonal stock exchange.(37) According to the majority, the plaintiff's theory of liability puts:

      [a]n honest director ... in a difficult situation... [since] he could

      neither buy nor sell on the stock exchange shares of stock in his

      corporation without first seeking out the other actual ultimate party to

      the transaction and disclosing to him everything which a court or jury

      might later find that he then knew affecting the real or speculative value

      of such shares .... Fiduciary obligations of directors ought not to be made

      so onerous that men of experience and ability will be deterred from

      accepting such office.(38)

      While the majority of jurisdictions did not impose a duty of disclosure on insiders, an exception developed known as the "special facts" doctrine.(39) In Strong, the Supreme Court acknowledged the majority rule, but stated that a trust relationship and the concomitant duty to speak exist when the insider knows special facts.(40) The purpose of the special facts doctrine was to eliminate inherently unfair transactions where a corporate insider intentionally withheld superior knowledge of essential facts to the shareholder's detriment.(41)

      Since there was no explicit method to distinguish ex-ante between those cases that satisfied the special facts exception and those that did not, the exception either swallowed the majority rule or made the rule impossible to administer consistently.(42) Regardless, the common law actions in fraud did not sufficiently protect shareholders from insiders who traded on impersonal stock markets based on material nonpublic information.(43) Due to the increased importance of these impersonal markets, Congress endeavored to better protect investors through the passage of the Securities and Exchange Act of 1934.(44)

   3. [sections] 10(B) AND RULE 10B-5

      Reacting to the 1929 stock market crash and the impotency of the common law to protect investors, Congress enacted the Securities Act of 1933(45) and the Securities Exchange Act of 1934.(46) These federal securities laws were passed "[t]o provide fair and honest mechanisms for the pricing of securities, to assure that dealing in securities is fair and without undue preferences or advantages among investors, ... and to provide, to the maximum degree practicable, markets that are open and orderly."(47) In particular, Congress wanted to eliminate insiders' grievous abuses of fiduciary duties committed solely for personal profits in the securities markets.(48) Thus, a prohibition on insider trading(49) developed under [sections] 10(b) and Rule 10b-5 of the Securities and Exchange Act of 1934.(50)

      Section 10(b) prohibits any "deceptive device" used "in connection with" a securities transaction "in contravention of [any] rules ... the Commission may proscribe as necessary or appropriate in the public interest or for the protection of investors."(51) In 1942, the SEC promulgated Rule 10b-5(52) under its [sections] 10(b) rulemaking authority.(53) Rule 10b-5 prohibits any person from making "affirmative misrepresentations, half-truths or omissions... in connection with" a securities transaction.(54) Liability under Rule 101y5 extends only to conduct encompassed by [sections] 10(b)'s prohibitions.(55) The majority of violations of [sections] 10(b) and Rule 10b-5 occur from material omissions(56) rather than misrepresentations.(57) By their terms, [sections] 10(b) and Rule 10b-5 focus not on unfair insider trading per se, but on deception and fraud.(58) Since the failure to disclose a material fact becomes fraudulent only when there is a duty to speak,(59) courts have grappled with the issue of when such a duty arises.(60)

      In a 1961 administrative proceeding, the Securities and Exchange Commission attempted to define when a duty to disclose inside information arises before trading on that information.(61) In Cady, Roberts, a director of a corporation informed his broker that the corporation decided to decrease its cash dividend by 40%.(62) Upon receiving this inside information, but before it had been publicized, the broker sold thousands of shares for his personal account.(63) The SEC found the broker's conduct a violation of [sections] 10(b) and Rule 101y5.(64) According to the SEC, a duty to speak is based on two principal elements:

      first, the existence of a relationship giving access . to information

      intended to be available only for a corporate purpose, and not for the

      personal benefit of anyone, and second the inherent unfairness involved

      where a party takes advantage of such information knowing it is unavailable

      to those with whom he is dealing.(65)

      Accordingly, the Cady, Roberts rule meant that individuals who have a special relationship with a company and are privy to its internal affairs either must disclose such information before trading or, if disclosure is impossible, abstain from trading.(66)

      In 1968, the United States Court of Appeals for the Second Circuit extended the standard established in the Cady, Roberts rule to individuals who are not necessarily insiders of the corporation.(67) In Texas Gulf Sulphur, a corporation made significant mineral discoveries.(68) Based on this information, corporate directors and officers bought stock in their corporation without disclosing their knowledge to the selling shareholders.(69) The insiders' conduct...