United States v. O'hagan: Defining the Limits of Fraud and Deceptive Pretext Under Rule 10b-5

• Jurisdiction: United States,Federal
• Citation: Vol. 22 No. 04
• Publication year: 1998

SEATTLE UNIVERSITY LAW REVIEWVolume 22, No. 1SUMMER 1998

NOTE

United States v. O'Hagan: Defining the Limits of Fraud and Deceptive Pretext Under Rule 10b-5

Theodore C. McCullough(fn*)

I. Introduction

Imagine you had information regarding the results of a horse race before the race was even run. More than a gambler's dream, the trading of stocks based upon inside information(fn1) is a phenomenon which is real and, by some accounts, pervasive.(fn2) For numerous reasons, insider trading is considered problematic.(fn3) In particular, Congress has acknowledged insider trading to be problematic in terms of the unfairness it creates in the securities markets.(fn4) In response to this unfairness, Congress promulgated a broad sanction regime.(fn5) Part of this sanction regime is the misappropriation theory of criminal liability arising under Securities and Exchange Commission (SEC) Rule 10b-5.(fn6) This Note argues that broadening the present embezzlement model of the Rule 10b-5 misappropriation theory will more fully reflect both the language and intent of § 10(b) (of the 1934 Securities Exchange Act) and Rule 10b-5, and more importantly accommodate the sophistication of today's insider trading schemes. Part II of this Note examines the uses of inside information both prior to and after the creation of the 1934 Securities Exchange Act, and how § 10(b) and Rule 10b-5 were created to proscribe these uses. Part III examines the language and intent behind § 10(b) and Rule 10b-5 and argues that their language and intent legitimates a broader sanction regime which is necessary to combat the present sophistication of insider trading. Part IV examines the criticisms of the present embezzlement model of the Rule 10b-5 misappropriation theory as expressed by Justices Scalia and Thomas,(fn7) and shows how a broader form of criminal liability is necessary despite these criticisms.

II. The History of the Rule 10b-5 Misappropriation Model

While § 10(b) and Rule 10b-5 arose as a part of the 1934 Securities Exchange Act and from the SEC's regulative power respectively, the misappropriation theory of Rule 10b-5 arose as a product of case law.(fn8)

The sanction regime of § 10(b) and Rule 10b-5 arose as a response to massive investor losses before and shortly after the stock market crash of 1929.(fn9) After the crash, stock exchanges, particularly the New York Stock Exchange, made attempts at self-regulation.(fn10) Specifically, the exchanges attempted to regulate fraud perpetrated on investors.(fn11) These attempts at self-regulation, however, failed,(fn12) prompting Congress to begin a series of widely supported(fn13) investigations into stock market practices.(fn14)

These congressional investigations revealed that inside information was a vehicle by which fraud was perpetrated on investors. For example, inside information allowed for the creation of stock pools.(fn15) Stock pools were considered fraudulent in that pools induced investors outside the pools to invest through the creation of fictitious activity.(fn16) The Senate received testimony regarding the creation of a pool to manipulate RCA stock.(fn17) The members of the pool were the president of RCA, his wife, the president of M.J. Meehan and Co. (a brokerage firm), his wife, and a number of others.(fn18) The members of the pool sought to manipulate the price of RCA stock though the creation of massive short-term volatility.(fn19) In one week the pool made $4,924,073.27.(fn20)

Congress created § 16(b) in response to pools and other forms of fraudulent activities.(fn21) Section 16(b) made it illegal for a beneficial owner (one who owns or is the beneficiary of at least ten percent of a corporation's stock), a director, or an officer of a corporation to buy or sell the securities of any issuing corporation with which they have one of the aforementioned relationships within a six-month period.(fn22) While § 16(b) covered individuals such as the president of RCA, it failed to cover individuals such as the wife of the president of RCA and other persons.(fn23) Criminal liability for these outsiders was created in the form of Rule 10b-5 via the SEC's § 10(b) enforcement power.(fn24) In short, Rule 10b-5 acted to fill the gaps in § 16(b).

In 1942 the SEC promulgated Rule 10b-5(fn25) as a fraud catchall.(fn26) The catch-all nature of Rule 10b-5 is reflected in the SEC's comments on the first application of Rule 10b-5: "These anti-fraud provisions are not intended as a specification of particular acts or practices which constitute fraud, but rather are designed to encompass the infinite variety of devices by which undue advantage may be taken of investors and others."(fn27) It is clear from the above passage that the SEC was concerned with advantage being taken of investors and others. It is the category of "others" and the creation of criminal liability for the purposes of protecting this category of persons which has created the most controversy regarding Rule 10b-5.(fn28)

There are two theories of Rule 10b-5 criminal liability.(fn29) The traditional theory sanctions individuals who trade on inside information obtained in the course of a fiduciary relationship with shareholders.(fn30) There are two ways in which an outsider can have a fiduciary relationship with shareholders.(fn31) First, a fiduciary relationship can arise where an insider discloses information to an individual and the individual knows, or should have known, that the disclosure is a breach of a fiduciary duty.(fn32) This is known as "tippee liability."(fn33) An example of Rule 10b- 5 tippee liability would be the case of the wife of the president of RCA, who would be liable in that she received inside information(fn34) from a fiduciary of the company (her husband, the president) and traded on this information.(fn35)

Second, a fiduciary duty can arise where an outsider obtains access to confidential information via a fiduciary relationship with a company or its shareholders.(fn36) This is known as temporary insider liability.(fn37) Temporary insider liability can be illustrated by the case of an attorney who receives inside information in the course of her relationship with a corporate client and trades on this information.(fn38)

The fraud in these examples arises from the fact that the wife via the husband, and the attorney via her employment relationship with the corporation, maintain the pretext of having a relationship of trust and confidence with the shareholders of a company.

The second theory of Rule 10b-5 criminal liability is the misappropriation theory. The misappropriation theory sanctions individuals who trade on inside information gained in the course of a fiduciary relationship with another party.(fn39) Specifically, criminal liability under the misappropriation theory occurs when one willfully misappropriates material nonpublic information in breach of a fiduciary duty or similar relationship of trust and confidence, and uses that information in a securities transaction.(fn40) Unlike the traditional theory, the misappropriation theory does not require a breach of fiduciary duty to a shareholder, but rather requires a breach of fiduciary duty to some party in the course of obtaining inside information.(fn41) For example, in United States v. Willis,(fn42) the district court refused to dismiss the indictment of a psychiatrist who traded on inside information obtained from a patient.(fn43) The court found that the relationship between a treating psychiatrist and his patient is an inherently fiduciary relationship.(fn44) Similarly, in United States v. Reed,(fn45) the district court refused to dismiss the indictment of the son of an insider who obtained inside information from his father and proceeded to trade on this inside information.(fn46) The court found that a fiduciary relationship existed where the defendant's father expected the issues discussed between the father and son to remain confidential.(fn47) In short, these cases illustrate that the source of inside information is irrelevant for the purposes of determining Rule 10b-5 criminal liability because criminal liability is ascertained by determining whether a fiduciary duty was breached during the course of obtaining inside information.

Congress has given tacit approval to the misappropriation theory.(fn48) Apparent congressional approval of the misappropriation theory is expressed in Congress's rejection of attempts to reform Rule 10b-5 by creating more definite types of criminal liability.(fn49) In particular, Congress has resisted attempts to define insider trading, a step that would limit the scope of the misappropriation theory by creating a bright-line rule as to what constitutes criminal liability for insider trading.(fn50)

Congressional resistance to defining insider trading in part can be attributed to the increased sophistication of insider trading over the past fifteen years. For example, in 1986, Ivan Boesky paid a $150,000,000 penalty to the SEC for insider trading.(fn51) Boesky engaged in an insider trading scheme whereby Boesky traded on inside information gained through companies he controlled.(fn52) Congress responded to this increased sophistication by creating the Insider Trading and Securities Fraud Enforcement Act of 1988 (hereinafter I.T.S.F.E.A.).(fn53) Among other things,(fn54) the I.T.S.F.E.A. created controlling person liability(fn55) to stop insider...