United States v. O’Hagan

Brief Fact Summary.

O’Hagan (Defendant), an attorney, was indicted for trading securities in Pillsbury based on confidential information he gained due to his association with the corporation’s law firm.

Synopsis of Rule of Law.

(1) A person violates SEC § 10(b) and Rule 10b-5 when he misappropriates confidential information and trades on that information for his own personal benefit.  (2) The SEC (Plaintiff) did not overstep its rulemaking authority when it promulgated Rule 14e-3(a), which prohibits trading on undisclosed information in a tender offer situation, even where the person has no fiduciary duty to disclose the information.

Facts.

The law firm of Dorsey & Whitney was retained by Grand Metropolitan PLC (Grand Met) as counsel in a proposed tender offer for the stock of Pillsbury.  O’Hagan (Defendant), a partner in the firm, was not assigned to the case.  But during the time of the representation, Defendant purchased a total of 2,500 Pillsbury call options and 5,000 shares of common stock.  Following the announcement of the tender offer, he sold his interests and profited more than $4.3 million.  The Securities and Exchange Commission (SEC) (Plaintiff) began investigating Defendant and indicted him on 57 counts of mail ad securities fraud, fraudulent trading, and money laundering.  He was convicted on all 57 counts and sentenced to 41 months in prison.  The Court of Appeals for the Eighth Circuit reversed all of the convictions on the basis that Rule 10b-5 liability may not be based on a misappropriation theory.  Furthermore, the court held that SEC Rule 14e-3(a) was beyond the scope of the SEC’s (Plaintiff) power to make rules.  Because of this, none of the convictions could stand since they were based on the underlying securities fraud violations.  The Supreme Court granted certiorari to determine the propriety of the misappropriation theory, and the authority of the SEC (Plaintiff) to promulgate Rule 14e-3(a).

Issue.

(1) Does a person violate SEC § 10(b) and Rule 10b-5 and thereby violate his fiduciary duty by misappropriating confidential information by trading on that information for his own personal benefit?  (2) Did the SEC (Plaintiff) overstep its rulemaking authority when it promulgated Rule 14e-3(a), which prohibits trading on undisclosed information in a tender offer situation, even where the person has no fiduciary duty to disclose the information?

Held.

(Ginsburg, J.) (1) Yes.  (1) A person violates SEC § 10(b) and Rule 10b-5 when he misappropriates confidential information in violation of his fiduciary duty, and trades on that information for his own personal benefit.  Section 10(b) prohibits the use of any deceptive device in conjunction with the purchase or sale of securities.  The “traditional†theory holds an insider liable for trading in securities of his corporation based on relevant, nonpublic information.  Such trading satisfies the requirement of deception because of the relationship of trust and confidence placed in the insider due to his position.  This entrustment requires the insider to disclose or refrain from trading in the securities of the corporation in order to protect nonsuspecting shareholders.  This duty applies to officers and directors, and also to anyone else who acts in a fiduciary capacity toward the corporation, such as attorneys, accountants, and consultants.  In contrast, the “misappropriation†theory holds a person liable for the misappropriation of material, nonpublic information for the purpose of trading on that information, in breach of a fiduciary duty due to the provider of the information.  The misappropriation theory extends liability to include corporate outsiders who owe no duty to the shareholders of the corporation, but who still have access to the confidential information because of their fiduciary position.  In this situation, Defendant did not owe a duty to the Pillsbury shareholders as he was not an attorney involved in the case.  However, Defendant owed a fiduciary duty to his law firm, Dorsey & Whitney, to abstain from trading on the basis of material, nonpublic information he may have became aware of due to his position of employment in the firm.

(2) No.  The SEC (Plaintiff) did not overstep its rulemaking authority when it promulgated Rule 14e-3(a), which prohibits trading on undisclosed information in a tender offer situation, even where the person has no fiduciary duty to disclose the information.  Under § 14(e) of the Exchange Act, the Plaintiff is granted authority to pass rules and regulations that are necessary to prevent the act of fraud or deception in connection with the sale of securities.  The reasoning in support of the rule is the protection of uninformed shareholders involved in a potential tender offer situation.  The rule imposes a duty on the trader to disclose or refrain from trading on the confidential information.  This rule is consistent with the legislative goal of prohibiting acts of fraud or deception in the purchase or sale of securities.  The Court, in reviewing whether the SEC (P) regulations are appropriate, must give great deference to Plaintiff’s judgment where no blatant contrary intent is present.  Reversed and remanded.

Dissent.

(Scalia, J.) The broad statutory language of § 10(b) and Rule 10b-5, which prohibits the use of any deceptive device in conjunction with the purchase or sale of any security, must be narrowly interpreted to apply only to the deception of a party involved in a securities transaction.

Concurrence.

(Thomas, J.) In this case, the application of the misappropriation theory, as approved by the majority of the Court, is in an inconsistent application of § 10(b).  In addition, the imposition of liability, regardless of whether a fiduciary duty exists, fails to agree with the purpose of § 14(e) in the prevention of fraudulent acts connected with the sale of securities.

Discussion.

Whether the misappropriation theory was valid depended on whether it satisfied the requirement of a “deceptive device†under § 10(b).  The Court holds that a person who misappropriates confidential information essentially causes a deception on the source of that information through his nondisclosure of his intent to trade on it.  Such deception involves forsaken loyalty to the company that has the exclusive right use the information, and is equal to an act of embezzlement.