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Class 7.1 Insider Trading

Dirks; United States v. OHagan

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Objectives

Understand basic rule prohibiting insidertrading.

Understand tippee liability for insidertrading.

Discuss why current insider trading rulesmay be inefficient.

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Insider trading Basic rules andtippee liability

Dirks

Facts?

Issues?

Arguments?

Reasoning?

Holding?

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Dirks Secrist works at insurance company Equity

Funding.

Company was doing bad stuff. Forgery parties,workers passing around fake insurance contracts foreach other to sign.

Secrist tries to report, no one believes him. Finallycalls Dirks, an investment analyst.

Dirks investigates, discovers its true, informs WallStreet Journal, probably California insuranceauthorities.

Also tells his clients, who trade on that information.

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Dirks

Was Dirks an insider?

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Dirks Was Dirks an insider?

No.

SEC is pursuing him for tippee liability under Rule 10b-5 (theSEC recognized that the common law in some jurisdictionsimposes on corporate insiders, particularly officers,directors, or controlling stockholders an affirmative duty ofdisclosure when dealing in securities. The SEC found thatnot only did breach of this common-law duty also establishthe elements of a Rule 10b-5 violation, but that individualsother than corporate insiders could be obligated either todisclose material nonpublic information before trading or toabstain from trading altogether.

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Dirks

What if Dirks had been walking along thesidewalk, behind the Chairman of the Board

of Equity Funding, when the chairmandropped an internal report detailing massivefraud at Equity Funding would Dirks be ableto trade on that information?

Discuss

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Dirks

The general rule is that a corporate insiderwho is in possession of material nonpublic

information must disclose that informationbefore trading on it.

Can you justify this rule in terms of 10(b)sprohibition on trading in any security using any

manipulative or deceptive device? Discuss.

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Dirks

What does the Court mean when it says notall breaches of fiduciary duty in connection

with a securities transaction, however, comewithin the ambit of Rule 10b-5?

Discuss.

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Dirks

What is the source of liability for tippeeinsider trading?

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Dirks

What is the source of liability for tippeeinsider trading?

There must be some fiduciary duty.

What does the SEC argue was Dirks fiduciaryduty?

Discuss.

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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 agencytheory.

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 fiduciaryduty by trading while in possession of material nonpublicinformation.

Seeks a level playing field.

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Dirks

What rule does the Court adopt with respectto tippee liability?

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Dirks

What rule does the Court adopt with respectto tippee liability?

A tippee violates Rule 10b-5 if: (1) the tipper violates a fiduciary duty to the firms

shareholders in giving the tip; and

(2) the tippee knew or should have known of that breach.

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Dirks

How could Secrist have violated a fiduciaryduty in reporting the fraud?

Discuss.

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Dirks

How could Secrist have violated a fiduciaryduty in reporting the fraud?

If the tipper receives a benefit for the breach offiduciary duty (note that this only implicates theduty of loyalty, not the duty of care).

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Dirks

What if Dirks had been a lawyer for EquityFunding? Our lawyers immune from trading

on their clients inside information? Discuss.

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Dirks

What if Dirks had been a lawyer for EquityFunding? Our lawyers immune from trading

on their clients inside information? Discuss.

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Dirks

Why did the court absolve Secrist ofwrongdoing?

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Dirks

Why did the court absolve Secrist ofwrongdoing?

The court holds that Secrist had every right todisclose the fraud because he did not personallybenefit from the disclosure.

Consider an alternative rule why might it be more

efficient to permit Secrist (and others) to trade onthe basis of their inside information?

Discuss.

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U.S. v. OHagan

Facts?

Issues?

Arguments?

Reasoning?

Holding?

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U.S. v. OHagan This case provides your first major introduction to the

tender offer process.

In the 1950s and 1960s, the most common way totake over a firm was a proxy fight. An insurgentgroup who believed that their policies would yieldhigher profits and returns for investors would seekto elect an insurgent slate of directors to replace theincumbent board.

This process is cumbersome.

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U.S. v. OHagan 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 targets stock on the market.

Announces that it will buy a certain percentage of shares at aspecified 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 cantprohibit the tender offer.

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U.S. v. OHagan OHagan is a partner at Dorsey & Whitney. D&Ws

client (handled by another partner) Grand Metplanned a tender offer for Pillsbury Co.

OHagan began purchasing call options for Pillsburystock in August 1988 at $39 per share.

Grand Met publicly announces the tender offer on

October 4, 1988. Pillsbury stock rises to $60 pershare.

OHagan sells Elsberry call options and commonstock, making profit of more than $4.3 million.

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U.S. v. OHagan

What were the SECs theories of liabilityagainst OHagan?

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U.S. v. OHagan

What were the SECs theories of liabilityagainst OHagan?

OHagan violated 10(b) / Rule 10b-5 by trading inpossession of material nonpublic information.

Fraudulent trading in connection with a tender offerin violation of Rule 14e-3(a).

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U.S. v. OHagan

What is the misappropriation theory ofinsider trading liability?

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U.S. v. OHagan


The misappropriation theory holds that a personcommits fraud in connection with a securitiestransaction, and thereby violates 10(b) and Rule10b-5, when he misappropriates confidential

information for securities trading purposes, inbreach of a duty owed to the source of theinformation. @503

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U.S. v. OHagan


Under this theory, a fiduciarys undisclosed, self-serving use of a principals information to purchaseor sell securities, in breach of a duty of loyalty andconfidentiality, defrauds the principle of the

exclusive use of that information. @503

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U.S. v. OHagan

If the misappropriation theory is really just abreach of fiduciary duty of loyalty i.e.

stealing the principals right to exclusive useof its information why do we botherimposing liability on the basis of securitiesfraud (instead of fiduciary duty)?

Discuss.

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U.S. v. OHagan

Why does the Court hold here that OHaganmisappropriated the tender offer information?

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U.S. v. OHagan Why does the Court hold here that OHagan

misappropriated the tender offer information?

OHagan owed a fiduciary duty of loyalty to his lawfirm, and through the law firm to the client.

He had no right to that information.

Additionally, the courts opinion is informed by itsdesire to maintain the integrity of the securitiesmarkets.

Is this desire realistic? Are there better ways to obtainthis goal?

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U.S. v. OHagan

Note that Rule 14d-3(a) which prohibitsfraud in connection with any tender offer

does not require any breach of a fiduciaryduty.

Thus, misappropriation theory really doesnt applyhere.

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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 hisannual review. The options can be exercised no sooner than oneyear from the date of issuance.

To maintain a diversified portfolio, Bob wishes to exercise hisoptions regularly and to reinvest 40% of the proceeds in mutualfunds and the stocks of other companies.

As part of his job duties, Bob is responsible for preparing annualand quarterly reports on the financial condition of the companyfor 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.

Week7 - Dirks

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