Murky Law on Insider Trading

Article excerpt

A decision this month by a federal appeals court in St. Louis reversing the securities fraud conviction of a Minneapolis attorney has dealt a potentially crippling setback to enforcement of the laws against insider trading.

In July 1988, the British conglomerate Grand Met retained Dorsey & Whitney, one of the largest and most prestigious law firms in the Midwest, to represent its interest in acquiring the Minneapolis-based Pillsbury Co. James O'Hagan, a Dorsey partner specializing in securities law, soon became very interested in acquiring Pillsbury securities. Within the next two months, O'Hagan became the world's largest investor in Pillsbury options, mortgaging his house in the process.

Ordinarily this would have been an extremely high-risk investment strategy. Unlike corporate stock, which has intrinsic value, "call" options are a wasting asset that eventually become worthless unless the underlying stock appreciates in value before the expiration date of the option. Of course, O'Hagan was in a position to know not only that the value of Pillsbury stock was going to rise but also when and by how much. When Grand Met announced its takeover plans in October, the price of Pillsbury stock rose immediately to almost $60 a share from $39. O'Hagan realized a profit of $4.3 million. The magnitude and timing of O'Hagan's trades attracted the attention of the Securities and Exchange Commission. Its investigation culminated in a 57-count indictment. A Minneapolis jury convicted him on all counts, and he was sentenced to 41 months in prison. The 8th U.S. Circuit Court of Appeals saw it differently, vacating O'Hagan's conviction in a 2-1 decision. Insider trading is a violation of Section 10(b) of the Securities and Exchange Act of 1934, and the SEC's Rule 10(b)-5. Both require proof of deceptive conduct "in connection with" the purchase or sale of securities. The Supreme Court has held that the insider trading prohibition is a function of the duty of loyalty owed by a corporation's directors, officers and employees to its shareholders. It is unlawful to corporate insiders with secret information to purchase securities from, or sell securities to, their own shareholders. Though he clearly had access to material nonpublic information about the future of Pillsbury, O'Hagan owed no loyalty to Pillsbury securities holders who sold him their options in August and September 1980. However, by appropriating for personal profit client information required to be held in the strictest confidentiality, O'Hagan betrayed the trust and confidence of his own employer, Dorsey & Whitney. The 2nd, 3rd, 7th and 9th federal court circuits in recent years have all adopted the "misappropriation" theory, of which O'Hagan was surely aware at the time of his Pillsbury trading and under which he was indicted. …