Not surprisingly, the Supreme Court's June 25, 1997, decision in United States v. O'Hagan,(1) concerning the controversial legal topics of insider trading and securities regulation,(2) elicited a wide variety of reactions.(3) Somewhat unexpected, however, was the legal community's focus on the Court's ruling in regard to SEC Rule 10b-5 and the judicially-created "misappropriation theory" of insider trading liability.(4) Although the predecision circuit split(5) concerning the misappropriation theory's validity as a foundation for SEC Rule 10b-5 securities fraud liability certainly justified the significant attention paid to it within both the Court's analysis and the resulting legal commentary, an unfortunate repercussion of the attention seems to be that an equally important aspect of the O'Hagan decision has received inadequate treatment.(6)
Specifically, legal scholars have neglected the Court's ruling with respect to SEC Rule 14e-3 and its prohibition against fraudulent trading in connection with a tender offer.(7) Although the O'Hagan Court's brief analysis of Rule 14e-3(8) settled several legal questions surrounding the rule's scope and validity(9) significant questions nonetheless remain unanswered, if not unaddressed. This Note focuses on the most significant unresolved question surrounding Rule 14e-3 in the wake of the O'Hagan decision: What is the rule's legitimate scope? This Note's analysis of the legitimate scope of Rule 14e-3 arises not out of anything the Court settled in O'Hagan, but rather from something specifically left unresolved by the Court--the applicability of Rule 14e-3 to the practice of "warehousing."(10)
Before analyzing the practice of warehousing, this Note reviews Rule 14e-3 and the legal context of the O'Hagan controversy. The first section also discusses the legislative history of Rule 14e-3, as well as the legal treatment of the rule. Specifically, this exercise involves an effort to discern the legitimate scope of Rule 14e-3, in light of the Court's classification of Rule 14e-3 as a prophylactic rule. In addition, the first section discusses the Court's limiting language in O'Hagan, particularly in relation to the misappropriation theory and its potential application to Rule 14e-3. To facilitate a more lucid understanding of the implications of the O'Hagan decision, this discussion also provides a brief overview of the factual setting of the case. The first section concludes with an examination of the O'Hagan Court's formulation of the term "misappropriation" as presented in its analysis of Rule 10b-5.
The second section of this Note moves to a detailed examination of the practice of warehousing, including an explanation of the value of testing the boundaries of Rule 14e-3 with the specific practice of warehousing. The second section delineates the relationship of warehousing to insider trading generally, and the trading activity in O'Hagan specifically, through the use of a warehousing model that this Note constructs and employs in several scenarios. This model serves to highlight the significant distinctions between the activity described by the Court in O'Hagan and the practice of warehousing. With these distinctions revealed, this Note conducts a more detailed comparison between misappropriation and warehousing, focusing upon the nature and the extent of both deception and nondisclosure within the two tender offer trading activities.
The third section directly addresses the issue of the legitimate scope of Rule 14e-3. By reexamining section 14(e) of the Securities Exchange Act of 1934, with a focus upon its authorization mandate, and the twin concerns of fairness and market integrity, this Note shows that the policy rationale undergirding section 14(e) does not carry over to the nature and extent of deception and nondisclosure exhibited within the practice of warehousing, and thus the legitimate prophylactic scope of Rule 14e-3 should not be expanded to warehousing.
Finally, the fourth section of this Note assesses the proper role of both the judiciary and Congress within the debate over insider trading regulation. This Note concludes that an expansion of the current framework of insider trading prohibition is an act best reserved for the legislature, where the significant public policy arguments may be debated and analyzed in a manner more consistent with the separation of powers doctrine.
SEC RULE 14e-3
Background and History
The SEC implemented Rule 14e-3 under the authority of section 14(e) of the Securities Exchange Act of 1934 ("Exchange Act"),(11) as a response to the perceived growth of problems of securities fraud within the specific realm of the tender offer.(12) Prior to the Supreme Court's decision in O'Hagan, the Eighth Circuit discredited Rule 14e-3, arguing that the SEC had exceeded its permissible rulemaking authority as framed by section 14(e) of the Exchange Act.(13) The Eighth Circuit focused its analysis on the scope of authority intended by Congress in its grant of power to the SEC--within section 14(e)--to "define, and prescribe means reasonably designed to prevent" fraudulent acts in connection with a tender offer.(14) In particular, the court questioned the legitimacy of Rule 14e-3 in light of the absence of any requirement that a prohibited "fraudulent" act involve an actual breach of fiduciary duty.(15) On the basis of this very argument, the Eighth Circuit reversed the criminal convictions against James O'Hagan.(16) The Supreme Court, however, did not agree with the Eighth Circuit,(17) and ruled that the SEC had not exceeded its rulemaking authority in adopting Rule 14e-3 or in applying the rule to the type of activity that was presented in O'Hagan,(18) thus seemingly placing to rest the legal battle over the legitimacy of Rule 14e-3.(19)
The remainder of this Note argues otherwise, showing that the limits to Rule 14e-3's legitimate scope are still very much in question. By employing the practice of warehousing as a foundation for the construction of a basic model to illustrate the possibility that trading on the basis of nonpublic information in the context of a tender offer, and in the absence of a breach of fiduciary duty, in fact legitimately may fall outside of the permissible scope of post-O'Hagan Rule 14e-3, this Note attempts to clarify the boundaries of Rule 14e-3.
Scope of Rule 14e-3 Post O'Hagan
In the opening paragraph of the O'Hagan decision, Justice Ginsburg, writing the opinion of the Court,(20) framed one of the two "prime questions" posed by the O'Hagan appeal: "Did the [SEC] exceed its rulemaking authority by adopting Rule 14e-3(a), which proscribes trading on undisclosed information in the tender offer setting, even in the absence of a duty to disclose?"(21) In the process of addressing this question, the Court first signaled a potential willingness to limit the breadth of its Rule 14e-3 holding in O'Hagan: "Our answer to ... [this] question, ... viewed in the context of this case, [is] no.(22)
To understand the potential significance of this limitation, it is first essential to understand the context in which the O'Hagan Court held that Rule 14e-3 properly applied.(23) James O'Hagan was a lawyer with a firm retained as counsel by a large corporation in anticipation of a potential takeover by means of a tender offer.(24) Although not involved personally in this representation, O'Hagan learned Of the client's plans to initiate a takeover bid for another corporation, and proceeded to use this knowledge to acquire both common stock and call options of the potential target corporation.(25) Within this specific context, the Court focused its analysis and final determination on the fact that the corporation from which O'Hagan had indirectly acquired information regarding the potential tender offer had no knowledge of,(26) and had not consented to,(27) O'Hagan's trading.(28) O'Hagan's failure to notify the corporate source of his trading plans was especially significant in this context. Although O'Hagan's lack of any personal association with the target corporation put into question the formation of a fiduciary duty traditionally required as an element of fraud within the realm of insider trading,(29) the Court's classification of Rule 14e-3 as a "prophylactic measure"(30) had the effect of generating an area, outside that of traditional or common-law fraud, in which Rule 14e-3 nonetheless may operate permissibly.(31) As such, by applying Rule 14e-3 to the specific facts of the O'Hagan case, the Court stated that "insofar as it serves to prevent the type of misappropriation charged against O'Hagan, Rule 14e-3(a) is a proper exercise of the [SEC's] prophylactic power under [section] 14(e)."(32)
From this statement, it is clear that although the Court recognized that misappropriation of nonpublic information may fall outside the area of traditional fraudulent fiduciary breach, it also acknowledged that misappropriation nonetheless may fall within the prophylactic, and thus legitimate, scope of Rule 14e-3.(33) By focusing its analysis and decision regarding the prophylactic scope of Rule 14e-3 on the specific facts implicated in O'Hagan, the Court apparently limited, at least for the present time, its holding as to the validity of applying Rule 14e-3 to situations involving either traditional breach of fiduciary duty and fraud or a "misappropriation" of inside information regarding a tender offer.(34)
Rule 14e-3 and Misappropriation
The Court's use of the term "misappropriation" in describing the context in which Rule 14e-3 may be applied legitimately cannot, within the O'Hagan decision, be considered a vague or shifting term of art. In its discussion of James O'Hagan's Rule 10b-5 violations,(35) the Court analyzed, and ultimately approved, the "misappropriation theory" of insider trading liability.(36) In the process of doing so, the Court articulated specific elements that, when pieced together, provide a definition...