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United States v. O'Hagan

June 25, 1997

UNITED STATES, PETITIONER

v.

JAMES HERMAN O'HAGAN



SYLLABUS BY THE COURT

CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE EIGHTH CIRCUIT

No. 96-842.

Argued April 16, 1997

Decided June 25, 1997

After Grand Metropolitan PLC (Grand Met) retained the law firm of Dorsey & Whitney to represent it regarding a potential tender offer for the Pillsbury Company's common stock, respondent O'Hagan, a Dorsey & Whitney partner who did no work on the representation, began purchasing call options for Pillsbury stock, as well as shares of the stock. Following Dorsey & Whitney's withdrawal from the represention, Grand Met publicly announced its tender offer, the price of Pillsbury stock rose dramatically, and O'Hagan sold his call options and stock at a profit of more than $4.3 million. A Securities and Exchange Commission (SEC) investigation culminated in a 57-count indictment alleging, inter alia, that O'Hagan defrauded his law firm and its client, Grand Met, by misappropriating for his own trading purposes material, nonpublic information regarding the tender offer. The indictment charged O'Hagan with securities fraud in violation of Section(s) 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, with fraudulent trading in connection with a tender offer in violation of Section(s) 14(e) of the Exchange Act and SEC Rule 14e-3(a), and with violations of the federal mail fraud and money laundering statutes. A jury convicted O'Hagan on all counts, and he was sentenced to prison. The Eighth Circuit reversed all of the convictions, holding that Section(s) 10(b) and Rule 10b-5 liability may not be grounded on the "misappropriation theory" of securities fraud on which the prosecution relied; that Rule 14e-3(a) exceeds the SEC's Section(s) 14(e) rulemaking authority because the Rule contains no breach of fiduciary duty requirement; and that the mail fraud and money laundering convictions rested on violations of the securities laws, so could not stand once the securities fraud convictions were reversed.

Held:

1. A person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of the information, may be held liable for violating Section(s) 10(b) and Rule 10b-5. Pp. 4-22.

(a) Section 10(b) proscribes (1) using any "deceptive device" (2) "in connection with the purchase or sale of any security," in contravention of SEC rules. The Commission adopted Rule 10b-5 pursuant to its Section(s) 10(b) rulemaking authority; liability under Rule 10b-5 does not extend beyond conduct encompassed by Section(s) 10(b)'s prohibition. See, e.g., Ernst & Ernst v. Hochfelder, 425 U. S. 185, 214. Under the "traditional" or "classical theory" of insider trading liability, a violation of Section(s) 10(b) and Rule 10b-5 occurs when a corporate insider trades in his corporation's securities on the basis of material, confidential information he has obtained by reason of his position. Such trading qualifies as a "deceptive device" because there is a relationship of trust and confidence between the corporation's shareholders and the insider that gives rise to a duty to disclose or abstain from trading. Chiarella v. United States, 445 U. S. 222, 228-229. Under the complementary "misappropriation theory" urged by the Government here, a corporate "outsider" violates Section(s) 10(b) and Rule 10b-5 when he misappropriates confidential information for securities trading purposes, in breach of a fiduciary duty owed to the source of the information, rather than to the persons with whom he trades. Pp. 5-8.

(b) Misappropriation, as just defined, is the proper subject of a Section(s) 10(b) charge because it meets the statutory requirement that there be "deceptive" conduct "in connection with" a securities transaction. First, misappropriators deal in deception: A fiduciary who pretends loyalty to the principal while secretly converting the principal's information for personal gain dupes or defrauds the principal. A company's confidential information qualifies as property to which the company has a right of exclusive use; the undisclosed misappropriation of such information constitutes fraud akin to embezzlement. Cf. Carpenter v. United States, 484 U. S. 19, 25-27. Deception through nondisclosure is central to liability under the misappropriation theory. The theory is thus consistent with Santa Fe Industries, Inc. v. Green, 430 U. S. 462, 473-476, a decision underscoring that Section(s) 10(b) is not an all-purpose breach of fiduciary duty ban, but trains on conduct that is manipulative or deceptive. Conversely, full disclosure forecloses liability: Because the deception essential to the theory involves feigning fidelity to the information's source, if the fiduciary discloses to the source that he plans to trade on the information, there is no "deceptive device" and thus no Section(s) 10(b) violation. Second, Section(s) 10(b)'s requirement that the misappropriator's deceptive use of information be "in connection with the purchase or sale of [a] security" is satisfied by the misappropriation theory because the fiduciary's fraud is consummated, not when he obtains the confidential information, but when, without disclosure to his principal, he uses the information in purchasing or selling securities. The transaction and the breach of duty coincide, even though the person or entity defrauded is not the other party to the trade, but is, instead, the source of the nonpublic information. Because undisclosed trading on the basis of misappropriated, nonpublic information both deceives the source of the information and harms members of the investing public, the misappropriation theory is tuned to an animating purpose of the Exchange Act: to ensure honest markets, thereby promoting investor confidence. It would make scant sense to hold a lawyer-turned-trader like O'Hagan a Section(s) 10(b) violator if he works for a law firm representing the target of a tender offer, but not if he works for a firm representing the bidder. The statute's text requires no such result. Pp. 8-15.

(c) The Eighth Circuit erred in holding that the misappropriation theory is inconsistent with Section(s) 10(b). First, that court understood the theory to require neither misrepresentation nor nondisclosure; as this Court explains, however, deceptive nondisclosure is essential to Section(s) 10(b) liability under the theory. Concretely, it was O'Hagan's failure to disclose his personal trading to Grand Met and Dorsey, in breach of his duty to do so, that made his conduct "deceptive" under Section(s) 10(b). Second, the Eighth Circuit misread this Court's precedents when it ruled that, under Chiarella v. United States, 445 U. S. 222, 230, 232, 233; Dirks v. SEC, 463 U. S. 646, 655; and Central Bank of Denver, N. A. v. First Interstate Bank of Denver, N. A., Justice Ginsburg

ON WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE EIGHTH CIRCUIT

This case concerns the interpretation and enforcement of Section(s) 10(b) and Section(s) 14(e) of the Securities Exchange Act of 1934, and rules made by the Securities and Exchange Commission pursuant to these provisions, Rule 10b-5 and Rule 14e-3(a). Two prime questions are presented. The first relates to the misappropriation of material, nonpublic information for securities trading; the second concerns fraudulent practices in the tender offer setting. In particular, we address and resolve these issues: (1) Is a person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of the information, guilty of violating Section(s) 10(b) and Rule 10b-5? (2) Did the Commission exceed its rulemaking authority by adopting Rule 14e-3(a), which proscribes trading on undisclosed information in the tender offer setting, even in the absence of a duty to disclose? Our answer to the first question is yes, and to the second question, viewed in the context of this case, no.

I.

Respondent James Herman O'Hagan was a partner in the law firm of Dorsey & Whitney in Minneapolis, Minnesota. In July 1988, Grand Metropolitan PLC (Grand Met), a company based in London, England, retained Dorsey & Whitney as local counsel to represent Grand Met regarding a potential tender offer for the common stock of the Pillsbury Company, headquartered in Minneapolis. Both Grand Met and Dorsey & Whitney took precautions to protect the confidentiality of Grand Met's tender offer plans. O'Hagan did no work on the Grand Met representation. Dorsey & Whitney withdrew from representing Grand Met on September 9, 1988. Less than a month later, on October 4, 1988, Grand Met publicly announced its tender offer for Pillsbury stock.

On August 18, 1988, while Dorsey & Whitney was still representing Grand Met, O'Hagan began purchasing call options for Pillsbury stock. Each option gave him the right to purchase 100 shares of Pillsbury stock by a specified date in September 1988. Later in August and in September, O'Hagan made additional purchases of Pillsbury call options. By the end of September, he owned 2,500 unexpired Pillsbury options, apparently more than any other individual investor. See App. 85, 148. O'Hagan also purchased, in September 1988, some 5,000 shares of Pillsbury common stock, at a price just under $39 per share. When Grand Met announced its tender offer in October, the price of Pillsbury stock rose to nearly $60 per share. O'Hagan then sold his Pillsbury call options and common stock, making a profit of more than $4.3 million.

The Securities and Exchange Commission (SEC or Commission) initiated an investigation into O'Hagan's transactions, culminating in a 57-count indictment. The indictment alleged that O'Hagan defrauded his law firm and its client, Grand Met, by using for his own trading purposes material, nonpublic information regarding Grand Met's planned tender offer. Id., at 8. *fn1 According to the indictment, O'Hagan used the profits he gained through this trading to conceal his previous embezzlement and conversion of unrelated client trust funds. Id., at 10. *fn2 O'Hagan was charged with 20 counts of mail fraud, in violation of 18 U. S. C. Section(s) 1341; 17 counts of securities fraud, in violation of Section(s) 10(b) of the Securities Exchange Act of 1934 (Exchange Act), 48 Stat. 891, 15 U. S. C. Section(s) 78j(b), and SEC Rule 10b-5, 17 CFR Section(s) 240.10b-5 (1996); 17 counts of fraudulent trading in connection with a tender offer, in violation of Section(s) 14(e) of the Exchange Act, 15 U. S. C. Section(s) 78n(e), and SEC Rule 14e-3(a), 17 CFR Section(s) 240.14e-3(a) (1996); and 3 counts of violating federal money laundering statutes, 18 U. S. C. Section(s) 1956(a)(1)(B)(i), 1957. See App. 13-24. A jury convicted O'Hagan on all 57 counts, and he was sentenced to a 41-month term of imprisonment.

A divided panel of the Court of Appeals for the Eighth Circuit reversed all of O'Hagan's convictions. 92 F. 3d 612 (1996). Liability under Section(s) 10(b) and Rule 10b-5, the Eighth Circuit held, may not be grounded on the "misappropriation theory" of securities fraud on which the prosecution relied. Id., at 622. The Court of Appeals also held that Rule 14e-3(a)-which prohibits trading while in possession of material, nonpublic information relating to a tender offer-exceeds the SEC's Section(s) 14(e) rulemaking authority because the rule contains no breach of fiduciary duty requirement. Id., at 627. The Eighth Circuit further concluded that O'Hagan's mail fraud and money laundering convictions rested on violations of the securities laws, and therefore could not stand once the securities fraud convictions were reversed. Id., at 627-628. Judge Fagg, dissenting, stated that he would recognize and enforce the misappropriation theory, and would hold that the SEC did not exceed its rulemaking authority when it adopted Rule 14e-3(a) without requiring proof of a breach of fiduciary duty. Id., at 628.

Decisions of the Courts of Appeals are in conflict on the propriety of the misappropriation theory under Section(s) 10(b) and Rule 10b-5, see infra this page and n. 3, and on the legitimacy of Rule 14e-3(a) under Section(s) 14(e), see infra, at 25. We granted certiorari, 519 U. S. ___ (1997), and now reverse the Eighth Circuit's judgment.

II.

We address first the Court of Appeals' reversal of O'Hagan's convictions under Section(s) 10(b) and Rule 10b-5. Following the Fourth Circuit's lead, see United States v. Bryan, 58 F. 3d 933, 943-959 (1995), the Eighth Circuit rejected the misappropriation theory as a basis for Section(s) 10(b) liability. We hold, in accord with several other Courts of Appeals, *fn3 that criminal liability under Section(s) 10(b) may be predicated on the misappropriation theory. *fn4

A.

In pertinent part, Section(s) 10(b) of the Exchange Act provides:

"It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange-

. . . . .

"(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange] Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors." 15 U. S. C. Section(s) 78j(b).

The statute thus proscribes (1) using any deceptive device (2) in connection with the purchase or sale of securities, in contravention of rules prescribed by the Commission. The provision, as written, does not confine its coverage to deception of a purchaser or seller of securities, see United States v. Newman, 664 F. 2d 12, 17 (CA2 1981); rather, the statute reaches any deceptive device used "in connection with the purchase or sale of any security." Pursuant to its Section(s) 10(b) rulemaking authority, the Commission has adopted Rule 10b-5, which, as relevant here, provides:

"It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

"(a) To employ any device, scheme, or artifice to defraud, [or]

. . . . .

"(c) 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 CFR Section(s) -240.10b-5 (1996).

Liability under Rule 10b-5, our precedent indicates, does not extend beyond conduct encompassed by Section(s) 10(b)'s prohibition. See Ernst & Ernst v. Hochfelder, 425 U. S. 185, 214 (1976) (scope of Rule 10b-5 cannot exceed power Congress granted Commission under Section(s) 10(b)); see also Central Bank of Denver, N. A. v. First Interstate Bank of Denver, N. A., 511 U. S. 164, 173 (1994) ("We have refused to allow [private] 10b-5 challenges to conduct not prohibited by the text of the statute.").

Under the "traditional" or "classical theory" of insider trading liability, Section(s) 10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information. Trading on such information qualifies as a "deceptive device" under Section(s) 10(b), we have affirmed, because "a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation." Chiarella v. United States, 445 U. S. 222, 228 (1980). That relationship, we recognized, "gives rise to a duty to disclose [or to abstain from trading] because of the `necessity of preventing a corporate insider from . . . tak[ing] unfair advantage of . . . uninformed . . . stockholders.' " Id., at 228-229 (citation omitted). The classical theory applies not only to officers, directors, and other permanent insiders of a corporation, but also to attorneys, accountants, consultants, and others who temporarily become fiduciaries of a corporation. See Dirks v. SEC, 463 U. S. 646, 655, n. 14 (1983).

The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates Section(s) 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. See Brief for United States 14. 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 principal of the exclusive use of that information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information.

The two theories are complementary, each addressing efforts to capitalize on nonpublic information through the purchase or sale of securities. The classical theory targets a corporate insider's breach of duty to shareholders with whom the insider transacts; the misappropriation theory outlaws trading on the basis of nonpublic information by a corporate "outsider" in breach of a duty owed not to a trading party, but to the source of the information. The misappropriation theory is thus designed to "protec[t] the integrity of the securities markets against abuses by `outsiders' to a corporation who have access to confidential information that will affect th[e] corporation's security price when revealed, but who owe no fiduciary or other duty to that corporation's shareholders." Ibid.

In this case, the indictment alleged that O'Hagan, in breach of a duty of trust and confidence he owed to his law firm, Dorsey & Whitney, and to its client, Grand Met, traded on the basis of nonpublic information regarding Grand Met's planned tender offer for Pillsbury common stock. App. 16. This conduct, the Government charged, constituted a fraudulent device in connection with the purchase and sale of securities. *fn5

B.

We agree with the Government that misappropriation, as just defined, satisfies Section(s) 10(b)'s requirement that chargeable conduct involve a "deceptive device or contrivance" used "in connection with" the purchase or sale of securities. We observe, first, that misappropriators, as the Government describes them, deal in deception. A fiduciary who "[pretends] loyalty to the principal while secretly converting the principal's information for personal gain," Brief for United States 17, "dupes" or defrauds the principal. See Aldave, Misappropriation: A General Theory of Liability for Trading on Nonpublic Information, 13 Hofstra L. Rev. 101, 119 (1984).

We addressed fraud of the same species in Carpenter v. United States, 484 U. S. 19 (1987), which involved the mail fraud statute's proscription of "any scheme or artifice to defraud," 18 U. S. C. Section(s) 1341. Affirming convictions under that statute, we said in Carpenter that an employee's undertaking not to reveal his employer's confidential information "became a sham" when the employee provided the information to his co-conspirators in a scheme to obtain trading profits. 484 U. S., at 27. A company's confidential information, we recognized in Carpenter, qualifies as property to which the company has a right of exclusive use. Id., at 25-27. The undisclosed misappropriation of such information, in violation of a fiduciary duty, the Court said in Carpenter, constitutes fraud akin to embezzlement-" `the fraudulent appropriation to one's own use of the money or goods entrusted to one's care by another.' " Id., at 27 (quoting Grin v. Shine, 187 U. S. 181, 189 (1902)); see Aldave, 13 Hofstra L. Rev., at 119. Carpenter's discussion of the fraudulent misuse of confidential information, the Government notes, "is a particularly apt source of guidance here, because [the mail fraud statute] (like Section 10(b)) has long been held to require deception, not merely the breach of a fiduciary duty." Brief for United States 18, n. 9 (citation omitted).

Deception through nondisclosure is central to the theory of liability for which the Government seeks recognition. As counsel for the Government stated in explanation of the theory at oral argument: "To satisfy the common law rule that a trustee may not use the property that [has] been entrusted [to] him, there would have to be consent. To satisfy the requirement of the Securities Act that there be no deception, there would only have to be disclosure." Tr. of Oral Arg. 12; see generally Restatement (Second) of Agency Section(s) 390, 395 (1958) (agent's disclosure obligation regarding use of confidential information). *fn6

The misappropriation theory advanced by the Government is consistent with Santa Fe Industries, Inc. v. Green, 430 U. S. 462 (1977), a decision underscoring that Section(s) 10(b) is not an all-purpose breach of fiduciary duty ban; rather, it trains on conduct involving manipulation or deception. See id., at 473-476. In contrast to the Government's allegations in this case, in Santa Fe Industries, all pertinent facts were disclosed by the persons charged with violating Section(s) 10(b) and Rule 10b-5, see id., at 474; therefore, there was no deception through nondisclosure to which liability under those provisions could attach, see id., at 476. Similarly, full disclosure forecloses liability under the misappropriation theory: Because 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 Section(s) 10(b) violation-although the fiduciary-turned-trader may remain liable under state law for breach of a duty of loyalty. *fn7

We turn next to the Section(s) 10(b) requirement that the misappropriator's deceptive use of information be "in connection with the purchase or sale of [a] security." This element is satisfied because the fiduciary's fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities. The securities transaction and the breach of duty thus coincide. This is so even though the person or entity defrauded is not the other party to the trade, but is, instead, the source of the nonpublic information. See Aldave, 13 Hofstra L. Rev., at 120 ("a fraud or deceit can be practiced on one person, with resultant harm to another person or group of persons"). A misappropriator who trades on the basis of material, nonpublic information, in short, gains his advantageous market position through deception; he deceives the source of the information and simultaneously harms members of the investing public. See id., at 120-121, and n. 107.

The misappropriation theory targets information of a sort that misappropriators ordinarily capitalize upon to gain no-risk profits through the purchase or sale of securities. Should a misappropriator put such information to other use, the statute's prohibition would not be implicated. The theory does not catch all conceivable forms of fraud involving confidential information; rather, it catches fraudulent means of capitalizing on such information through securities transactions.

The Government notes another limitation on the forms of fraud Section(s) 10(b) reaches: "The misappropriation theory would not . . . apply to a case in which a person defrauded a bank into giving him a loan or embezzled cash from another, and then used the proceeds of the misdeed to purchase securities." Brief for United States 24, n. 13. In such a case, the Government states, "the proceeds would have value to the malefactor apart from their use in a securities transaction, and the fraud would be complete as soon as the money was obtained." Ibid. In other words, money can buy, if not anything, then at least many things; its misappropriation may thus be viewed as sufficiently detached from a subsequent securities transaction that Section(s) 10(b)'s "in connection with" requirement would not be met. Ibid.

The dissent's charge that the misappropriation theory is incoherent because information, like funds, can be put to multiple uses, see post, at 4-8, misses the point. The Exchange Act was enacted in part "to insure the maintenance of fair and honest markets," 15 U. S. C. Section(s) 78b, and there is no question that fraudulent uses of confidential information fall within Section(s) 10(b)'s prohibition if the fraud is "in connection with" a securities transaction. It is hardly remarkable that a rule suitably applied to the fraudulent uses of certain kinds of information would be stretched beyond reason were it applied to the fraudulent use of money.

The dissent does catch the Government in overstatement. Observing that money can be used for all manner of purposes and purchases, the Government urges that confidential information of the kind at issue derives its value only from its utility in securities trading. See Brief for United States 10, 21; post, at 4-6 (several times emphasizing the word "only"). Substitute "ordinarily" for "only," and the Government is on the mark. *fn8

Our recognition that the Government's "only" is an overstatement has provoked the dissent to cry "new theory." See post, at 9-11. But the very case on which the dissent relies, Motor Vehicle Mfrs. Assn. of United States, Inc. v. State Farm Mut. Automobile Ins. Co., 463 U. S. 29 (1983), shows the extremity of that charge. In State Farm, we reviewed an agency's rescission of a rule under the same "arbitrary and capricious" standard by which the promulgation of a rule under the relevant statute was to be judged, see id., at 41-42; in our decision concluding that the agency had not adequately explained its regulatory action, see id., at 57, we cautioned that a "reviewing court should not attempt itself to make up for such deficiencies," id., at 43. Here, by contrast, Rule 10b-5's promulgation has not been challenged; we consider only the Government's charge that O'Hagan's alleged fraudulent conduct falls within the prohibitions of the rule and Section(s) 10(b). In this context, we acknowledge simply that, in defending the Government's interpretation of the rule and statute in this Court, the Government's lawyers have pressed a solid point too far, something lawyers, occasionally even judges, are wont to do.

The misappropriation theory comports with Section(s) 10(b)'s language, which requires deception "in connection with the purchase or sale of any security," not deception of an identifiable purchaser or seller. The theory is also well-tuned to an animating purpose of the Exchange Act: to insure honest securities markets and thereby promote investor confidence. See 45 Fed. Reg. 60412 (1980) (trading on misappropriated information "undermines the integrity of, and investor confidence in, the securities markets"). Although informational disparity is inevitable in the securities markets, investors likely would hesitate to venture their capital in a market where trading based on misappropriated nonpublic information is unchecked by law. An investor's informational disadvantage vis- -vis a misappropriator with material, nonpublic information stems from contrivance, not luck; it is a disadvantage that cannot be overcome with research or skill. See Brudney, Insiders, Outsiders, and Informational Advantages Under the Federal Securities Laws, 93 Harv. L. Rev. 322, 356 (1979) ("If the market is thought to be systematically populated with . . . transactors [trading on the basis of misappropriated information] some investors will refrain from dealing altogether, and others will incur costs to avoid dealing with such transactors or corruptly to overcome their unerodable informational advantages."); Aldave, 13 Hofstra L. Rev., at 122-123.

In sum, considering the inhibiting impact on market participation of trading on misappropriated information, and the congressional purposes underlying Section(s) 10(b), it makes scant sense to hold a lawyer like O'Hagan a Section(s) 10(b) violator if he works for a law firm representing the target of a tender offer, but not if he works for a law firm representing the bidder. The text of the statute requires no such result. *fn9 The misappropriation at issue here was properly made the subject of a Section(s) ...


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