Securities Regulation - David M. Calhoun and L. Briley Brisendine, Jr.

• Publication year: 1999

Securities Regulationby David M. Calhoun*and

L. Briley Brisendine, Jr.**

This Article surveys significant cases decided by the United States Supreme Court and the United States Court of Appeals for the Eleventh Circuit during 1997 and 1998 in the area of securities regulation.

I. Application of the Misappropriation Theory to Liability Under Section 10(b) and Rule 10b-5; Confirmation of Commission's Rulemaking Authority Under Section 14(e)

In United States v. O'Hagan,¹ the United States Supreme Court considered whether criminal liability under section 10(b) of the Securities Exchange Act of 1934, as amended ("the Exchange Act"),² and rule 10b-5³ thereunder may be predicated on the "misappropriation theory."⁴ The Supreme Court also considered whether the Securities and Exchange Commission (the "Commission'') exceeded its rulemaking authority by adopting rule 14e-3(a),⁵ which prohibits trading on material, nonpublic information in the context of a tender offer. In O'Hagan James Herman O'Hagan ("O'Hagan") was a partner in a law firm that acted as local counsel to represent Grand Metropolitan PLC ("Grand Met") in connection with a potential tender offer for the common stock of the Pillsbury Company ("Pillsbury").⁶ O'Hagan did not perform any work relating to the Grand Met representation.⁷ During and following his firm's representation, however, O'Hagan purchased call options for Pillsbury common stock, with each option giving him the right to purchase shares of Pillsbury common stock at a specified price by a specified date.⁸ O'Hagan also purchased shares of Pillsbury common stock at a price of slightly less than $39 per share.⁹ Upon Grand Met's public announcement of its tender offer, the price of Pillsbury common stock rose to almost $60 per share, and O'Hagan sold his Pillsbury options and stock, making a profit in excess of $4.3 million.¹⁰

A Commission investigation resulted in a fifty-seven-count indictment.¹¹ The indictment charged O'Hagan with twenty counts of mail fraud;¹² seventeen counts of securities fraud in violation of section 10(b) of the Exchange Act and rule 10b-5 promulgated thereunder; seventeen counts of "fraudulent trading in connection with a tender offer" in violation of section 14(e) of the Exchange Act and rule 14e-3(a) promulgated thereunder; and three counts of violating federal money laundering statutes.¹³

A district court jury convicted O'Hagan on all counts.¹⁴ The Eighth Circuit Court of Appeals reversed O'Hagan's securities fraud convictions under section 10(b) and rule 10b-5, holding that "Sec. 10(b) liability cannot be based on the misappropriation theory" because, "contrary to Sec. 10(b)'s explicit requirements, the misappropriation theory does not require 'deception,' and, even assuming that it does, it renders nugatory the requirements that the 'deception' be 'in connection with the purchase or sale of any security.'"¹⁵ The Eighth Circuit also reversed O'Hagan's securities fraud convictions under section 14(e) of the Exchange Act and rule 14e-3(a) promulgated thereunder, holding that the Commission "exceeded its rulemaking authority under Sec. 14(e) when it promulgated Rule 14e-3(a) without including a requirement of a breach of a fiduciary obligation."¹⁶ Finally, the Eighth Circuit reversed O'Hagan's convictions for money laundering and mail fraud because the indictment on each was structured to premise these charges on the acts allegedly constituting the securities fraud.¹⁷

The Supreme Court first addressed the reversal of O'Hagan's convictions under section 10(b) and rule 10b-5.¹⁸ Section 10(b) of the Exchange Act provides, in pertinent part:

[i]t shall be unlawful for any person, directly or indirectly,. . . [t]o use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.¹⁹

Rule 10b-5 provides, in part, that "[i]t shall be unlawful. . . [t]o employ any device, scheme, or artifice to defraud, [or] [t]o engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security."²⁰

Examining the language of section 10(b), the Supreme Court determined that the statute "proscribes (1) using any deceptive device (2) in connection with the purchase or sale of securities, in contravention of rules prescribed by the Commission."²¹ The Supreme Court also determined that section 10(b) "does not confine its coverage to deception of a purchaser or seller of securities, . . . rather the statute reaches any deceptive device used 'in connection with the purchase or sale of any security.'"²² Furthermore, the Supreme Court stated that liability under Rule 10b-5 does not extend beyond the section 10(b) prohibitions.²³ In comparing the "classical theory" of insider trading liability with the misappropriation theory, the Supreme Court noted that

[t]he classical theory targets a corporate insider's breach of duty to shareholders with whom the insider interacts; the misappropriation theory outlaws trading on the basis of nonpublic information by a

corporate "outsider" in breach of a duty owed not to a trading party, but to the source of the information.²⁴

The misappropriation theory protects "against abuses by outsiders" to a corporation with material, nonpublic information "who owe no fiduciary or other duty to that corporation's shareholders."²⁵

Next, the Supreme Court analyzed whether misappropriation satisfies the section 10(b) requirement of the use of a "deceptive device or contrivance" in order to establish liability.²⁶ In doing so, the Supreme Court referenced two of its earlier decisions, Carpenter v. United States²⁷ and Santa Fe Industries, Inc. v. Green.²⁸ In Carpenter the Supreme Court considered the federal mail fraud statute's proscription of "any scheme or artifice to defraud"²⁹ and held that the undisclosed misappropriation of a company's confidential information in violation of a fiduciary duty constitutes fraud.³⁰ In Green the Supreme Court considered allegations of section 10(b) violations and found no deception when those charged with the violations had disclosed all pertinent facts to those to whom they owed a duty.³¹ The Court stated that "[b]ecause the deception essential to the misappropriation theory involves feigning fidelity to the source of information, if the fiduciary discloses to the source that he plans to trade on the nonpublic information, there is no 'deceptive device' and thus no Sec. 10(b) violation."³² Ultimately, the Supreme Court found that O'Hagan's misappropriation met the section 10(b) requirement "that there be 'deceptive' conduct."³³

The Supreme Court then considered the section 10(b) requirement that the deceptive use of information be '"in connection with the purchase or sale of [a] security.'"³⁴ The Court determined that "[t]his element is satisfied because the fiduciary's fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities."³⁵ The Supreme Court emphasized that section 10(b) liability under the misappropriation theory does not arise from all forms of fraud involving confidential information, but only "fraudulent means of capitalizing on such information through securities transactions."³⁶ The Supreme Court concluded that O'Hagan's misappropriation was "'in connection with' securities transactions."³⁷ As a result of its analysis of the misappropriation theory, the Supreme Court held that the Eighth Circuit Court of Appeals erred in holding that the misappropriation theory is inconsistent with section 10(b).³⁸

The Supreme Court next considered whether the Commission exceeded its rulemaking authority under section 14(e) of the Exchange Act by adopting rule 14e-3(a) without requiring the establishment of a breach of fiduciary duty in connection with the trading at issue.³⁹ Section 14(e) of the Exchange Act provides, in relevant part, that it shall be unlawful for any person to engage in any "fraudulent, deceptive or manipulative acts or practices," in connection with any tender offer.⁴⁰ The section further states that the Commission shall, "by rules and regulations define, and prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive, or manipulative."⁴¹

Rule 14e-3(a) provides:

[I]f any person has taken a substantial step or steps to commence, or has commenced, a tender offer (the 'offering person'), it shall constitute a fraudulent, deceptive or manipulative act or practice within the meaning of Section 14(e) of the [Exchange] Act for any other person who is in possession of material information relating to such 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: (1) The offering person, (2) The issuer of the securities sought or to be sought by such tender offer, or (3) Any officer, director, partner or employee or any other person acting on behalf of the offering person or such issuer, to purchase or sell or cause to be purchased or sold any of such securities or any securities convertible into or exchangeable for any such securities or any option or right to obtain or to dispose of any of the foregoing securities, unless within a reasonable time prior to any purchase or sale such informa-

tion and its source are publicly disclosed by press release or otherwise.⁴²

Rule 14e-3(a) is a "disclose or abstain" requirement.⁴³ The thrust of rule 14e-3(a), as articulated by the Court of Appeals for the Second Circuit, is that "'[i]t creates a duty in...