Class 7.

1 – Insider Trading

Dirks; United States v. O’Hagan

 Objectives
• Understand basic rule prohibiting insider
trading.
• Understand tippee liability for insider
trading.
• Discuss why current insider trading rules
may be inefficient.
 Insider trading – Basic rules and
tippee liability
• Dirks
– Facts?
– Issues?
– Arguments?
– Reasoning?
– Holding?
 Insider trading – Basic rules and
tippee liability
• Dirks
– Secrist works at insurance company – Equity
Funding.
– Company was doing bad stuff. Forgery parties,
workers passing around fake insurance contracts for
each other to sign.
– Secrist tries to report, no one believes him. Finally
calls Dirks, an investment analyst.
– Dirks investigates, discovers it’s true, informs Wall
Street Journal, probably California insurance
authorities.
• Also tells his clients, who trade on that information.
 Insider trading – Basic rules and
tippee liability
• Dirks
– Was Dirks an insider?
 Insider trading – Basic rules and
tippee liability
• Dirks
– Was Dirks an insider?
• No.
• SEC is pursuing him for tippee liability under Rule 10b-5 (“the
SEC recognized that the common law in some jurisdictions
imposes on ‘corporate insiders,’ particularly officers,
directors, or controlling stockholders an ‘affirmative duty of
disclosure … when dealing in securities. The SEC found that
not only did breach of this common-law duty also establish
the elements of a Rule 10b-5 violation, but that individuals
other than corporate insiders could be obligated either to
disclose material nonpublic information before trading or to
abstain from trading altogether.”
 Insider trading – Basic rules and
tippee liability
• Dirks
– What if Dirks had been walking along the
sidewalk, behind the Chairman of the Board
of Equity Funding, when the chairman
dropped an internal report detailing massive
fraud at Equity Funding – would Dirks be able
to trade on that information?
• Discuss
 Insider trading – Basic rules and
tippee liability
• Dirks
– The general rule is that a corporate insider
who is in possession of material nonpublic
information must disclose that information
before trading on it.
• Can you justify this rule in terms of §10(b)’s
prohibition on trading in any security using any
manipulative or deceptive device?
– Discuss.
 Insider trading – Basic rules and
tippee liability
• Dirks
– What does the Court mean when it says “not
all breaches of fiduciary duty in connection
with a securities transaction, however, come
within the ambit of Rule 10b-5”?
• Discuss.
 Insider trading – Basic rules and
tippee liability
• Dirks
– What is the source of liability for tippee
insider trading?
 Insider trading – Basic rules and
tippee liability
• Dirks
– What is the source of liability for tippee
insider trading?
• There must be some fiduciary duty.
• What does the SEC argue was Dirks’ fiduciary
duty?
– Discuss.
 Insider trading – Basic rules and
tippee liability
• Dirks
– What is the source of liability for tippee insider
trading?
• There must be some fiduciary duty.
• What does the SEC argue was Dirks’ fiduciary duty?
– Again, you should see how this entire course relates to agency
theory.
– Without some relationship that is at least analogous to agency,
the court is reluctant to impose liability on a tippee.
– The SEC argues that the tippee violates some kind of fiduciary
duty by trading while in possession of material nonpublic
information.
» Seeks a level playing field.
 Insider trading – Basic rules and
tippee liability
• Dirks
– What rule does the Court adopt with respect
to tippee liability?
 Insider trading – Basic rules and
tippee liability
• Dirks
– What rule does the Court adopt with respect
to tippee liability?
• A tippee violates Rule 10b-5 if:
– (1) the tipper violates a fiduciary duty to the firm’s
shareholders in giving the tip; and
– (2) the tippee knew or should have known of that breach.
 Insider trading – Basic rules and
tippee liability
• Dirks
– How could Secrist have violated a fiduciary
duty in reporting the fraud?
• Discuss.
 Insider trading – Basic rules and
tippee liability
• Dirks
– How could Secrist have violated a fiduciary
duty in reporting the fraud?
• If the tipper receives a benefit for the breach of
fiduciary duty (note that this only implicates the
duty of loyalty, not the duty of care).
 Insider trading – Basic rules and
tippee liability
• Dirks
– What if Dirks had been a lawyer for Equity
Funding? Our lawyers immune from trading
on their clients’ inside information?
• Discuss.
 Insider trading – Basic rules and
tippee liability
• Dirks
– What if Dirks had been a lawyer for Equity
Funding? Our lawyers immune from trading
on their clients’ inside information?
• Discuss.
 Insider trading – Basic rules and
tippee liability
• Dirks
– Why did the court absolve Secrist of
wrongdoing?
 Insider trading – Basic rules and
tippee liability
• Dirks
– Why did the court absolve Secrist of
wrongdoing?
• The court holds that Secrist had every right to
disclose the fraud because he did not personally
benefit from the disclosure.
• Consider an alternative rule – why might it be more
efficient to permit Secrist (and others) to trade on
the basis of their inside information?
– Discuss.
 Insider trading – Basic rules and
tippee liability
• U.S. v. O’Hagan
– Facts?
– Issues?
– Arguments?
– Reasoning?
– Holding?
 Insider trading – Basic rules and
tippee liability
• U.S. v. O’Hagan
– This case provides your first major introduction to the
tender offer process.
– In the 1950s and 1960s, the most common way to
take over a firm was a proxy fight. An insurgent
group – who believed that their policies would yield
higher profits and returns for investors – would seek
to elect an insurgent slate of directors to replace the
incumbent board.
– This process is cumbersome.
 Insider trading – Basic rules and
tippee liability
• U.S. v. O’Hagan
– This case provides your first major introduction to the
tender offer process.
– The proxy fight has largely been replaced by the
tender offer as a mechanism for corporate takeovers.
• In a tender offer, an acquiror:
– Purchases up to 5% of the target’s stock on the market.
– Announces that it will buy a certain percentage of shares at a
specified price that are tendered by the closing date of the
tender offer.
» Contingent on tender of certain percentage of shares
(usually a controlling block).
– Board may recommend for or against tendering, but they can’t
prohibit the tender offer.
 Insider trading – Basic rules and
tippee liability
• U.S. v. O’Hagan
– O’Hagan is a partner at Dorsey & Whitney. D&W’s
client (handled by another partner) Grand Met
planned a tender offer for Pillsbury Co.
– O’Hagan began purchasing call options for Pillsbury
stock in August 1988 at $39 per share.
– Grand Met publicly announces the tender offer on
October 4, 1988. Pillsbury stock rises to $60 per
share.
– O’Hagan sells Elsberry call options and common
stock, making profit of more than $4.3 million.
 Insider trading – Basic rules and
tippee liability
• U.S. v. O’Hagan
– What were the SEC’s theories of liability
against O’Hagan?
 Insider trading – Basic rules and
tippee liability
• U.S. v. O’Hagan
– What were the SEC’s theories of liability
against O’Hagan?
• O’Hagan violated §10(b) / Rule 10b-5 by trading in
possession of material nonpublic information.
• Fraudulent trading in connection with a tender offer
in violation of Rule 14e-3(a).
 Insider trading – Basic rules and
tippee liability
• U.S. v. O’Hagan
– What is the “misappropriation” theory of
insider trading liability?
 Insider trading – Basic rules and
tippee liability
• U.S. v. O’Hagan
– What is the “misappropriation” theory of
insider trading liability?
• “The misappropriation theory holds that a person
commits fraud in connection with a securities
transaction, and thereby violates §10(b) and Rule
10b-5, when he misappropriates confidential
information for securities trading purposes, in
breach of a duty owed to the source of the
information.” @503
 Insider trading – Basic rules and
tippee liability
• U.S. v. O’Hagan
– What is the “misappropriation” theory of
insider trading liability?
• “Under this theory, a fiduciary’s undisclosed, self-
serving use of a principal’s information to purchase
or sell securities, in breach of a duty of loyalty and
confidentiality, defrauds the principle of the
exclusive use of that information.” @503
 Insider trading – Basic rules and
tippee liability
• U.S. v. O’Hagan
– If the misappropriation theory is really just a
breach of fiduciary duty of loyalty – i.e.
stealing the principal’s right to exclusive use
of its information – why do we bother
imposing liability on the basis of securities
fraud (instead of fiduciary duty)?
• Discuss.
 Insider trading – Basic rules and
tippee liability
• U.S. v. O’Hagan
– Why does the Court hold here that O’Hagan
misappropriated the tender offer information?
 Insider trading – Basic rules and
tippee liability
• U.S. v. O’Hagan
– Why does the Court hold here that O’Hagan
misappropriated the tender offer information?
• O’Hagan owed a fiduciary duty of loyalty to his law
firm, and through the law firm to the client.
• He had no right to that information.
• Additionally, the court’s opinion is informed by its
desire to maintain the integrity of the securities
markets.
– Is this desire realistic? Are there better ways to obtain
this goal?
 Insider trading – Basic rules and
tippee liability
• U.S. v. O’Hagan
– Note that Rule 14d-3(a) – which prohibits
fraud in connection with any tender offer –
does not require any breach of a fiduciary
duty.
• Thus, misappropriation theory really doesn’t apply
here.
 Insider trading – Basic rules and
tippee liability
• Problem:
– Bob Smith is a director and the president of a publicly traded
technology company. As part of his compensation package,
Bob receives annual stock options priced at the date of his
annual review. The options can be exercised no sooner than one
year from the date of issuance.
– To maintain a diversified portfolio, Bob wishes to exercise his
options regularly and to reinvest 40% of the proceeds in mutual
funds and the stocks of other companies.
– As part of his job duties, Bob is responsible for preparing annual
and quarterly reports on the financial condition of the company
for filing with the SEC. Consequently, he is regularly in
possession of material nonpublic information.
– Take 10 minutes and develop a proposal for Bob to accomplish
his diversification goals without incurring insider-trading liability.
• Assume as an alternative that Bob is a lawyer for the company.