One of the fundamental tenets of our Constitution is that the federal government may not impose criminal punishment on its citizens unless Congress has acted clearly and decisively to declare their conduct illegal. In its recent decision in United States v. O'Hagan,1 the United States Supreme Court violated that principle by criminalizing conduct that was never explicitly made a crime by the federal securities statutes. By accepting much of the Government's misappropriation theory of liability under Rule 10b-5, the Court seems to have greatly enlarged the ability of the Securities & Exchange Commission (the "SEC") and the Department of Justice ("DOJ") to punish outsiders that trade on material nonpublic information. Moreover, the Court's opinion threatens to federalize the determination of what constitutes a fiduciary relationship, a determination currently made by the states. The reality, however, may well be that the impractical standard enunciated by the Court will prove once again that the judiciary is ill-suited to craft policy.

In a case that seems to epitomize the oft repeated axiom that "bad facts make bad law," O'Hagan involved a partner at a Minneapolis law firm who purchased shares in a potential takeover target of one of his firm's clients. Mr. O'Hagan abused his position as a fiduciary by stealing one client's funds and attempting to cover up that theft with proceeds gained from trading on the misappropriated material nonpublic information of another client. For these actions, he was convicted on eight counts of theft by the State of Minnesota. He served thirty months in state prison and was disbarred. In addition, Mr. O'Hagan was indicted by the federal government on 57 federal charges, including securities fraud under Rule 10b-5 and Rule 14e-3(a), mail fraud, and money laundering. He was convicted on all counts and sentenced to an additional 41 months in federal prison. On appeal to the Eighth Circuit, his federal convictions were overruled on all counts and the Circuit court rejected the so-called "misappropriation theory" of insider trading liability.2 The U.S. Supreme Court reversed and remanded.

Classic insider trading — where an insider or his affiliate commits "deception" by trading with a purchaser or seller of securities to whom he owes a fiduciary duty, without disclosing material nonpublic information — has been prosecuted by the Government for over thirty years under Section 10(b) of the Securities Exchange Act of 1934 and the SEC's Rule 10b-5. Rule 10b-5 provides that it is "unlawful for any person . . . [t]o employ any device, scheme or artifice to defraud, [or] . . . [t]o 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." This language creates a broad and pliable definition of criminal activity, without delineating the specific actions that Section 10(b) and Rule 10b-5 seek to prevent.

Beginning with In the Matter of Cady, Roberts,3 the SEC determined that Section 10(b) and Rule 10b-5 barred trading by insiders or their affiliates on the basis of nonpublic information because of the special duty owed by corporate insiders to shareholders. Not surprisingly in light of Congress' failure to craft the statute with particularity, the SEC creatively grounded application of Rule 10b-5 in Cady, Roberts upon a rather amorphous disclosure duty flowing from the special relationship between the buyer and seller in the transactions at issue, which gave the shareholder the right to all material information known by the insider before making an investment decision.4

With aggrandizing boldness and without guidance from Congress, since Cady, Roberts the SEC and DOJ have consistently asked federal courts for expanding "interpretations" of Section 10(b) that reach far beyond any boundaries ever contemplated by the legislature. The Government has attempted to persuade the U.S. Supreme Court to interpret Section 10(b) to prohibit mere negligence,5 any trading while in possession of material nonpublic information (even where there is no duty to disclose),6 mere breaches of fiduciary duties,7 and "aiding and abetting" violations of Section 10(b) by others.8 These attempted expansions of Section 10(b) all failed, not because the Court disagreed with the policies the Government sought to advance, but because the Court adhered to the constitutional principle that Congress must make those policy judgments in legislation it enacts. Any contrary result would violate the long-standing principle that "[i]t is the legislature, not the Court, which is to define a crime, and ordain its punishment."9 This principle is embodied by the rule of lenity, which requires that all ambiguities in a criminal statute be resolved in the defendant's favor.10

In contrast to classic insider trading, which involves "fraud on the purchaser/seller of securities," Mr. O'Hagan was convicted of "fraud on the source," meaning that he did not commit fraud on the people from whom he purchased his shares, as was the case in all Supreme Court precedent under Section 10(b) before O'Hagan. Rather, he committed fraud on his law firm and its client by misappropriating material nonpublic information from them without disclosure and then using the information to trade. This theory of liability, generally known as the misappropriation theory, is a judicial creation11 that was used to fill a perceived "gap" in securities regulation — a gap that flows from the very framework of Section 10(b) that the SEC itself recognized in Cady, Roberts. In fact, if activities such as misappropriation were believed to fall squarely within Section 10(b) when Cady, Roberts was decided, the focus on the duty of the insider to the shareholder would have been unnecessary and the ascension of the disclosure duty as the touchstone of insider trading law would not have occurred in Chiarella v. United States.12 By asking the Supreme Court to interpret Section 10(b) to include the misappropriation theory in O'Hagan, the Government was simply taking another step in its more than 35 year campaign to expand its powers to punish those actions it deems undesirable, without guidance from the legislature. Unfortunately, the current Court allowed this expansion and "construct[ed] its own misappropriation theory from whole cloth," with little apparent awareness of the potential impact of their "inconsistent" and, at times, "incoherent" decision.13

There is substantial reason to believe that the imprecise standard that the Court created in O'Hagan may cause significant difficulties for enforcement in the future. First, it is unclear what types of fiduciary relationships may give rise to the duty to disclose that underlies the misappropriation theory. In the case of Mr. O'Hagan, the analysis was simple: he was a partner in a law firm; his law firm had a client; he owed a fiduciary duty to both his firm and its client; he broke that duty by failing to disclose his misappropriation; and he traded on the basis of that information. But O'Hagan provides little guidance as to what other types of relationships also will create such a duty, since fiduciary duties are generally defined by state law. In the past, lower federal courts have allowed private, confidential relationships — such as those between husband and wife,14 parent and child,15 and doctor and patient16 — to be the basis for what amounts to a federal common law crime of "fraud" enforced by DOJ and the SEC. Because inquiries into misconduct under the misappropriation theory turn on detailed examinations of such private relationships, which have never before been subjected to federal regulation, such investigations are destined to become either engrossed in second-guessing of state courts or, more ominously, in federalizing fiduciary law. In effect, O'Hagan has left the judiciary with little choice but to adopt a traditionally legislative role and determine what is and is not a fiduciary relationship, and potentially decide what is and is not a crime.

Second, because the O'Hagan Court made an explicit finding that if the source of the inside information consents or authorizes its use for trading, fiduciaries will likely be able to abuse that information unless it directly conflicts with the interests of the source. For example, an attorney who is advising a client as to whether the client's company should acquire another business might ask if she could buy a few thousand shares of the potential target. Assuming permission is given, there is no Section 10(b) violation. But permission actually is not even necessary under the new regime. Disclosure before trading also negates liability under Section 10(b). The same attorney in the example above might enter into a meeting with her client and say "I've decided to purchase 10,000 shares of the target company, and I thought you should know." Cases of authorized and informed insider trading will almost certainly start moving through the federal courts as market participants seek to exploit the loopholes left by the imprecision of the Court's opinion. This is especially true because conviction for securities violations requires both an intent to do the underlying act as well as knowledge that the act was illegal. The current state of the law is so unclear that demonstrating knowledge will be difficult, if not impossible.

Third, under O'Hagan's misappropriation theory, the requirement that material nonpublic information be used "in connection with the purchase or sale of any security" is satisfied simply if the misappropriated information is actually used in a subsequent securities transaction. O'Hagan focused, almost myopically, on breaches of fiduciary duties, so much so that the requirement that the resulting fraud be "in connection with the purchase or sale of any security" is basically read out of the statute and Rule 10b-5. The Court accomplishes this task by assuming that the breach does not occur until after the fiduciary has actually traded on the information, rather than when he misappropriates the information. The result of this act of prestidigitation is that now the Government has to establish that the misappropriated information is actually used in making the securities transaction; previously, it was possible to establish a securities violation by showing mere possession of such misappropriated information prior to a transaction.17

In 1987, Senator Alfonse D'Amato, then ranking member of the Securities subcommittee, recognized that "it is incumbent upon Congress to confront the basic policy questions of what uses of informational advantage are to be forbidden, rather than leaving the law to be developed on a case by case basis."18 As one would expect, the SEC has preferred the "flexibility" offered by "case-by-case" determinations, which enables the Government to prosecute "evolving types of conduct,"19 and it is exactly this kind of imprecision that the rule of lenity in criminal prosecutions is meant to prevent. Congress must act in order to define more precisely what constitutes a crime under the insider trading laws, because it is not the Executive's constitutional role, with the approval of the Judiciary, to criminalize activities. Such overreaching is particularly unnecessary because a fiduciary's use of misappropriated information could be better addressed by the states through their existing fiduciary laws. The decision in O'Hagan is especially unfortunate in light of this more practical, not to mention constitutional, alternative.


   1. 117 S. Ct. 2199 (1997).
   2. See U.S. v. O'Hagan, 92 F.3d 612 (8th Cir. 1996).
   3. 40 S.E.C. 907 (1961).
   4. See id. at 911-13
   5. While it was not a party in the case, the Government submitted an amicus curiae brief urging the Court to expand Section 10(b) to cover negligence in Ernst & Ernst v. Hochfelder, 425 U.S. 185, 197-99 (1976).
   6. See, e.g., Dirks v. Securities and Exchange Comm'n, 463 U.S. 646 (1983); Chiarella v. United States, 445 U.S. 222 (1980).
   7. See, e.g., Sante Fe Industries v. Green, 430 U.S. 462 (1977).
   8. See, e.g., Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994).
   9. U.S. v. Wiltberger, 18 U.S. (5 Wheat) 76, 95 (1820) (Marshall, C.J.).
  10. See, e.g., O'Hagan, 117 S. Ct. at 2220 (Scalia, J., concurring in part and dissenting in part) (citing Reno v. Koray 515 U.S. 50, 64-65 (1995); U.S. v. Bass, 404 U.S. 336, 347-48 (1971)).
  11. See, e.g., S.E.C. v. Cherif, 933 F.2d 403,410 (7th Cir. 1991); S.E.C. v. Clark, 915 F.2d 439, 443-44 (9th Cir. 1990); S.E.C. v. Materia, 745 F.2d 197, 201-02 (2d Cir. 1984). In 1987, some in Congress once again sought to address the misappropriation theory by proposing legislation that would define the unlawful uses of misappropriated information. See S. 1380, 100th Cong. (1987). The sponsors' memorandum accompanying the proposed legislation, the "Insider Trading Proscriptions Act of 1987," noted that "the misappropriation theory . . . is itself judicially-created construct, the parameters of which have never been addressed by either Congress or the Supreme Court." See Explanatory Memorandum accompanying introduction of S. 1380, the proposed "Insider Trading Proscriptions Act of 1987," introduced by Senators Alfonse D'Amato and Donald Riegel on June 17, 1987, at 2, reprinted in 133 CONG. REC. 16,391 (1987).
  12. See 455 U.S. at 230 ("But such liability is premised upon a duty to disclose arising from a relationship of trust and confidence between the parties to a transaction.").
  13. 117 S. Ct. at 2221, 2224 (Thomas, J., concurring in the judgment and dissenting in part).
  14. See, e.g., U.S. v. Chestman, 947 F.2d 551 (2d Cir. 1991), cert. denied, 503 U.S. 1004 (1992); S.E.C. v. Lenfest, 949 F. Supp. 341 (E.D. Pa. 1996).
  15. See, e.g., S.E.C v. Sheinberg, 1992 WL 372190 (S.E.C. Release No. 13465) (C.D. Cal. 1992); United States v. Reed, 601 F. Supp. 685 (S.D.N.Y.), rev'd on other grounds, 773 F.2d 477 (2d Cir. 1985).
  16. See, e.g., U.S. v. Willis, 737 F. Supp. 269 (S.D.N.Y. 1990); S.E.C. v. Cooper, 1995 WL 739046 (S.E.C. Release No. 14754) (C.D. Cal. 1995).
  17. See, e.g., In the Matter of Sterling Drug, Inc., Release No. 34-14675 (April 19, 1978).
  18. Definition of Insider Trading; Hearings Before the Subcomm. on Securities of the Senate Comm. on Banking, Housing, and Urban Affairs, Part I, 100th Cong. 4 (1987) (statement of Sen. D'Amato).
  19. Fedders at 35, 37

Jay V. Prabhu is an associate with Wilmer, Cutler & Pickering in Washington, D.C. He and his firm filed an amicus brief (available at 1997 WL 145007) in support of the respondent on behalf of the National Association of Criminal Defense Lawyers in United States v. O'Hagan, 117 S. Ct. 2199 (1997). Wilmer, Cutler & Pickering formerly represented Mr. O'Hagan in connection with the Securities & Exchange Commission's investigation of the events at issue in the case. Mr. Prabhu has not received any confidential information concerning that representation.