The Misappropriation Theory of Insider Trading in the Supreme Court: A (Brief) Response to the (Many) Critics of United States V. O'Hagan

By Quinn, Randall W. | Fordham Journal of Corporate & Financial Law, January 1, 2003 | Go to article overview

The Misappropriation Theory of Insider Trading in the Supreme Court: A (Brief) Response to the (Many) Critics of United States V. O'Hagan


Quinn, Randall W., Fordham Journal of Corporate & Financial Law


INTRODUCTION

The extent that insider trading should be regulated under the antifraud provisions of the federal securities laws, although not the most urgent issue facing the securities markets in light of the corporate accounting scandals that came to light in 2001-2002 and the passage of the landmark Sarbanes-Oxley Act,2 remains important.3 The proper scope of insider trading regulation also remains controversial, notwithstanding the Supreme Court's 1997 decision in United States v. O'Hagan,4 which upheld the validity of the misappropriation theory of insider trading. Under that theory, "a person commits fraud 'in connection with' a securities transaction, and thereby violates [section] 10(b) [of the Securities Exchange Act of 1934] 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."5 From the perspective of law enforcement, O'Hagan was a major victory that settled key issues with respect to enforcing anti-fraud insider trading prohibitions.6 Several commentators also expressed support for the decision.7 However, this trickle of published support for the O'Hagan decision has been swamped by a flood of critical articles.8

Critics have argued that the decision suffers from numerous flaws, including: misconstruing the relevant statute9; misreading the Supreme Court's own precedents10; lacking a coherent doctrinal basis for prohibiting insider trading11; leaving too many unanswered questions12; creating illogical loopholes in the regulatory scheme; and extending the reach of federal securities laws too far13. Some representative statements from this body of criticism illustrate the lack of admiration for the decision. One author wrote that the Supreme Court "ducked, misunderstood, or mishandled virtually every issue presented by the case."14 Another stated that the O'Hagan decision worked a "vast, unwitting, and wholly unwarranted expansion of Rule 10b-5";15 while yet another held the view that the misappropriation theory is "foolish in enforcement and absurd in private actions . . . [and] underestimates the problems with the Court's acceptance of the theory."16

I do not share this assessment of O'Hagan. The Supreme Court's adoption of the misappropriation theory is consistent with the statute and relevant precedent, rests on a reasonable policy foundation, does not leave open too many unanswered questions or create significant loopholes in the regulatory scheme, and does not extend the reach of the federal securities laws too far. In sum, O'Hagan's critics have overstated their case. The purpose of this comment is to restore balance to the commentary on O'Hagan.

Part 1 of this Comment presents a brief overview of the development of the misappropriation theory of insider trading prior to O'Hagan; Part 2 summarizes the O'Hagan litigation; Part 3 responds to a number of arguments advanced by O'Hagan's critics, focusing on three themes: the alleged lack of a coherent doctrine supporting the misappropriation theory; the questions left open by the decision, and the asserted loopholes created by the Court.17

I. HISTORY OF THE MISAPPROPRIATION THEORY OF INSIDER TRADING PRIOR TO O'HAGAN

"Theories" of insider trading exist because insider trading is not expressly prohibited in the securities statutes, except in the limited context of section 16(b) of the Exchange Act.18 Section 16(b), which is not an antifraud provision, generally requires corporate officers, directors, and 10% owners to give back to the corporation any profits made (or losses avoided) on trading in that company's securities within any six-month period.19 Proof that the person trading engaged in deception or was aware of any material non-public information is not required.20 The argument has been made, but never accepted by any court, that section 16 should be the exclusive means of addressing insider trading.21

Two theories have been used to prosecute insider trading under section 10(b) and Rule 10b-5: the classical or traditional theory, and the misappropriation theory. …

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