Opinion ID: 202498
Heading Depth: 2
Heading Rank: 1

Heading: The Misappropriation Theory of Insider Trading Liability

Text: 21 The text of § 10(b) makes it unlawful to use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of rules promulgated by the SEC. 15 U.S.C. § 78j(b). Rule 10b-5 furnishes further explication of this statute, providing inter alia that it is unlawful to 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. 17 C.F.R. § 240.10b-5(c). From these two sources of law on insider trading, the Supreme Court has fashioned two theories of liability: the classical theory, and the misappropriation theory. See O'Hagan, 521 U.S. at 651-52, 117 S.Ct. 2199. 22 Under the classical theory, § 10(b) and Rule 10b-5 are violated when an insider trades (without disclosure) in a corporation's securities based on material, nonpublic information that he has acquired. So long as that insider owes a fiduciary duty to the corporation's stockholders, the Supreme Court has deemed such trades to be deceptive because they constitute a breach of that fiduciary duty. Id. However, when the trading individual owes no fiduciary duty to the stockholders of the traded-in corporation, and he has not obtained the information from one who has breached such a duty, there can be no insider trading liability under the classical theory. See Chiarella v. United States, 445 U.S. 222, 231-35, 100 S.Ct. 1108, 63 L.Ed.2d 348 (1980). 23 In such cases, however, liability may still be premised on a misappropriation theory. Liability under that theory is based on deception of the source of the information, rather than on deception of the shareholders; it is that deception which brings this trading within the statutory language. See O'Hagan, 521 U.S. at 652, 117 S.Ct. 2199 ([T]he misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information.). Such deceptive trading exploits unfair informational disparities in the securities market; making such trading illegal also comports with the congressional purposes underlying § 10(b). See id. at 658-59, 117 S.Ct. 2199. 24 O'Hagan, the case in which the Supreme Court first recognized the misappropriation theory, illustrates the theory's underpinnings. The defendant, James O'Hagan, worked at a law firm representing the bidding company in a contemplated tender offer. Id. at 647, 117 S.Ct. 2199. O'Hagan learned about the proposed deal and purchased shares in the target company before the deal was made public. Id. at 647-48, 117 S.Ct. 2199. Because O'Hagan's firm represented the bidder, he owed no fiduciary duty to the target's stockholders and could not be prosecuted under the classical theory. Id. at 653, 117 S.Ct. 2199 n. 5. Nevertheless, the Court held he was liable under a misappropriation theory because he had deceived both his law firm and its client: he had pretended to be loyal to them while secretly converting information obtained from them into personal gain. See id. at 653-55, 117 S.Ct. 2199. The Court remarked that it would make scant sense to hold a lawyer like O'Hagan a § 10(b) violator if he work[ed] for a law firm representing the target of a tender offer, but not if he work[ed] for a law firm representing the bidder. The text of the statute requires no such result. Id. at 659, 117 S.Ct. 2199. 25 The Court did say, however, 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 § 10(b) violation. Id. at 655, 117 S.Ct. 2199. It is this language in O'Hagan, arguably dicta, 3 on which defendants pin their argument: they contend that Mrs. Rocklage's disclosure to her husband eliminated any deception involved with her tipping, which would mean that her actions did not come within the text of § 10(b). 26