A CRITIQUE OF THE MISAPPROPRIATION
THEORY OF INSIDER TRADING
David M. Brodsky* and DanielJ. Kramer**
INTRODUCTION
The term insider trading is not defined in the federal securities
laws, but is generally used to describe the use of material, nonpublic information in securities trading. Such wrongful trading is
prosecuted under section 10(b) of the Securities Exchange Act of
1934 ("section 10(b)") and SEC Rule 10b-5 ("Rule 10b-5") promulgated thereunder as a type of fraud.' A considerable body of
case law has developed attempting to apply section 10(b)'s general
prohibition against using "any manipulative or deceptive device or
contrivance" and Rule 10b-5's admonition against "engag[ing] in
* J.D., Harvard University, 1967; B.A., Brown University, 1964. Mr. Brodsky is
Chairman of the litigation department at the New York law firm of Schulte Roth & Zabel
LLP.
** I.D., New York University, 1984; B.A., Wesleyan University, 1980. Mr. Kramer is a
partner in the litigation department at the New York law firm of Schulte Roth & Zabel
LLP. The authors wish to thank Dan Ackman and Marc Elovitz, associates at Schulte
Roth & Zabel LLP, for their assistance.
I Section 10 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 exchange or any security not so registered, any
manipulative or deceptive device or contrivance in contravention of such
rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
Securities Exchange Act of 1934 § 10(b), 15 U.S.C. § 78j(b) (1994). Rule lob-5 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,
(b) To make any untrue statement of a material fact or to omit to state a
material fact necessary in order to make the statements made, in the light of
the circumstances under which they were made, not misleading, 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 C.F.R. § 240.10b-5 (1998).
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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," to fact patterns that appear
to involve the misuse or inappropriate use of "inside informa2
tion."
Traditionally, the duty not to trade securities on the basis of
material, nonpublic information concerning the issuer was premised upon the common law duty owed by a director, officer, or
controlling shareholder of a corporation to the corporation's
shareholders not to gain a personal advantage through the use of
nonpublic information concerning the corporation's securities.
Absent such a special relationship between the insider and the
shareholders, there was no duty to disclose or abstain from trading
while in possession of inside information.
However, as the mergers and acquisitions explosion began in
the mid- to late 1970s, the Securities and Exchange Commission
("SEC") and the Department of Justice began using more novel
and elastic interpretations of fraud to capture participants in corporate deals who did not fit traditional insider profiles. In United
States v. O'Hagan,3 the United States Supreme Court endorsed for
the first time what has become known as the "misappropriation
theory" of insider trading. That theory extends section 10(b) to
outsiders who are not fiduciaries of the issuing company or its
shareholders, but who trade securities while breaching a duty to
the source of material, non-public information.4 As the Court
stated:
The "misappropriation theory" holds that a person commits
fraud "in connection with" a securities transaction, and thereby
violates § 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. 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.5
Thus, after some uncertainty created by the Supreme Court itself
in Central Bank, N.A. v. First Interstate Bank, N.A.,6 and by the
17 C.F.R. § 240.10b-5 (1998).
117 S. Ct. 2199 (1997).
4 See SEC v. Cherif, 933 F.2d 403, 409 (7th Cir. 1991).
5 O'Hagan,117 S.Ct. at 2207 (citation omitted).
6 511 U.S. 164 (1994). In Central Bank, the Supreme Court adhered to a strict construction of the language of section 10(b) in holding that there can be no private right of
2
3
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CRITIQUE OF MISAPPROPRIATION THEORY
43
United States Courts of Appeals for the Fourth 7 and Eighth Circuits," which had rejected the misappropriation theory, the law is
now clear that a person can be convicted for insider trading without being an insider at all, at least not in the classical sense of the
term.9
The misappropriation theory is not new. Indeed, the Justice
Department pressed the theory on the Supreme Court in 1980 in
Chiarella v. United States,0 and four members of the Court endorsed the theory." The United States Court of Appeals for the
Second Circuit accepted the misappropriation theory in 1981 in
United States v. Newman. 2 Yet it was not until O'Hagan, where
the Supreme Court reversed an Eighth Circuit decision rejecting
the theory that misappropriation was finally established as a basis
for a securities fraud prosecution. 3
While O'Hagan settles the law, it has not ended the confusion
as to the basis for, or logic behind, the misappropriation theory.
This confusion is long-standing, in part because the federal securities statutes do not define insider trading, and in part because
there is no clear link between the misappropriation theory and section 10(b) and Rule 10b-5. The cases up to and including O'Hagan
have not clarified how the misappropriation of information from a
person who is not a party to the securities transaction can be said
4
to constitute a violation of the terms of the statute or the rule.
action for aiding and abetting a violation of section 10(b). In so holding, the Court upset
what had become a standard practice of suing aiders and abettors along with primary violators of section 10(b) and Rule 10b-5. The Court acknowledged that numerous federal
courts had permitted private aiding and abetting actions but stated that adherence to the
statutory text required the opposite result. See id. at 169. The Eighth Circuit relied on
Central Bank in holding that the misappropriation theory was no longer viable. See
United States v. O'Hagan, 92 F.3d 612,618-19 (8th Cir.), rev'd, 117 S. Ct. 2199 (1997). But
the Supreme Court later distinguished Central Bank. See O'Hagan,117 S. Ct. at 2213.
7 See United States v. Bryan, 58 F.3d 933 (4th Cir. 1995); United States v. ReBrook,
58 F.3d 961 (4th Cir. 1995).
8 United States v. O'Hagan, 92 F.3d 612 (8th Cir.), rev'd, 117 S. Ct. 2199 (1997).
9 See generally United States v. O'Hagan, 117 S. Ct. 2199 (1997).
10 445 U.S. 222 (1980).
11The Chiarella majority declined to reach the misappropriation theory as a potential
basis for liability because the theory had not been submitted to the jury. See Chiarella v.
United States, 445 U.S. 222,236-37 (1980); see also O'Hagan,117 S. Ct. at 2212.
12 664 F.2d 12 (2d Cir. 1981).
13 The misappropriation theory might have been addressed on appeal from the decision in United States v. Bryan, 58 F.3d 933 (4th Cir. 1995), but the government decided not
to seek certiorari in the case. See Elkan Abramowitz, A Lost Opportunity to Clarify the
Law on Insider Trading, N.Y. L.J., Nov. 7,1996, at 7.
14 In his O'Hagan dissent, Justice Thomas questioned the statutory authority for the
majority opinion essentially on the ground that the fraud in a misappropriation case is to a
third party-the information source-and not to a party to the securities transaction. See
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Under the misappropriation theory, section 10(b) and Rule
10b-5 have been applied in a wide range of administrative, civil,
and criminal actions to corporate outsiders. Bankers, lawyers, arbitrageurs, financial printers, reporters, and psychiatrists stood accused of abusing a variety of relationships and obtaining informational advantages emanating not only from within a corporation
but from outside of the corporation whose securities they have
bought and sold. These professionals have been accused of fraud
in connection with the purchase or sale of securities even though
there may have been no fraud in the traditional sense and even
though they owed no duty to the persons with whom they dealt.
The piecemeal judicial elaboration of the doctrine of insider
trading has created an amorphous offense that is dependent upon
case-by-case definitions of the scope of illegal trading. As a result,
persons participating in the securities marketplace confront a significant degree of uncertainty when they try to locate the line between permitted and prohibited activity. Concerns about the
open-ended nature of this criminal offense have intensified as the
penalties for wrongful trading on the basis of material, nonpublic
information have increased.15 Even after O'Hagan, there is no
O'Hagan,117 S. Ct. at 2221-23, 2225 n.6. The majority had conceded that if O'Hagan had
informed his law firm of his intention to use the misappropriated information to trade,
there would have been no section 10(b) violation. See id. at 2209 n.7. This concession, the
dissent argued, rendered the majority opinion "incoherent" since the impact on the market is the same whether or not the source of the information knows how the information is
to be used. See id. at 2225. The misappropriator would still be trading on the basis of
nonpublic information that the public has no hope of obtaining, albeit with the knowledge
and perhaps consent of the person who "owns" the information. See id. at 2225. The dissent concluded:
Where the relevant element of fraud has no impact on the integrity of the subsequent transactions as distinct from the nonfraudulent element of using nonpublic
information, one can reasonably question whether the fraud was used in connection with the securities transaction, [as is supposedly required by the language of
the statute].
Id. at 2226.
15 The Insider Trading Sanctions Act of 1984, Pub. L. No. 98-376, 98 Stat. 1264
("ITSA"), trebles the civil monetary sanction and increases the criminal fine a court can
impose upon a finding that a person or entity has engaged in unlawful trading in violation
of the Securities Exchange Act of 1934. 15 U.S.C. §§ 78a-78kk (1994). ITSA also expands
the reach of the securities laws, making it a violation to purchase or sell a derivative security, such as a put, call, straddle, or option, or a group or index of securities, while in possession of material, nonpublic information. 15 U.S.C. § 78t. The Insider Trading and Securities Fraud Enforcement Act of 1988, Pub. L. No. 100-704, 102 Stat. 4677 ("ITSFEA"),
extended treble sanctions to "control persons" (generally employers or supervisors) of
people who commit insider trading. 15 U.S.C. § 78u-1. ITSFEA also drastically increases
the criminal penalties, doubling the maximum prison term from five to ten years and raising the maximum fine from $100,000 to $1 million for individuals and $2.5 million for nonnatural persons. See 15 U.S.C. § 78ff(a). It also created a private right of action for con-
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CRITIQUE OF MISAPPROPRIATION THEORY
45
clear statutory basis for the prosecution of outsiders for insider
trading. The Supreme Court clarified only the result, but not the
reasoning, for many, if not most, of the recent prosecutions for insider trading.
This Article addresses the tension among the different theories of liability for insider trading and critiques the misappropriation theory in particular. Part I of this Article discusses the development of the fraud and possession theories of insider trading.
Part II describes the emergence and extension of the misappropriation theory and critiques the use of the misappropriation theory as a basis for liability under section 10(b).
I.
COMPETING THEORIES OF LIABILITY: FRAUD VS. POSSESSION
Although section 10(b) and Rule 10b-5 have become the primary provisions for prosecuting insider trading, 6 the initial basis
for this application of the securities laws is somewhat obscure.
Milton V. Freeman, one of the Rule 10b-5 co-authors, reports that
Rule 10b-5 was hastily drafted by the SEC in May 1942 in response
to a report that the president of a corporation was purchasing the
shares of other shareholders at depressed prices after misinforming them about the condition of the corporation. 17 The same day
the report was received, Rule 10b-5 was adopted, without discussion, other than Commissioner Sumner Pike's remark, "Well, we
are against fraud, aren't we?"' 8 This sketchy "legislative history,"
and the subsequent broad application of Rule 10b-5, prompted
Professor Louis Loss to write that, "it is difficult to think of antemporaneous traders. See 15 U.S.C. § 78t-1.
16 Section 10(b) and Rule 10b-5 are not the only provisions of the 1934 Act that regulate insider trading. For example, section 16 of the 1934 Act, 15 U.S.C. § 7 8 p, which applies when both purchases and sales are made within six months of each other and extends
only to officers, directors, and persons who beneficially own more than ten percent of a
corporation's outstanding securities, gives an issuer the right to recover any profit made by
an officer, director, or controlling shareholder from purchases and sales that occur within
six months of each other. In addition, section 14 of the 1934 Act, 15 U.S.C. § 78n, and
SEC Rule 14e-3 ("Rule 14e-3"), 17 C.F.R. § 240.14e-3 (1998), prohibit insider trading in
the context of tender offers. Also, some state laws permit a corporation to recover profits
made by an insider trading in its stock on the basis of material, nonpublic information. See
Diamond v. Oreamuno, 248 N.E.2d 910 (N.Y. 1969) (creating a common law derivative
cause of action against corporate insiders trading on material, nonpublic information).
17 See Milton V. Freeman, 'Insider Trading' v. 'Unfair Use,' NAT'L L.J., June 13, 1983,
at 15.
18 See LOUIS Loss, FUNDAMENTALS OF SECURITIES REGULATION 821 (3d ed. 1983)
(citing Milton Freeman, Remarks at the Conference on Codification of the FederalSecurities Laws, 22 BUs. LAW. 793, 922 (1967)); see also Ernst & Ernst v. Hochfelder, 425 U.S.
185,212-13 n.32 (1976).
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other instance in the entire corpus juris in which the interaction of
the legislative, administrative rulemaking, and judicial processes
has produced so much from so little. What is more remarkable is
that the whole development was unplanned."' 9
Thus, the primary instrument for redressing wrongful insider
trading was not born out of a struggle of competing philosophies
concerning the proper regulation of the flow of information in the
securities marketplace. Rather, Rule 10b-5 sprung from the SEC's
general sense of unfairness arising out of a specific instance concerning a corporate officer's fraudulent misrepresentation to the
corporation's shareholders." The struggle of philosophies would
not occur in the legislative or rulemaking process, but in the
courts, as they struggled with the question of the proper mix of fiduciary duty, fraud, and fairness in defining a violation of section
10(b) and Rule 10b-5.
A. The Fraud Theory
The theory underlying the prohibition against insider trading
with the longest doctrinal history was enunciated in 1961 by the
SEC in In re Cady, Roberts & Co.2 In Cady, Roberts, a director of
the Curtiss-Wright Corporation learned during a directors' meeting that Curtiss-Wright would be reducing its dividend for the
fourth quarter of 1959. After the meeting recessed, but before the
dividend decision had been transmitted to the New York Stock
Exchange and Dow Jones News Ticker Service, the director, who
was also affiliated with the brokerage firm, informed his broker of
the decision to cut the dividend, and that broker sold his clients'
shares in Curtiss-Wright before the dividend information was released to the public."
In imposing liability on the Curtiss-Wright director, the SEC
stated its "disclose or abstain" rule:
An affirmative duty to disclose material information has been
traditionally imposed on corporate "insiders," particularly offisupra note 18, at 820.
20 This conduct constituted a violation of common law notions of fiduciary duties of
officers. As early as 1909, in Strong v. Repide, 213 U.S. 419 (1909), the Supreme Court
held that a major shareholder and general manager of a company was liable for purchasing
a minority shareholder's stock without first disclosing that the company was about to sell
property. See id. at 431-33. Most jurisdictions agree that a corporate officer's use of information from inside the corporation violates that officer's fiduciary duties. See Speed v.
Transamerica Corp., 99 F. Supp. 808 (D. Del. 1951); Kardon v. National Gypsum Co., 73
F. Supp. 798 (E.D. Pa. 1947). But see Loss, supra note 18, at 870 (Supp. 1984).
21 40 S.E.C. 907 (1961).
22 See id. at 908-09.
19 Loss,
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CRITIQUE OF MISAPPROPRIATION THEORY
47
cers, directors, or controlling stockholders. We, and the courts
have consistently held that insiders must disclose material facts
which are known to them by virtue of their position but which
are not known to persons with whom they deal and which, if
known, would affect their investment judgment. Failure to
make disclosure in these circumstances constitutes a violation of
the anti-fraud provisions. If, on the other hand, disclosure prior
to affecting a purchase or sale would be improper or unrealistic
under the circumstances, we believe the alternative is to forego
the transaction.23
In Cady, Roberts, the SEC also discussed the duty of an outsider, such as the brokerage firm employee, to disclose. Although
outsiders do not automatically have the special obligation 24 of corporate insiders, the SEC found that analytically an obligation to
disclose or abstain may be imposed if two conditions are present:
[F]irst,the existence of a relationship giving access, directly
or indirectly, to information intended to be available only for a
corporate purpose and not for the personal benefit of anyone,
and second, the inherent unfairness involved where a party
takes advantage of such information knowing it is unavailable
to those with whom he is dealing. 5
The SEC premised tippee liability not only on the presence of an
informational disadvantage, but also on a special relationship, either directly or derivatively, between the trader and the corporation's shareholders.
In Cady, Roberts, the SEC did not find defendants liable
merely because they traded while in possession of material, nonpublic information. Rather, defendants violated section 10(b) and
Rule 10b-5 because they were under a fiduciary duty to the corporation's shareholders. 2 6 That duty imposed upon defendants an
23 Id. at 911 (footnote omitted); see also Oliver v. Oliver, 45 S.E. 232 (Ga. 1903). In
Oliver, the Supreme Court of Georgia stated:
It might be that the director was in possession of information which his duty to
the company required him to keep secret; and, if so, he must not disclose the fact
even to the shareholder, for his obligation to the company overrides that to an
individual holder of the stock. But if the fact so known to the director cannot be
published, it does not follow that he may use it to his own advantage, and to the
disadvantage of one whom he also represents. The very fact that he cannot disclose prevents him from dealing with one who does not know, and to whom material information cannot be made known.
Id. at 234.
24 See Cady, Roberts, 40 S.E.C. at 912.
25 Id. (emphasis added) (footnote omitted).
26 But cf. Barbara Bader Aldave, Misappropriation:A General Theory of Liability for
Trading on Nonpublic Information, 13 HOFSTRA L. REV. 101,104 (1984) ("[Ilt is probably
entirely fictional to say that a shareholder reposes trust and confidence in a director, offi-
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obligation to disclose the nonpublic information to the corporation's shareholders and rendered their silence fraudulent. 7 Since
such an affirmative duty is not always present when persons trade
while in possession of nonpublic information, the SEC and the Justice Department have advocated, and some courts have accepted,
other theories that would permit a broader application of section
10(b).
28
B.
The Possession Theory
1. Texas Gulf Sulphur and the Merrill Lynch Trilogy
Seven years after Cady, Roberts, the Second Circuit reduced
the possession theory to a single standard of unfairness in SEC v.
Texas Gulf Sulphur Co. 9 The SEC brought an injunctive action
against Texas Gulf Sulphur ("Texas Gulf"), and certain of its directors, officers, and employees were charged with violating section 10(b) and Rule 10b-5 by either purchasing stock or calls on
stock3 ° in the company, or recommending such purchases to others,
based on undisclosed information regarding Texas Gulf's mining
activities in Ontario.3 The court based its decision on the twoprong Cady, Roberts test of (1) a relationship giving access to information and (2) unfairness in acting on such information32 and
on the analysis of federal common law precedents involving the fiduciary duties owed by corporate officers to the corporations'
shareholders. The Texas Gulf court determined that employees
who are in possession of material, nonpublic information by virtue
of their employment are insiders and subject to the disclosure re-
cer, or controlling shareholder.").
27 See, e.g., State Teachers Retirement Bd. v. Fluor Corp., 654 F.2d 843, 851 (2d Cir.
1981); D & G Enters. v. Continental Ill. Nat'l Bank & Trust Co., 574 F. Supp. 263, 269
(N.D. Il.1983) ("[A] mere failure to disclose material information, absent other compelling legal circumstances, does not operate as a fraud.") (citation omitted). See generally
RESTATEMENT (SECOND) OF TORTS § 551(2)(a) (1977) (failure to disclose material facts,
as distinguished from an affirmative misrepresentation, is generally not actionable unless
one party owes a duty of disclosure to another "because of a fiduciary or other similar relation of trust and confidence between them").
28 See discussion infra Parts H.A., II.B.1-.3.
29 401 F.2d 833 (2d Cir. 1968) (en banc).
30 "A 'call' is a negotiable option contract by which the bearer has the right to buy
from the writer of the contract a certain number of shares of a particular stock at a fixed
price on or before a certain agreed-upon date." Id. at 841 n.3.
31 See SEC v. Texas Gulf Sulphur Co., 258 F. Supp. 262, 267 (S.D.N.Y. 1966), aff'd in
part and rev'd in part,401 F.2d 833 (2d Cir. 1968) (en banc).
32 See discussion supra notes 24-26 and accompanying text.
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CRITIQUE OF MISAPPROPRIATION THEORY
49
quirements of section 10(b) and Rule 10b-5.33 The district court
did not impose liability on a director who did not trade himself,
but who tipped his brother-in-law minutes after a press conference
in which the mineral discoveries were announced 4 and before the
news had been absorbed by the public.
The Second Circuit, sitting en banc, reversed the district court
decision in part, holding liable the director-tipper as well. 35 Although liability of all defendants, including the tipper, could have
been premised on a fiduciary duty owed to the corporation's
shareholders, the Second Circuit, instead, made a parity of information rationale the primary motivation for the disclose or abstain
rule. The reviewing court held that Rule 10b-5 "is based in policy
on the justifiable expectation of the securities marketplace that all
investors trading on impersonal exchanges have relatively equal
access to material information. '36 Quoting selectively from Cady,
Roberts,37 the Court held that the obligation to disclose or abstain
from trading applies to "anyone... trading for his own account...
[who] has 'access, directly or indirectly, to information intended to
be available only for a corporate purpose.' 38 Therefore, the duty
to disclose or abstain arises whenever one party to a securities
transaction is in possession of nonpublic, material information of
which the other party is unaware.
The SEC was quick to expand upon the parity of information
approach and sought to apply the duty to disclose or abstain to
persons who were not traditional corporate insiders. The opportunity to apply this approach arose in a group of cases known as
the Merrill Lynch trilogy,39 each of which involved Merrill Lynch's
33 See Texas Gulf Sulphur, 258 F. Supp. at 279. "If an employee in the course of his
employment acquires secret information relating to his employer's business, he occupies a
position of trust and confidence toward it, analogous in most respects to that of a fiduciary, and must govern his actions accordingly." Id. (quoting Brophy v. Cities Serv. Co., 70
A.2d 5, 7 (Del. Ch. 1949)).
34 See id. at 288-89. The district court also declined the SEC's invitation to fix a waiting period-aftera public announcement is made, while the information is being digested
by the public-before trading by insiders is permitted, finding that such a requirement
would be more appropriately imposed by the SEC through its rulemaking powers. See id.
at 289.
35 See Texas Gulf Sulphur, 401 F.2d at 854.
36 Id. at 848. See also Victor Brudney, Insiders, Outsiders, and InformationalAdvantages Under the FederalSecurities Laws, 93 HARV. L. REV. 322, 339 (1979).
37 In re Cady, Roberts & Co., 40 S.E.C. 907 (1961).
38 Texas Gulf Sulphur, 401 F.2d at 848 (quoting Cady, Roberts, 40 S.E.C. at 912).
39 In re Merrill Lynch, Pierce, Fenner & Smith, Inc., 43 S.E.C. 933 (1968); In re Investors Management Co., 44 S.E.C. 633 (1971); Shapiro v. Merrill Lynch, Pierce, Fenner &
Smith, Inc., 495 F.2d 228 (2d Cir. 1974).
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receipt of nonpublic information. While managing an underwriting for Douglas Aircraft Co. ("Douglas"), Merrill Lynch learned
that Douglas would report sharply lower earnings and was expecting to show little or no profit for the year.4° Merrill Lynch
shared this information with certain of its institutional and other
large customers, some of whom sold short Douglas stock prior to
public disclosure. 41 At the same time, Merrill Lynch did not disclose this adverse information to other customers for whom it
bought Douglas stock.42
In In re Investors Management Co.,43 a proceeding brought
against the sellers who were tipped by Merrill Lynch, the SEC
found that the tippees had a duty to disclose that arose when (1)
the information acquired is material and nonpublic, (2) the tippee
knows, or has reason to know, the information is nonpublic and
was acquired improperly, and (3) the information was a factor in
the decision to effect the transaction.' The SEC rejected the argument that a fourth requirement-that the recipients have a special relationship with the issuer or inside corporate source that
provided them with inside nonpublic information-should be imposed.45 The SEC instead cast its vote in favor of the parity of information theory:
We consider that one who obtains possession of material,
nonpublic corporate information, which he has reason to know
emanates from a corporate source, and which by itself places
him in a position superior to other investors, thereby acquires a
relationship with respect to that information within the purview
and restraints of the antifraud provisions.'
Following the Second Circuit's lead in Texas Gulf Sulphur,47
the SEC focused the analysis of Rule 10b-5 away from the trader's
relationship with the issuing corporation's shareholders, a derivative relationship in this case, and anchored the duty to disclose on
40 See In re Merrill Lynch, 43 S.E.C. at 935.
41 See id.
42 In In re Merrill Lynch, Pierce, Fenner
& Smith, Inc., the SEC accepted Merrill
Lynch's offer of settlement, imposing certain sanctions for the company's failure to exercise reasonable supervision to prevent the violations. The SEC noted that the firm had
undertaken to adopt procedures to prohibit members of the underwriting department
from disclosing to other parts of the firm material, nonpublic information obtained from a
corporate client. See id. at 938.
43 44 S.E.C. 633, 634-35 (1971) (reviewing the hearing examiner's decision on the
SEC's own motion).
44 See id. at 641 (relying on Cady, Roberts principles).
45 See id. at 643.
46 Id. at 644 (emphasis added).
47 401 F.2d 833 (2d Cir. 1968).
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CRITIQUE OF MISAPPROPRIATION THEORY
51
the trader's possession of nonpublic information. 48 The SEC simply reduced the Cady, Roberts two-part test of a special relationship and unfairness to the single test of unfairness.4 9
The Merrill Lynch trilogy 0 imposed insider trading liability on
outsiders, such as brokers, who were thought to be virtually
equivalent to insiders because of their relationship with the issuer
and its shareholders.51 This outcome, however, was not justified on
the basis of a special, albeit temporary, relationship between the
outside trader and the corporation's shareholders, but on a view
that the securities laws should promote equal access to information.
As Texas Gulf Sulphur52 and the Merrill Lynch trilogy53 expanded the class of persons subject to the duty to disclose or abstain to include persons other than traditional insiders, the SEC in
In re Oppenheimer & Co.54 expanded the type of information that
would give rise to a Rule 10b-5 violation from strictly corporate information, which emanates from within a corporation and concerns that corporation's securities, to include market information,
which emanates from non-corporate sources and generally concerns trading markets for a corporation's securities, rather than the
securities' intrinsic value.55 In In re Oppenheimer, a broker-dealer
See id.
In a concurring opinion, SEC Commissioner Richard Smith took issue with the SEC
for focusing "on policing information per se and its possession," rather than "on policing
insiders and what they do." Id. at 648. Smith criticized the SEC's approach as impracticable and based "upon a concept-too vague for me to apply with any consistency-of relative informational advantages in the marketplace." Id. He premised liability instead on
the tippees derivatively, through their knowledge of the special relationship between
Merrill Lynch and Douglas and the fact that this relationship was the source of the nonpublic information. See id. at 649.
50 In Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, Inc., the third leg of the Merrill
Lynch trilogy, the court held that the defendants owed a duty to all persons who bought
Douglas stock during the period the sellers were disposing of their stock. 495 F.2d 228,
237 (2d Cir. 1974).
51 See also Ross v. Licht, 263 F. Supp. 395, 409 (S.D.N.Y. 1967) (defining a corporate
insider as one who has "such [a]relationship to the corporation that he had access to information which should be used 'only for a corporate purpose and not for the personal
benefit of anyone."' (quoting In re Cady, Roberts & Co., 40 S.E.C. 907,912 (1961))).
52 See discussion supra notes 29-36 and accompanying text.
53 See discussion supra notes 39-51 and accompanying text.
54 Exchange Act Release No. 12,319, [1975-1976 Transfer Binder] Fed. Sec. L. Rep.
(CCH) 80,551, at 86,414 (Apr. 2, 1976).
55 See id. at 86,415 n.2; see also United States v. Chiarella, 588 F.2d 1358, 1365 n.8 (2d
Cir. 1978) ("Examples include information that an investment adviser will shortly issue a
'buy' recommendation or that a large stockholder is seeking to unload his shares-or that
a tender offer will soon be made for the company's stock."), rev'd on other grounds, 445
U.S. 222,231 (1980).
48
49
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was charged with disclosing to institutional customers and other
persons that an article to appear in the "Heard on the Street" column of the Wall Street Journal would contain views of one of the
firm's research analysts that would adversely affect the market
price of AMF, Inc. common stock. 6 Although the SEC declined to
impose liability in this case of first impression, it stated that
"[tihere is today no question that the misuse of undisclosed, material 'market information' can be the basis of antifraud violations."57
2. Chiarella and Dirks
The possession theory was short lived as a basis for insider
trading liability. In 1980, in Chiarella v. United States,8 the Supreme Court rejected the parity of information rationale of the
possession theory and refocused the analysis of insider trading liability under Rule 10b-5 on concepts of fiduciary duty stemming
from the insider's relationship to the corporation's shareholders.
Vincent Chiarella worked as a "markup man" in a financial
printing house. 9 He was charged With purchasing securities in
companies that he learned were the targets of prospective tender
offers or mergers from nonpublic material he received in the
course of his employment.60 After the proposed merger or tender
offer was announced, Chiarella sold the shares in the target companies at a substantial profit.61 He was indicted and convicted on
seventeen counts of securities fraud in violation of section 10(b)
and Rule 10b-5.62
Chiarella argued in the district court that he could not be liable under the securities laws because neither he, nor his employer, had a fiduciary relationship to the target companies' shareholders. 6 3 He claimed that he did not have a duty to disclose
because the source of the information was the acquiring company.64 The district court rejected the view that section 10(b) requires that defendant breach a duty owed to the selling shareholders. 65 Relying instead on a single sentence from the legislative
[1975-1976 Transfer Binder] Fed. Sec. L. Rep. (CCH) at 86,415.
Id. at 86,415 n.4.
58 445 U.S. 222 (1980).
59 See Chiarella,445 U.S. at 224.
60 See id.
61 See id. at 222.
62 See id. at 225.
63 See United States v. Chiarella, 450 F. Supp. 95, 96 (S.D.N.Y. 1978).
64 See id.
65 See id. at 96-97 (contrasting Chiarella's personal misuse with legitimate business
purpose).
56
57
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CRITIQUE OF MISAPPROPRIATION THEORY
53
history of the 1934 Act, the court held that section 10(b) and Rule
10b-5 apply to "those manipulative and deceptive practices...
[that] fulfill no useful function." 66
The Second Circuit, in a divided opinion, affirmed Chiarella's
conviction,67 adopting the view that the securities laws "created a
system providing equal access to the information necessary for
reasoned and intelligent investment decisions. ' 6 Consequently, it
did not matter that Chiarella owed no fiduciary duty to the target's
shareholders who sold before the tender offer or merger was announced because he was under the duty to disclose or abstain as a
result of his "regular access to market information. ' 69 The Second
Circuit held: "Anyone-corporate insider or not-who regularly
receives material nonpublic information may not use that information to trade in securities without incurring an affirmative duty to
disclose. And if he cannot disclose, he must abstain from buying
or selling."70 Chiarella's possession of nonpublic information imposed upon him a duty to disclose or abstain.
The Supreme Court overturned Chiarella's conviction and
sought to put an end to the possession theory by reattaching to
section 10(b) the requirement of a special relationship between the
trader and the shareholders of the issuer corporation. 71 Justice
Lewis Powell, writing for the Court, rejected the Second Circuit's
notion that a person with regular access to nonpublic information
owes a duty to the market as a whole. 7 The Court stressed that
there is no policy of equal access to information underlying the securities laws that creates a general duty to disclose material, nonpublic information or refrain from trading.73 Rather, Chiarella's
silence in purchasing securities could constitute fraudulent activity
under section 10(b) only if it is "premised upon a duty to disclose
arising from a relationship of trust and confidence between parties
Id. at 97 (quoting S. REP. No. 73-792, at 6 (1934), reprinted in 5 LEGISLATIVE
ACT OF 1933 AND SECURITIES EXCHANGE ACT OF 1934
(J.S. Ellenberger & Ellen P. Mahar eds., 1973)).
67 See United States v. Chiarella, 588 F.2d 1358 (2d Cir. 1978), rev'd, 445 U.S. 222
(1980). Judge Meskill dissented in a separate opinion, writing that "[tioday's decision expands § 10(b) drastically [and] it does so without clear indication in prior law that this is
the most logical step on the path of judicial development of § 10(b) .
I..."
Id. at 1373.
68 Id. at 1362.
69 Id. at 1366.
70 Id. at 1365 (footnote omitted).
71 See Chiarella v. United States, 445 U.S. 222 (1980).
72 See id. at 232-33.
73 See id. at 233.
66
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to a transaction."74 Because Chiarella owed no duty to the sellers
of the target companies' securities, his transactions did not violate
section 10(b).75 After Chiarella, the mere possession of material,
nonpublic information could no longer serve as the basis of a sec76
tion 10(b) violation.
The Supreme Court reaffirmed its rejection of the possession
theory three years later in Dirks v. SEC.77 In 1973 Raymond L.
Dirks, a securities analyst at Delafield Childs, Inc. specializing in
insurance stocks, learned from a former employee of Equity
Funding Corporation of America ("Equity Funding") that its
management perpetrated a massive fraud and that one-third of
Equity Funding's life insurance policies might not actually exist.78
During Dirks' investigation of these charges, he repeated his findings to a number of his institutional customers, who then sold Equity, Funding securities. 79 Although neither Dirks nor Delafield
Childs traded Equity Funding securities, the SEC found that Dirks
aided and abetted violations of the securities laws by his selective
dissemination of information concerning the fraud at Equity
Funding. 0 The SEC held that nontrading tippees, such as Dirks,
must either disclose nonpublic information or refrain from trading
"[w]here 'tippees'-regardless of their motivation or occupationcome into possession of material corporate information that they
know is confidential and know or should know came from a corporate insider." 8 ' The SEC did not discuss the nature of the duty to
Equity Funding that its former employee and Dirks violated.
The United States Court of Appeals for the District of Columbia Circuit let stand the SEC's decision. 2 Judge J. Skelly
Id. at 230.
See id. at 232 ("No duty could arise from petitioner's relationship with the sellers of
the target company's securities, for petitioner had no prior dealings with them. He was
not their agent, he was not a fiduciary, he was not a person in whom the sellers had placed
their trust and confidence.").
76 See id. at 235. Two other Supreme Court cases in the late 1970s staunched the expansion of section 10(b) and Rule lOb-5 in other respects. In Ernst & Ernst v. Hochfelder,
the Court ruled that negligence would not suffice as a culpable state of mind under Rule
lOb-5. 425 U.S. 185, 214-15 (1976). In Santa Fe Industries v. Green, the Court held that a
breach of fiduciary duty by majority stockholders, without any deception, misrepresentation or nondisclosure, is not a violation of Rule lOb-5. 430 U.S. 462, 476 (1977).
77 463 U.S. 646 (1983), rev'g 681 F.2d 824 (D.C. Cir. 1982).
78 See In re Dirks, Exchange Act Release No. 17,480, [1981 Transfer Binder] Fed. Sec.
L. Rep. (CCH) 182,812, at 83,941 (Jan. 22,1981).
79 See id. at 83,942-44.
80 See id.
81 Id. at 83,945 (quoting Chiarella v. United States, 445 U.S. 222,230 n.12 (1980)).
82 See Dirks v. SEC, 681 F.2d 824 (D.C. Cir. 1982), rev'd, 463 U.S. 646 (1983).
74
75
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CRITIQUE OF MISAPPROPRIATION THEORY
55
Wright, a member of the panel, later issued an opinion that wrestled with the nature of the duty Dirks violated. 3 Judge Wright
first tried to cast Dirks in the role of a traditional insider, stating
that "the obligations of corporate fiduciaries pass to all those to
whom they disclose their information before it has been disseminated to the public at large."84 However, recognizing that Dirks'
informants may not have breached their fiduciary duties in exposing Equity Funding's corporate crimes, Judge Wright alternatively
held that it was Dirks's obligations to the SEC, "implicit in the
scheme of broker-dealer registration under the federal securities
laws," that provided the basis for imposing upon him a duty to disclose the information learned from his investigation."
By a six to three vote, the Supreme Court rejected the SEC's
argument that the mere possession of material, nonpublic information imposes upon the possessor a fiduciary duty to disclose or abstain from trading and reversed Dirks's conviction. 6 Writing for
the Court, Justice Powell noted that the SEC's position "differs little from the view [that the Court] rejected as inconsistent with
87
congressional intent in Chiarella."
88 JusAccordingly, as he did three years earlier in Chiarella,
tice Powell rejected the notion that a general duty to disclose or
abstain applied to all participants in market transactions and disapproved of the related notion that federal securities laws require
equal access to information among all traders.89 Justice Powell
again emphasized the requirement, first announced in Cady, Roberts,90 of a specific relationship between the corporation's shareholders and the person trading on inside information. 91
83 A judgment in this case issued before the published opinion simply stated that Dirks
"breached his duty to the SEC and to the public not to misuse insider information .... "
Id. Judge Robb concurred in the result, and Judge Tamm dissented without an opinion.
See id. at 828.
84 Id. at 839.
85 Id. at 840.
86 See Dirks v. SEC, 463 U.S. 646, 657-663 (1983).
87 Id. at 656.
88 445 U.S. 222 (1980); see discussion supra notes 72-76 and accompanying text.
89 See Dirks, 463 U.S. at 657.
90 40 S.E.C. 907 (1961); see discussion supra notes 21-26 and accompanying text.
91 See Dirks, 463 U.S. at 654 ("[T]here can be no duty to disclose where the person
who has traded on inside information 'was not [the corporation's] agent,.... was not a fiduciary, [or] was not a person in whom the sellers [of the securities] had placed their trust
and confidence."') (quoting Chiarella, 445 U.S. at 232 (1980)). Justice Powell also was
concerned that the activities of market analysts would be inhibited if the duty to disclose
or abstain were predicated merely on a person knowingly receiving material, nonpublic
information from an insider. See id. at 658.
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Moreover, not all disclosures of material, nonpublic corporate
information by an insider-tipper constitute a breach of duty. Instead, the Court held that there is a breach only if "the insider per' 92
sonally will benefit, directly or indirectly, from his disclosure. "
Having found that Dirks had no preexisting duty to the shareholders of Equity Funding and that the "whistle blower" did not receive a personal benefit in revealing Equity Funding's secrets to
Dirks, the Court concluded that Dirks had no duty, either directly
or derivatively, to abstain from using the information he obtained. 93
In Dirks, the Supreme Court restated the view it set out in
Chiarella that section 10(b) and Rule 10b-5 do not prohibit all
trading using material, nonpublic information. 94 Once again, the
limiting principle stressed by the Court was the requirement of a
specific relationship between the trader and the issuing corporation's shareholders.95 Accordingly, traditional insiders such as officers, directors, and controlling shareholders, who occupy a traditional fiduciary relationship with shareholders of the corporation,
have a duty to disclose material, nonpublic information before
92 Id. at 662. This "personal benefit test" may be met if "[tihe tip and trade resemble
trading by the insider himself followed by a gift of the profit to the recipient, or if the insider would gain a reputational benefit that would translate into future earnings, or if the
tipper is a stockholder and the tip tends to raise the stock's price." Id. at 663-64; see also
State Teachers Retirement Bd. v. Fluor Corp., 589 F. Supp. 1268, 1274 (S.D.N.Y. 1984)
("A tipper who owns stocks stands to benefit by tipping information that tends to raise the
stock's price."). But cf. In re Wentz, Administrative Proceeding File No. 3-6180, [1984
Transfer Binder] Fed. Sec. L. Rep. (CCH) 83,629, at 86,869 (May 15, 1984) (tip leading
to a rise in the stock's price is insufficient for liability where the record does not support a
finding of purpose or expectation on the part of the tipper). The requirement that the tipper's conduct be found to be improper was an expansion of prior law, which only focused
on whether the insider-tipper possessed material, nonpublic information and tipped someone who knew the quality of the information and the impropriety in acting on the information. See generally In re Investors Management Co., 44 S.E.C. 633 (1971); see discussion
supra notes 43-49 and accompanying text.
93 See Dirks, 463 U.S. at 667.
94 The Committee on Federal Regulation of Securities of the American Bar Association viewed the Court's decisions in Chiarellaand Dirks as representing:
[A] desire to protect a robust, if freewheeling, flow of information into the securities marketplace, even at the risk of individual instances of unfairness. This
macroeconomic, free-market perspective elevates market efficiency over the risk
of injury to individual investors and largely discounts the potentially corrosive
impact on the securities markets of a widespread fear of pervasive unfairness to
investors who do not have informational advantages.
Committee on Federal Regulation of Securities, Report of the Task Force on Regulation of
Insider Trading, Part I: Regulation Under the Antifraud Provisions of the Securities Exchange Act of 1934, 41 Bus. LAW. 223,225 (1985) ("Task Force Report"). Mr. Brodsky, a
co-author of this Article, was a member of the ABA Task Force.
95 See Dirks, 463 U.S. at 654.
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CRITIQUE OF MISAPPROPRIATION THEORY
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trading. 96 Also, lawyers, accountants, bankers, and others who
have a limited but special, confidential relationship with a corporation that gives them access to information intended only for corporate purposes may be "temporary insiders" who have a duty not to
trade in the corporation's securities until the confidential information has been disclosed. 9 Persons who do not have such a relationship to the shareholders of the issuer corporation, either directly or derivatively, are not under a duty either to disclose
material, nonpublic information or refrain from trading.98
II. THE MISAPPROPRIATION THEORY
The Supreme Court unequivocally rejected the parity of information rationale in Chiarellaand Dirks. While this stopped the
government from bringing prosecutions and enforcement actions
explicitly based on this rationale, or from arguing that mere possession of nonpublic information created a duty to disclose that information or abstain from trading, it did not prevent the emergence of another theory also premised on the notion of equal
information. Under the misappropriation theory, material, nonpublic information gained by the breach of any type of trust relationship creates a duty to disclose or abstain.
A. The Emergence of the MisappropriationTheory
The misappropriation theory grew out of an argument presented by the United States to the Supreme Court in Chiarella.99
As an alternate basis for supporting Chiarella's conviction, the
government argued that the Court could find that Chiarella, by
using information obtained in the course of employment, breached
a duty owed to his employer, i.e., the printer, and to his employer's
customers, i.e., the acquiring companies.1 0 Under this theory,
criminal liability under section 10(b) is extended to persons who
trade on information in violation of a duty to their employers, or
the corporations retaining their employers, even though they have
not violated a duty to persons with whom they trade. A majority
of the Court did not pass upon the sufficiency of this argument,
See id. at 653-54; Chiarella v. United States, 445 U.S. 222, 227 (1980).
See Dirks, 463 U.S. at 655 n.14.
98 See id. at 657.
99 445 U.S. at 235-37.
100 See Brief for the United States at 23-48, Chiarella v. United States, 445 U.S. 222
(1980) (No. 78-1202).
96
97
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finding that it was never presented to the jury.''
Chief Justice Burger, in his dissenting opinion in Chiarella,
concluded that the government's alternate argument had been
properly presented to the jury. 2 He voted to uphold Chiarella's
conviction, finding that "a person who has misappropriated nonpublic information has an absolute duty to disclose that information or to refrain from trading."'13 Chief Justice Burger based this
view of the federal securities law on the language of Rule 10b-5,
which applies to "any person engaged in any fraudulent
scheme. ' 104 He also noted that the two factors mentioned in Cady,
Roberts'015 that impose a duty to disclose on corporate insiders-access to information intended to be available only for a corporate
purpose and the inherent unfairness in trading on such information
when it is not public-do not necessarily limit the application of
federal securities laws to trading by corporate insiders who use
corporate information.1 °0 Chief Justice Burger did not mention
that the person who traded in Cady, Roberts was an employee of a
true insider of the issuer and did trade on corporate information. 70
In Chiarella,four members of the Court indicated that liability for
insider trading could be imposed in the absence of a preexisting
relationship between buyer and seller. 8
The Justice Department and the SEC were quick to explore
the possibilities of obtaining convictions for insider trading using
1
the misappropriation theory. 09
Soon after the Supreme Court's
decision in Chiarella, the government indicted James Mitchell
Newman and charged him with violating section 10(b) and Rule
101Chiarella, 445 U.S. at 237 n.21. Nevertheless, former Chief Justice Burger and Justices Brennan, Marshall and Blackmun, each indicated that they would be favorably disposed to imposing liability under section 10(b) where there was no breach of a duty arising
out of a fiduciary relationship between buyer and seller. See id. at 239 (Brennan, J., concurring); see id. at 240 (Burger, C.J., dissenting); see id. at 247 (Blackmun and Marshall,
J.J., dissenting). In addition, Justice Stevens, the potential fifth vote for the misappropriation theory, explicitly left this issue open, observing that "[riespectable arguments could
be made in support of either position." Id. at 238.
102 See id. at 243-45 (Burger, C.J., dissenting).
103 Id. at 240.
104 Id.
In re Cady, Roberts & Co., 40 S.E.C. 907 (1961).
See Chiarella,445 U.S. at 241-42.
107 See Cady, Roberts, 40 S.E.C. at 908-09.
108 See also Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 313 n.22
(1985) (characterizing Dirks as noting that "a tippee may be liable if he otherwise 'misappropriate[s] or illegally obtain[s] information').
109 In a swift reaction to Chiarella, the SEC promulgated Rule 14e-3, which makes it
unlawful for a tender offeror's tippee to purchase stock in a target company. See 17 C.F.R.
§ 240.14e-3 (1998).
105
106
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CRITIQUE OF MISAPPROPRIATION THEORY
59
0 for his role in purchasing shares in target companies
10b-5"1
based
on information about pending, but secret, mergers and acquisitions. 1 '
Newman obtained the information from his coconspirators, E. Jacques Courtois, Jr. and Adrian Antoniu, members of the mergers and acquisitions departments in the investment
banking firms Morgan Stanley & Co., Inc. and Kuhn Loeb & Co.,
respectively, who had misappropriated the information from their
employers.'
Although Newman was not an employee of either
investment banking firm, the government charged that he was liable because he "aided, participated in and facilitated Courtois
and Antoniu in violating the fiduciary duties of honesty, loyalty
and silence owed directly to Morgan Stanley, Kuhn Loeb, and clients of those investment banks." ' This language indicated the
government's view that an employee's act of fraud against an employer, when linked with the purchase or sale of securities, constitutes a Rule 10b-5 violation. It was an attempt to remedy the deficiency noted by the Supreme Court in Chiarella, where the
government failed to charge that Chiarella violated a duty to anyone other than the sellers of stock in the target companies. "4
The district court held that "there was no 'clear and definite
statement' in the federal securities laws which both antedated and
proscribed the acts alleged in [the] indictment" such as to give
Newman a reasonable opportunity to know that, absent an independent duty to disclose the nonpublic information, his conduct
would constitute fraud under section 10(b) or Rule 10b-5.15 The
court then dismissed the indictment, finding that Newman was not
under an independent duty to disclose the pending takeovers to
shareholders of the target corporations. The court stressed that
Newman had no connection with the target companies and that he
therefore lacked the special relationship with the shareholders of
the affected corporation required by the SEC in Cady, Roberts, to
110 See United States v. Courtois, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH)
98,024, at 91,287 (S.D.N.Y. 1981), rev'd sub nom. United States v. Newman, 664 F.2d 12
(2d Cir. 1981). Newman also was charged with violating the mail fraud statute, 18 U.S.C. §
1341 (1994). See Courtois, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) at 91,288.
111 See Courtois, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) at 91,288.
112 See id. Paragraph 9 of the indictment charged that the conspirators' actions operated as a fraud and deceit on Morgan Stanley, Kuhn Loeb, and those corporations and
shareholders on whose behalf the investment banking firms were acting and to whom they
owed fiduciary duties. See id. at 91,290 (quoting indictment).
113 Id. at 91,290 (quoting indictment).
114 United States v.Chiarella, 588 F.2d 1358, 1364 (2d Cir. 1978).
115 See Courtois, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) at 91,296.
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give rise to such a duty. 116
The United States appealed, and the Second Circuit, in an
opinion with broad implications, reversed the dismissal and remanded the case to the district court. 117 Using the misappropriation theory, the Second Circuit interpreted Rule 10b-5 to encompass virtually any activity that could be described as "operat[ing]
as a fraud or deceit upon any person 'inconnection with the purchase or sale of any security.""' 8
The Second Circuit's decision in Newman represents an expansion of earlier case law in three important respects. First, previous Supreme Court cases had established that not every instance
of fraud would constitute a violation under section 10(b) or Rule
10b-5-in other words, it was necessary that some element of deception, misrepresentation, or nondisclosure be present."9 Nevertheless, relying on the fact that the Chiarellamajority did not specifically rule on the viability of the misappropriation theory and
that Burger's dissent in Chiarella seemed to garner at least four,
116 See id. at 91,291. The court also noted that although Rule 14e-3 "undisputedly renders illegal the type of conduct allegedly engaged in by Newman," the text of that rule was
not released until September 4, 1980, approximately two years after the actions alleged in
the indictment ended. Id. at 91,292.
Rule 14e-3 provides, in pertinent part:
(a) If any person has taken a substantial step or steps to commence, or has
commenced, a tender offer (the "offering person"), it shall constitute a fraudulent, deceptive or manipulative act or practice within the meaning of section
14(e) of the Act for any other person who is in possession of material information relating to such tender offer which information he knows or has reason to
know is nonpublic and which he knows or has reason to know has been acquired
directly or indirectly from:
(1) The offering person,
(2) The issuer of the securities sought or to be sought by such tender offer,
or
(3) Any officer, director, partner or employee or any other person acting on
behalf of the offering person or such issuer, to purchase or sell or cause to
be purchased or sold any of such securities or any securities convertible into
or exchangeable for any such securities or any option or right to obtain or
to dispose of any of the foregoing securities, unless within a reasonable time
prior to any purchase or sale such information and its source are publicly
disclosed by press release or otherwise.
17 C.F.R. § 240.14e-3 (1998).
117 See United States v. Newman, 664 F.2d 12 (2d Cir. 1981).
118 Id. at 16-17.
119 See Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 472 (1977) (stating that section
10(b) violations must be based on deception); SEC v. Chenery Corp., 318 U.S. 80, 85-86
(1943) (same). The Supreme Court later reaffirmed this position in Chiarella, where it
held that "not every instance of financial unfairness constitutes fraudulent activity under
section 10(b)", 445 U.S. at 232, and again in Dirks, where it held that "even where permitted by [section 10(b)], one's trading on material nonpublic information is behavior that
may fall below ethical standards of conduct," 463 U.S. at 661 n.21.
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CRITIQUE OF MISAPPROPRIATION THEORY
61
possibly five, adherents, the Second Circuit's analysis of whether
Newman's activities violated section 10(b) is little more than a determination that Newman's cohorts' misappropriation of information from their employers constituted fraud. 120 As a result, the
opinion does not grapple with the nondisclosure issue that occupied the majority in Chiarella-whetherthe obligation to refrain
from trading is consistent with the fact that none of the defendants, i.e., Newman, the investment banking firm employees, the
firms themselves, or the firms' clients, were under a duty to disclose to the sellers of the target company securities that a takeover
attempt was about to occur. 121 The Newman court did not discuss
the implications of Chiarella'sholding that "[w]hen an allegation
of fraud is based on nondisclosure, there can be no fraud absent a
duty to speak.' ' 2 2 It also did not address the anomaly that disclosure by Newman would only have compounded the breach.
Second, earlier cases indicated that the federal securities laws
applied only when the victim was a purchaser or seller of securities. 123 The Newman court, however, fashioned a new variety of
securities fraud out of a breach of duty to a person, other than a
purchaser or seller of securities in the target companies, e.g., the
investment banking firms, or their clients, the acquiring companies. The court relegated the requirement of a defrauded buyer or
seller of securities to an element of standing,
required only of pri124
vate plaintiffs in civil actions for damages.
Third, the court diluted section 10(b)'s requirement that the
fraudulent activity be "in connection with" the purchase or sale of
securities. In one case, the Supreme Court had described the "in
connection with" test as being satisfied if the fraud "touch[es]" the
See Newman, 664 F.2d at 17-18.
The Second Circuit had earlier held that use by agents of an acquiring company of
confidential information learned in the course of employment to trade in securities of a
target company did not violate a duty to the target company's shareholders. See Moss v.
Morgan Stanley, Inc., 719 F.2d 5,13-14 (2d Cir. 1983). Cf. Feldman v. Simkins Indus., 679
F.2d 1299, 1304 (9th Cir. 1982) (holding that substantial, but not controlling, shareholder
does not owe a duty to other shareholders).
122 Chiarella, 445 U.S. at 235. But see Superintendent of Ins. v. Bankers Life & Cas.
Co., 404 U.S. 6, 10-11 n.7 (1971) (holding that "misappropriation is a 'garden variety' type
of fraud").
123 See, e.g., Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975); Birnbaum v.
Newport Steel Corp., 193 F.2d 461 (2d Cir. 1952) (Hand, J.).
124 Because the Supreme Court has held that standing in section 10(b) private actions is
limited to purchasers and sellers of securities, see Blue Chip Stamps v. Manor Drug
Stores, 421 U.S. 723 (1975), the misappropriation theory was not applicable to private actions until passage of ITSFEA in 1988. See Moss, 719 F.2d at 16.
120
121
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investor's purchase or sale of securities.'
In Newman, even
though the fraud was not perpetrated against persons in their capacities as purchasers or sellers, the court held that the "in connection with" requirement
was met based on a finding that Newman's
"sole purpose"'2 6 in misappropriating the information was to purchase stock in the target companies.1 27
In short, the Newman court shifted the analysis under section
10(b) away from the defrauded purchaser or seller of securities
and focused attention on the trader's relationship to the entity
from which the information was obtained. Under the misappropriation theory, almost any variety of fraud having even a remote
connection to the purchase or sale of securities could constitute a
violation of section 10(b) or Rule 10b-5. The effect of Newman's
holding was to transform section 10(b) and Rule 10b-5 from a prohibition against securities fraud into a general prohibition against
unfairness in the securities marketplace-a position that the Supreme Court explicitly rejected in both Chiarellaand Dirks.'28
In 1984 the Second Circuit restated its support of the misappropriation theory in SEC v. Materia,'2 9 a case with a factual scenario similar to that in Chiarella. Like Vincent Chiarella, Anthony
Materia was employed by a firm specializing in the printing of financial documents. And like Chiarella, Materia divined the identities of at least four tender offer targets from coded documents he
handled at work, purchased stock in those companies, and sold the
stock for a substantial profit after the offers were made public.'30
The SEC filed an enforcement action, charging that Materia violated sections 10(b) and 14(e) and Rules 10b-5 and 14e-3 by trading on material, nonpublic information that he misappropriated
See Bankers Life & Cas. Co., 404 U.S. at 12-13.
United States v. Newman, 664 F.2d 12, 18 (2d Cir. 1981).
See id. at 18. Judge Dumbauld did not join in this part of the court's opinion, noting
that recent Supreme Court decisions "seem to evince a trend to confine the scope of §
10(b) to practices harmful to participants in actual purchase-sale transactions." Id. at 20.
128 Chiarella and Dirks rejected the arguments that a duty to disclose arises from mere
possession of market information and that liability should be imposed whenever a person
trades on an informational advantage that is not legally available to others. See Dirks v.
SEC,463 U.S. 646, 657 (1983); Chiarella v. United States, 445 U.S. 222, 235 (1980); see also
David M. Brodsky, Insider Trading and the Insider Trading Sanctions Act of 1984: New
125
126
127
Wine Into New Bottles?, 41 WASH. & LEE L. REV. 921, 935 (1984); Task Force Report,
supra note 94, at 237 ("The task force believes that the lower courts' development of the
misappropriation theory since Chiarella and Dirks reflects less a reasoned application of
those decisions than a recognition of the significant regulatory gaps that would be created
if the Chiarella/Dirks analysis alone were strictly followed.").
129 745 F.2d 197 (2d Cir. 1984).
130 See id. at 199.
1998]
CRITIQUE OF MISAPPROPRIATION THEORY
63
from his employer and his employer's clients. 3' The district court
held Materia liable, finding that he breached a fiduciary duty owed
to his employer and its clients, enjoined Materia against future
violations, and ordered him to disgorge almost $100,000 in prof32
its.
On appeal, the Second Circuit affirmed the conviction in an
opinion that promised to "delineate the contours of what may still
be perceived as a novel theory of liability.' 33 The opinion, however, explains remarkably little about the misappropriation theory.
Like Newman, it ignored the problem inherent in imposing liability for fraudulent nondisclosure in the absence of a duty to speak.
Rather, relying on Chief Justice Burger's dissent in Chiarella, and
on a fragment of a sentence from the legislative history of the 1934
Act, the court concluded that section 10(b) constituted an "openended statutory scheme, capable of ongoing adaptation and refinement.' 34 This analysis essentially views section 10(b) as giving
the federal courts carte blanche to police informational inequities
in the marketplace whenever an element of fraud is present in the
135
equation.
As in Newman, the Second Circuit failed to analyze Materia's
relationship to the target companies' shareholders with whom he
traded and concluded that Materia violated federal securities laws
when he misappropriated information belonging to his employer
and to his employer's clients. 36 The court also dismissed the inquiry of whether Materia had "breached a duty to a particular
plaintiff," e.g., to the issuer's shareholders, as "germane only in the
context of private civil litigation,' 37 concluding that Materia's
breach of a fiduciary duty to his employer would constitute a suffi13
8
cient predicate for section 10(b) liability in a criminal action.
131 See id.
at 199-200.
See id. at 200.
133 Id. at 201.
134 Id. at 203.
135 The final sentence of the Materia opinion is an indication of the panel's broad view
of its role. Without further citation to legislative history, the court justified its view of section 10(b), writing: "We do not believe the drafters of the Securities Exchange Act of
1934--envisaging as they did an open and honest market-would have countenanced the
activities engaged in by Anthony Materia." Id.
136 See id. at 201-02; see S. REP. NO. 73-792, at 6 (1934), reprinted in 5 LEGISLATIVE
HISTORY OF THE SECURITIES ACT OF 1933 AND SECURITIES EXCHANGE ACT OF 1934,
supra note 66 (the 1934 Act prohibits "manipulative and deceptive practices which have
been demonstrated to fulfill no useful function").
137 Materia,745 F.2d at 202.
138 See id. at 203. But see Moss v. Morgan Stanley, Inc., 719 F.2d 5 (2d Cir. 1983) (dismissing private action by shareholders who sold stock to Newman and his cohorts for fail132
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This ruling disregards the fact that Chiarella concerned a criminal
conviction under section 10(b). It implies that the Supreme Court
in Chiarella, which reversed a criminal conviction on the basis of
an analysis that focused on the trader's duties to the target company's shareholders, relied on reasoning that is only relevant in a
private claim for damages. It is also notable that the opinion never
mentions the Supreme Court's decision in Dirks, which had been
decided between Newman and Materia.39
The Materia court also followed Newman in diluting the requirement under section 10(b) and Rule 10b-5 that the fraud be in
connection with the purchase or sale of a security. Finding that the
information Materia misappropriated had value only when used in
trading securities, and that the purpose of the scheme was to "reap
instant no-risk profits in the stock market," the court concluded
that the in connection with requirement had been met. 140
B. The Extension of the MisappropriationTheory
After Newman and Materia established the misappropriation
theory, it was broadened by courts within the Second Circuit to
cover breaches against nonmarket participants and breaches of duties outside of the employment context. The theory was also
adopted by courts outside of the Second Circuit.
1. Beyond Market Participants
A dramatic expansion of the misappropriation theory occurred in United States v. Carpenter.14"' R. Foster Winans, a reporter for the Wall Street Journal ("Journal") and one of the writers of the "Heard on the Street" column ("Column"), 142 was
charged with providing stockbrokers at Kidder Peabody with securities-related information scheduled to appear in the Column,
ure to establish a duty owed by defendants to plaintiffs).
139 See discussion supra notes 77-98 and accompanying text.
140 See Materia, 745 F.2d at 203; cf. Blue Chip Stamps v. Manor Drug Stores, 421 U.S.
723,731-33 (1975).
141 United States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986), affg in part and rev'g in
part United States v. Winans, 612 F. Supp. 827 (S.D.N.Y. 1985), affd in relevantpart by an
equally divided Court, 484 U.S. 19 (1987).
142 The court described the "Heard on the Street" column as:
[A] daily market gossip feature, which highlights a stock or group of stocks and
analyzes notable volumes of trading or price movements occurring in the market. The Heard column reports both negative and positive information about its
featured stocks, but also takes a point of view with respect to investment in the
stocks that it reviews.
Winans, 612 F. Supp. at 830.
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CRITIQUE OF MISAPPROPRIATION THEORY
65
which the stockbrokers subsequently used to buy or sell the subject securities ahead of the general investing public. 43 The district
court found Winans guilty of federal securities fraud in violation of
section 10(b) and Rule 10b-5. The court used the theory that Winans breached a fiduciary duty owed to his employer, the Journal,
and its parent company, Dow Jones & Co., when he misappropriated information concerning the "timing, content and tenor of
market-sensitive stories."'"
45
A divided Second Circuit affirmed Winans's convictions.1
The court noted that while there was no violation under Dirks, because neither Winans nor the Journal owed a duty to the corporations Winans wrote about; Dirks was not controlling because it did
not preclude the application of the misappropriation theory to future misconduct." Stressing the "broad remedial purposes of the
securities laws," the court held that misuse of corporate inside information is not the only type of fraud that the securities laws
cover but they apply to "all 'manipulative and deceptive practices
which have been demonstrated to fulfill no useful function. '" 147
The Supreme Court, by an evenly divided vote, upheld the convictions. 48
143 See Carpenter,791 F.2d at 1026.
144 Winans, 612 F. Supp. at 829.
145 See Carpenter,791 F.2d 1024. Judge Miner dissented, writing, "I am of the opinion
that the misappropriation theory cannot be interpreted so expansively as to encompass the
activities of these defendants." Id. at 1036 (Miner, J., dissenting).
146 See id. at 1029,
147 Id. at 1029-30 (quoting SEC v. Materia, 745 F.2d 197,201 (2d Cir. 1984); S. REP. No.
73-792, at 6 (1934), reprinted in 5 LEGISLATIVE HISTORY OF THE SECURITIES ACT OF
1933 AND SECURITIES EXCHANGE ACT OF 1934, supra note 66).
148 See Carpenter v. United States, 484 U.S. 19, 24 (1987). The opinion states only that
"[t]he Court is evenly divided with respect to the convictions under the securities laws and
for that reason affirms the judgment below on those counts." Id. at 24. The remainder of
the Court's opinion discusses the propriety of defendant's convictions under the mail and
wire fraud statutes, which the Court unanimously affirmed. Id.
After initiating judicial proceedings in United States v. Winans, the SEC and the Justice Department have continued to file injunctive actions and obtain indictments charging
violations of the federal securities laws under the misappropriation theory. See, e.g.,
United States v. David, [1986-1987 Transfer Binder] Fed. Sec. L. Rep. (CCH) 93,025, at
95,122, 95,124 (S.D.N.Y. Nov. 21, 1986) ("Under the rule of the Second Circuit, a party
who holds no fiduciary duty to the corporation or shareholders of the stock traded in may
nonetheless be held criminally liable for 'misappropriating material nonpublic information
in breach of an employer-imposed duty of confidentiality."') (citing Carpenter,791 F.2d at
1031); SEC v. Gaspar, [1984-1985 Transfer Binder] Fed. Sec. L. Rep. (CCH) 92,004, at
90,967, 90,979 (S.D.N.Y. Apr. 15, 1985) (a case where plaintiff's tips "breached his duties
of trust, loyalty and confidentiality" owed to his employer and "amounted to a misappropriation or theft of confidential corporate information"); SEC v. Karanzalis, [1984 Transfer Binder] Fed. Sec. L. Rep. (CCH) 91,415, at 98,059-60 (S.D.N.Y. Apr. 5, 1984) (issuing temporary restraining order against word processing supervisor -and document
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The Carpentercase represents an exceptionally broad use of
laws intended to prohibit insider trading in two respects. First, the
information in the Column was in no sense inside information. In
fact, all of the information contained in the articles was public information. It was only the fact of publication, date of publication,
and general tenor of the articles, not their informational content,
that was nonpublic. 49 The articles themselves also were not
fraudulent. They did not contain any misrepresentations and were
not published for the purpose of manipulating the price of stock.
Rather, the district court found that the articles were accurate to
the best of Winans's knowledge and the subject matter was chosen
on the basis of journalistic merit.5 0
Second, Winans was even more of an outsider than the defendants in other misappropriation cases,"' and the connection between Winans's fraud and the securities transactions that formed
the basis of the conviction were much more tenuous. In Newman
and Materia, the employers were temporary insiders of their clients, the acquiring companies, and owed those companies a duty
of loyalty and confidentiality.1 2 These duties passed on to their
employees, Newman's cohorts and Materia." 3 Although Newman
and Materia can be criticized for applying liability under section
10(b) where the defendants owed no duty to the issuer corporation's shareholders, and where the fraud was not perpetrated
against the buyer or seller of securities, at least those cases identified a duty running between defendants and entities connected in
some way to the securities transaction from which the defendants
were alleged to have wrongly profited.
proofreader at a law firm who were charged with violating Rule lOb-5 by "stealing confidential, material non-public information [from their employer] concerning proposed or
ongoing tender offers"); SEC v. Musella, 578 F. Supp. 425 (S.D.N.Y. 1984) (granting preliminary injunction against defendants who allegedly purchased options and stock on the
basis of information that an employee of a law firm misappropriated and tipped to them).
149 See Carpenter,484 U.S. at 24.
150 See United States v. Carpenter, 791 F.2d 1027 (2d Cir. 1986), aff'g in part and rev'g
in part United States v. Winans, 612 F. Supp. 827 (S.D.N.Y. 1985), affd in relevantpart by
an equally divided Court, 484 U.S. 19 (1987); Brief for Defendant-Appellant R. Foster Winans at 15-16, United States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986) (Nos. 85-1312, 851313, 85-1314); cf. Zweig v. Hearst Corp., 594 F.2d 1261 (9th Cir. 1979) (holding that journalist's false and misleading statements published about a company, which were imparted
by secret agreement with company directors with the intent to increase the price of the
company's stock, violated Rule lOb-5).
151 See SEC v. Materia, 745 F.2d 197 (2d Cir. 1984) (financial printer); United States v.
Newman, 664 F.2d 12 (2d Cir. 1981) (investment bankers working on mergers and acquisitions).
152 See Materia,745 F.2d at 200; Newman, 664 F.2d at 17-18.
'53 See Materia,745 F.2d at 200; Newman, 664 F.2d at 17-18.
1998]
CRITIQUE OF MISAPPROPRIATION THEORY
67
In Carpenter, by contrast, the Journal had no relationship
with, and owed no duty to, any of the companies about which Winans wrote. 54 Winans's misappropriation did not violate a duty
owed to any party engaged in the securities transactions that
formed the predicate for his conviction. 5 Carpentercould be read
to support the proposition that any embezzlement from one's employer, where the employee later uses the proceeds to purchase
stock, constitutes securities fraud. 56 If so, it is difficult to understand how the goal of section 10(b) and Rule 10b-5-"to protect
persons who are deceived in securities transactions"-is furthered
by application of the insider trading laws to these situations.'57
The Carpenter decision also results in illogical distinctions
concerning who may use the same information. Because the facts
used in the Column were public, anyone could have traded lawfully on the basis of the facts presented in them.'58 Had Winans
chosen not to write an article about a particular company, he could
have traded in that company's stock using the information obtained for the article. 9 Moreover, Winans' wrongful conduct was
based entirely on the Journal'sinternal policy that "deemed all...
material[s] gleaned by an employee during the course of employment to be company property" and required employees to treat
nonpublic information learned on the job as confidential. 6° If the
Journal had had no policy, or if it had had a different policy, Winans would not have been deemed to have violated the federal securities laws.' 61 It also would seem that Dow Jones, owner of the
Journal,could have traded on advance knowledge of the articles
without violating the federal securities laws. 62 After all, the Journal cannot misappropriate its own property. This result indicates
yet another extension of Newman and Materia, to where it would
have been unlawful for the defrauded employers, Morgan Stanley
154 See generally Brief for Defendant-Appellant R. Foster Winans at 14-19, United
States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986) (Nos. 85-1312, 85-1313, 85-1314).
155 See Carpenter,791 F.2d at 1033-34.
156 Cf. Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 943 (2d Cir. 1984)
(Friendly, J.) (holding that misrepresentation or omission involved in a securities transaction that does not pertain to the securities themselves cannot form the basis of a section
10(b) violation).
157 Id.
158 See Brief for Defendant-Appellant R. Foster Winans at 16, United States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986) (Nos. 85-1312, 85-1313, 85-1314).
159 See id.
Carpenter,791 F.2d at 1026.
161 See Brief for Defendant-Appellant R. Foster Winans at 16-17, United States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986) (Nos. 85-1312, 85-1313, 85-1314).
160
162 See id. at 18.
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and Bowne Printing Co., to have traded on the basis of the misappropriated information. Strange results indeed for a theory designed to bring about greater informational equality!
2. Beyond the Employment Context
The Second Circuit's decision in Carpenter was a' substantial
doctrinal shift from criminalizing breaches of fiduciary duties
against market participants to criminalizing breaches against the
broader universe of nonmarket participants. Carpenter,however,
confined it to the employment context. Other courts extended the
misappropriation theory to criminalize breaches of duties in contexts in which the expectations of the parties are very different
from those of parties in the employer-employee relationship. For
example, in United States v. Reed,'63 the court refused to dismiss an
indictment and held that the jury could find a son's breach of his
trust relationship with his father to be a sufficient basis for a section 10(b) indictment. 164 The son had used information from his
father concerning a merger proposal to make a profit trading in
the stock of the merged company. 165 The court looked to the
common law of confidential relationships and unjust enrichment
and determined that the familial relationship, which involved a history of shared information with the expectation of secrecy, was the
type of confidential relationship whose breach, in connection with
the purchase or sale of securities, creates criminal liability under
section 10(b). 166 Rejecting a narrower view of the reach of the securities laws, the court held that "the concept of 'confidential relationship,' born and reared in equity, is by nature flexible and defiant of precise definition."' 167
In a subsequent case, the Second Circuit rejected the government's claim that a husband's use of information from his wife's
family about the family business created a section 10(b) violation,
though it did not rule out breaches of familial duties as a source of
criminal liability under the federal securities laws. In United States
v. Chestman,68 the en banc Second Circuit reviewed the conviction
of a stock broker, Robert Chestman, under sections 10(b) and
14(e) and Rules 10b-5 and 14e-3(a). Keith Loeb, a client of
163
164
165
166
167
168
601 F. Supp. 685 (S.D.N.Y.), rev'd on other grounds, 773 F.2d 477 (2d Cir. 1985).
See id. at 737.
See id. at 690-91.
See id. at 712-18.
Id. at 704.
947 F.2d 551 (2d Cir. 1991).
1998]
CRITIQUE OF MISAPPROPRIATION THEORY
69
Chestman, informed Chestman that his wife-a member of the
Waldbaum family, owners of the Waldbaum supermarket chainhad told him that a controlling block of Waldbaum shares would
soon be sold to another company, A & P. Chestman purchased
Waldbaum stock for his own account and for the accounts of clients, including Loeb. After A & P's tender offer was publicly announced, the price of Waldbaum stock nearly doubled. An investigation into transactions in the stock ensued, and Loeb
cooperated with the government. Chestman was indicted for,
among other things, securities fraud, and was eventually convicted
by a jury. The Second Circuit, sitting en banc, upheld Chestman's
convictions under Rule 14e-3(a), but reversed those under section
10(b). The court held that Loeb's relationship with his wife's family-the source of the nonpublic information-was not a fiduciary
relationship or its functional equivalent. The court did leave the
door ajar for later cases involving familial breaches by distinguishing Reed as based on the repeated disclosure of business secrets between the father and son in that case. 69
In United States v. Willis,1 70 the misappropriation theory was
held to encompass a psychiatrist's use of information revealed by a
patient. The wife of Sanford Weill told her psychiatrist, Robert
Willis, about her husband's efforts to become CEO of BankAmerica, and Willis made a profit by purchasing shares in BankAmerica prior to the public announcement of Weill's failed effort
and selling them the day afterwards. The district court upheld the
indictment, which was premised on the misappropriation theory.
The court did not address the significant shift it was making by
bringing the physician/patient relationship within the purview of
the federal securities laws. Instead, the court focused on the confidential nature of such relationship, explaining that "[i]t is difficult
to imagine a relationship that requires a higher degree of trust and
1 71
confidence."
3. Beyond the Second Circuit
In the years following the Second Circuit's adoption of the
misappropriation theory, the theory was argued to courts in other
jurisdictions and was "welcomed by circuit and district court
alike.' ' 72 Indeed, in a two-year period, the theory was adopted by
169
170
171
172
See id. at 569.
737 F. Supp. 269 (S.D.N.Y. 1990).
Id. at 272.
SEC v. Clark, 915 F.2d 439, 448 (9th Cir. 1990).
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district courts in the United States Courts of Appeals for the Seventh and Tenth Circuits and by the Seventh and Ninth Circuits.'73
These decisions adopting the misappropriation theory are
noteworthy not just for their snowballing effect-each court's
adoption of the theory was used to justify adoption of the theory
by subsequent courts-but also for the minimal scrutiny applied
when considering the theory's legitimacy. The opinions rely on
United States v. Newman'74 without considering its soundness. Indeed, the Seventh Circuit went so far as to "decline to revisit" the
"issues of statutory construction and legislative history" raised by
the misappropriation theory because these issues had, said the
Seventh Circuit, been addressed by other courts.'75
C.
The Rejection of the MisappropriationTheory by
the Fourth Circuit
The first court of appeals to reject the misappropriation theory was the Fourth Circuit in United States v. Bryan.'76 In Bryan,
the director of the West Virginia state lottery was convicted of,
among other things, securities fraud for profiting by trading in
companies that were about to be awarded contracts to provide
goods and services to the lottery. In 1995, the Fourth Circuit reversed the securities fraud conviction in an opinion that rejected
the misappropriation theory of liability in its entirety. Following
the Supreme Court's approach in Central Bank, N.A. v. First Interstate Bank, N.A.,"' the Fourth Circuit closely read the text of section 10(b) and found that "neither the language of section 10(b),
Rule 10b-5, the Supreme Court authority interpreting these provisions, nor the purposes of these securities fraud prohibitions, will
support convictions resting on the particular theory of misappropriation adopted by our sister circuits."' 78 In particular, the court
held that the "deception" prohibited under section 10(b) was deception of persons with some interest in an actual securities transaction or deception in inducing persons to act or not act in rela173 See, e.g., SEC v. Cherif, 933 F.2d 403 (7th Cir. 1991); SEC v. Clark, 915 F.2d 439 (9th
Cir. 1990); SEC v. Peters, 735 F. Supp. 1505 (D. Kan. 1990); United States v. Elliott, 711 F.
Supp. 425 (N.D. Ill. 1989).
174664 F.2d 12 (2d Cir. 1981).
175Cherif, 933 F.2d at 410 n.5.
176 58 F.3d 933 (4th Cir. 1995). In United States v. ReBrook, a companion case to Bryan,
the Fourth Circuit reversed the section 10(b) convictions based on its holding in Bryan.
See 58 F.3d 961, 966 (4th Cir. 1995).
177511 U.S. 164 (1994). For discussion of Central Bank, see supra note 6.
178 Bryan, 58 F.3d at 944.
1998]
CRITIQUE OF MISAPPROPRIATION THEORY
71
tion to a securities transaction. The misappropriation theory,
however, was not based upon fraud connected to the securities
transaction. Rather, it
authorizes criminal conviction for simple breaches of fiduciary
duty and similar relationships of trust and confidence, whether
or not the breaches entail deception within the meaning of section 10(b) and whether or not the parties wronged by the
breaches were purchasers or sellers of securities, or otherwise
connected with or interested in the purchase or sale of securities.'79
The Court concluded that the misappropriation of information
from someone who had no connection to the securities transaction,
where no market participant is defrauded, is not the type of deceptive conduct that the federal securities laws were designed to prevent.
The Bryan court also relied upon the Supreme Court's statement in Central Bank that the securities market "demands certainty and predictability.' 80 It criticized the misappropriation theory as injecting substantial uncertainty, writing that "although
fifteen years have passed since the theory's inception, no court
adopting the misappropriation theory has offered a principled basis for distinguishing which types of fiduciary or similar relationships of trust and confidence can give rise to Rule 10b-5 liability
and which cannot."'181
D. The O'Hagan Case
James O'Hagan was a partner in the Minneapolis law firm of
Dorsey & Whitney. In July 1988 the firm was retained as local
counsel by British conglomerate Grand Metropolitan PLC
("Grand Met") in connection with a potential tender offer for the
common stock of the Pillsbury Company. O'Hagan himself did no
work in the transaction, and Dorsey & Whitney withdrew from
representing Grand Met in September. Less than a month after
the law firm's 2withdrawal, Grand Met announced its tender offer
18
for Pillsbury.
O'Hagan began purchasing call options for Pillsbury stock in
August 1988, while his firm was still representing Grand Met. By
the end of September, he owned 2,500 unexpired Pillsbury options,
179
180
181
182
Id.
Central Bank, 511 U.S. at 188 (quoting Pinter v. Dahl, 486 U.S. 622,652 (1988)).
Bryan, 58 F.3d at 951.
See United States v. O'Hagan, 117 S. Ct. 2199, 2205 (1997).
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apparently more than any other individual investor. 83 In addition,
O'Hagan bought some 5000 shares of Pillsbury in September for
just under $39 per share. In October, when Grand Met announced
its tender offer, the price of Pillsbury shares shot up to nearly $60,
and O'Hagan sold his holdings, resulting in a profit of more than
$4.3 million.
O'Hagan was investigated and indicted. The indictment alleged that O'Hagan defrauded his own law firm and its client
Grand Met "by using for his own trading purposes material, nonpublic information regarding Grand Met's planned tender offer."1 ,
O'Hagan was charged with various counts of mail fraud in violation of 18 U.S.C. § 1341, money laundering in violation of 18
U.S.C. § 1956(a)(1)(B)(i), as well as securities fraud in violation of
sections 10(b) and 14(e) of the Exchange Act, and Rule 14e-3(a).
The jury convicted O'Hagan on all counts.185
On appeal, the Eighth Circuit reversed O'Hagan's conviction,
holding that liability under section 10(b) could not properly be
premised upon the misappropriation theory because the theory
renders "nugatory the requirement that the 'deception' [required
under section 10(b)] be 'in connection with the purchase or sale of
any security."'186 The court held that section 10(b) requires "a
breach of a duty to parties to the securities transaction or, at the
most, to other market participants such as investors."'"
The
Eighth Circuit also reversed O'Hagan's conviction under Rule
14e-3(a), which prohibits trading on the basis of material, nonpublic information concerning a pending tender offer that the trader
knows or has reason to know, was obtained directly or indirectly
from an insider, or temporary insider, of the offeror or issuer.
Once again, focusing on the text of section 14(e) of the 1934 Act
and applying the methodology set out by the Supreme Court in
Central Bank, the Eighth Circuit held that the SEC had overstepped its rulemaking authority when, in promulgating Rule 14e183 "Each option gave him the right to purchase 100 shares of Pillsbury stock by a specified date in September 1988." Id.
184 Id. at 2205.
185 According to the indictment, O'Hagan started his insider trading scheme in order to
conceal his previous embezzlement and conversion of client funds, acts for which he was
later convicted in state court, sentenced to 30 months in prison, and fined. See Minnesota
v. O'Hagan, 474 N.W.2d 613 (Minn. Ct. App. 1991). In addition, the Minnesota Supreme
Court disbarred O'Hagan from the practice of law. See In re Disciplinary Action Against
O'Hagan, 450 N.W.2d 571 (Minn. 1990).
186 United States v. O'Hagan, 92 F.3d 612, 617 (8th Cir. 1996), rev'd 117 S. Ct. 2199
(1997).
187 Id. at 618.
1998]
CRITIQUE OF MISAPPROPRIATION THEORY
73
3(a), it failed to require proof of deception even though the term
188
fraud under section 14(e) requires a breach of fiduciary duty.
Resolving a circuit split, the Supreme Court reversed the
Eighth Circuit and held in accordance with the Second, Seventh,
and Ninth Circuits, 19 that proof of misappropriation of material,
nonpublic information could be the basis for a securities fraud
conviction either under section 10(b) or section 14(e). The Court
concluded that the misappropriation theory and the classical theory of insider trading "are complementary, each addressing efforts
to capitalize on nonpublic information through the purchase or
sale of securities.""' While the classical theory targets corporate
insiders who owe a duty to shareholders, "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."'' O'Hagan's breach
of trust that he owed to his law firm and its client, and his trading
on information gained by virtue of that trust, were held sufficient
to sustain his conviction.
The Court reasoned that the misappropriation of information
constituted, under section 10(b), "a 'deceptive device or contrivance' used 'in connection with' the purchase or sale of securities."' 192 The Court compared the misappropriation theory to the
common law rule that a trustee may not use the property that has
been entrusted to him without the owner's consent. Similarly, a
person who is entrusted with material,
nonpublic information may
93
not trade on it without disclosure.1
The Court further held with regard to the in connection with
requirement of section 10(b):
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
188 See id. at
624-27.
In O'Hagan, the Supreme Court cited United States v. Chestman, 947 .F.2d 551, 566
(2d Cir. 1991), SEC v. Cherif,933 F.2d 403,410 (7th Cir. 1991), and SEC v. Clark, 915 F.2d
439, 453 (9th Cir. 1990). See O'Hagan,117 S. Ct. at 2206 n.3.
190 O'Hagan,117 S. Ct at 2207.
191Id.
192Id. at 2208.
189
193
See id.
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party to the trade ....
E. A Critiqueof the MisappropriationTheory
The misappropriation theory transforms section 10(b) from a
statute focused on the fairness of the relationship between the
buyer and seller of securities, to one which provides for liability
based on a breach of a duty owed to individuals who are not connected with, and perhaps not even interested in, the securities
transaction.195 The traditional concept of insider trading concerns
fraud in relation to the two parties-the buyer and the seller-in a
securities transaction. The problem with the misappropriation
theory is that it replaces the relatively specific statutory requirement of deception in the course of a securities transaction in favor
of requiring only a breach of fiduciary duty between parties who
have a relationship quite apart from a securities transaction. Thus,
the theory "artificially divides into two discrete requirements-a
fiduciary duty breach and a purchase or sale of securities-the single [previously] indivisible requirement of deception upon the purchaser or seller of securities, or upon some other person intimately
linked with or affected by a securities transaction."' 196 In doing so,
the theory eliminates the rule that a party to the securities transaction be deceived and permits a defendant to be convicted where
not only no buyer or seller has been defrauded, but where no market participant at all has been deceived. The consequence of allowing the statutory fraud requirement to be satisfied by a breach
of fiduciary duty, whether or not the breach includes deceit, followed by an independent securities transaction is that the misappropriation theory transforms section 10(b) from a rule that governs relations among securities buyers and sellers to a federal
common law rule that also governs a variety of other trust relationships, leaving wide open the question of how far beyond the
traditional buyer-seller relationship section 10(b) will be allowed
to extend.
In determining what constitutes securities fraud, the SEC
194 Id. at 2209. A disagreement on this point was at the heart of a dissent by Justice
Thomas. Justice Thomas argued that the fraud in this case was the unauthorized taking of
information. That information could have been used for any number of purposes, thus the
fraud was complete when the information was taken. The subsequent trading was a separate transaction that was not in connection with the purchase or sale of securities. See id.
at 2223-24 (Thomas, J., dissenting); see also supra note 14.
195 See United States v O'Hagan, 92 F.3d 612, 618 (8th Cir. 1996), rev'd, 117 S. Ct. 2199
(1997).
196 United States v. Bryan, 58 F.3d 933, 950 (4th Cir. 1995).
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CRITIQUE OF MISAPPROPRIATION THEORY
75
might have treated securities fraud the same as other forms of
fraud. In other words, actors in the marketplace who have no duty
to whom they buy from, or sell to, would not be charged with fraud
for failure to divulge information that their trading partner does
not have. On the other hand, once the SEC and the courts determined that they will not limit themselves to the traditional notion
of fraud, the law of insider trading might have been limited by a
strict reading of the language in section 10(b).' 17 But, by its decision in O'Hagan, the Court has rejected this option as well. In
sanctioning the misappropriation theory, the Court has permitted
the possible scope of criminal insider trading prosecutions to be
open-ended.
As was true for the possession theory, the misappropriation
theory tries to fit cases involving unfair use of information by outsiders (such as tender offerors, reporters, psychiatrists, and family
members) into legal doctrines developed to apply to insider trading by corporate officials. 198 The wrongful use of information by
outsiders, however, presents distinct concerns, that are not adequately addressed by the elastic contours of the misappropriation
doctrine.
First, stock trading by true insiders is appropriately governed
by a rule against fraud because such conduct is fraudulent under
common law standards. Traditionally, an insider's duty not to
trade on the basis of material, nonpublic information was premised
upon the special circumstances of the insider's position as fiduciary
on behalf of the corporation's shareholders. As a fiduciary, the insider holds the shareholder's property in trust. When insiders have
information that affects the value of that property, they are obligated as fiduciaries either to disclose the information or not to
trade on it for their personal advantage if they choose not to disclose. In essence, the disclose or abstain rule is an acknowledgment of the insider's preexisting fiduciary duty to the corporation's
shareholders.
The duty breached by persons found liable under the misappropriation theory is different from the duty arising out of an insider's relationship to the corporation's shareholders and is dissociated from any concomitant disclosure duty to shareholders. In
the "misappropriation" cases, the duty not to steal from one's employer, not to tarnish the employer's reputation, or not to betray
197 But cf. Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511
U.S. 164 (1994).
198 See Freeman, supra note 17.
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the confidence of a patient or family member did not also include
an obligation to the shareholders of the corporation whose securities were being traded. Owing no duty to the issuer's shareholders,
these outsiders were under no preexisting duty to speak, and application of a rule requiring them to disclose the information to the
issuer's shareholders or refrain from trading does not make sense.
In fact, in each of the "misappropriation" cases, early disclosure of
the misappropriated information would have further harmed the
person or entity to whom the duty was owed.199
Second, the misappropriation theory changes section 10(b)
from a statute focused on protecting investors in securities to one
protecting sources of nonpublic information. This is because the
misappropriation theory is not premised upon the relationship between the possessor of inside information and the purchaser or
seller of securities who may be on the other side of the trade, but
focuses instead on the relationship between the person who possesses information and the person or entity from whom the information was obtained. Under the misappropriation theory, possessing someone else's information creates a duty to disclose or
abstain, not because the trader is an insider who owes a duty to the
issuer's shareholders, nor because of the harm to the trading counterpart who lacks the information, but because the trader has violated a duty to a person or entity possessing nonpublic information.2°° In enforcing the misappropriation theory, the courts, and
now the Supreme Court, have criminalized violations of private arrangements. 01 By basing the breach of duty in the property rights
to information, the misappropriation theory uncouples the deception requirement from the in connection with a securities transaction requirement of section 10(b). As a result, the fraud that is the
199 See Brodsky, supra note 128, at 935; Loss, supra note 18, at 869-70 n.40 (Supp.
1984); Richard M. Phillips, Insider Trading Liability After Dirks, 16 REV. SEC. REG. 841,
845-46 (1983).
200 See United States v. Libera, 989 F.2d 596, 600 (2d Cir. 1993) ("[T]he purpose of the
misappropriation theory ... is to protect property rights in information.") (citing United
States v. Chestman, 947 F.2d 551, 576-78 (2d Cir. 1991) (winter, J., concurring and dissenting)). Oddly, the other members of the panel who joined Judge Winter's opinion in
Liberia had been in the majority in Chestman, in which Judge Winter's reliance on the
property rights rationale was written in dissent.
201 For example, in United States v. Carpenter,the prosecution was premised on the reporter's use of information gained in the course of his employment in violation of the
Journal'sinternal policy. See United States v. Carpenter, 791 F.2d 1024, 1026 (2d Cir.
1986). See generally John C. Coffee Jr., From Tort to Crime: Some Reflections on the
Criminalizationof FiduciaryBreaches and the Problematic Line Between Law and Ethics,
19 AM. CRIM. L. REV. 117 (1981) (discussing the failure of the courts to require that the
fiduciary's conduct have caused harm in legal terms to the beneficiary).
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CRITIQUE OF MISAPPROPRIATION THEORY
77
basis for insider trading liability now need not have any connection
to the issuer or its shareholders.
Part of the problem with the O'Haganopinion is that the facts
of the case were so egregious and the defendant's "guilt," in the
sense that he knew what he was doing was both illegal and wrong,
was so clear. Even a novice lawyer knows that the use of information gained from a client to trade securities is forbidden. Most law
firms-certainly those such as Dorsey & Whitney that regularly
represent clients involved in tender offers-have written policies
banning the use of client information, going as far as requiring advance clearance of trades in order to prevent an apparent, though
inadvertent, violation of the rule. Then comes O'Hagan, clearly
flouting the rule (if not, in the Eighth Circuit's view, the federal
securities laws), yet having his convictions for securities fraud reversed notwithstanding the fact that he must have understood at
the time that his conduct was illegal. 2
O'Hagan, however, may be an instance of a case with bad
facts creating bad law. In classical insider trading cases, a person
need only avoid trading in shares of corporations in which he or
she is an insider. But whether one has a duty to a company of
which one is not (and has never been) an insider, is often a complex question of fact that will often be resolvable only in hindsight.
Put a different way, investors and market professionals know the
firms of which they are insiders. They may not, however, especially in the context of rapid-fire trading decisions or short term
analysis, know whether they have learned nonpublic information
from non-insiders in a way that will be later judged inappropriate.
Future applications of the theory will require traders and the
courts to consider several questions. First, what relationships will
be protected such that a breach of a duty between the parties may
be a basis for a section 10(b) prosecution? Second, what conduct
will constitute misappropriation of information as opposed to the
lawful taking or use of it?
The Supreme Court's decision in O'Hagan does not answer
these questions. The Court refers to a person who "misappropriates confidential information.., in breach of a duty owed to the
source of the information." 203 As noted, O'Haganwas an easy case
202 The Eighth Circuit was careful to state that the lawyer's conduct was "certainly unethical and immoral and must be condemned," even though it was not unlawful under section 10(b). United States v. O'Hagan, 92 F.3d 612, 628 (8th Cir. 1996), rev'd, 117 S.Ct.
2199 (1997).
203 O'Hagan,117 S. Ct. at 2207.
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in the sense that the attorney-client relationship has long been understood as one that requires absolute confidence and discretion.
The defendant in that case appropriated information he was not
supposed to use at all (since he had no role in the representation of
the client) and used it for a purpose that was improper, regardless
of how the information came into his possession. But what about
other cases, both those already adjudicated and those yet to come?
The Court's decision in O'Hagan offers scant guidance on who
may be prosecuted and what conduct might lead to an indictment.
Consider the case of a securities analyst whose business it is to
gather and disseminate information about particular companies.
If, during a visit to a company, the analyst overhears employees
talking about as yet unpublished quarterly results, can the analyst
then share that information with his own brokerage firm and the
firm's clients? If the analyst does, can the brokerage firm and its
traders be held liable for insider trading as having misappropriated
the company's confidential information? The answer depends on
whether the analyst owes the employee (or his company) a duty
and whether using the information is considered a form of misappropriation. The answer may also depend on whether the analyst's
own firm had a policy concerning the use of inadvertently disclosed information and whether the analyst's actions violated that
policy.
Given the nature of their work, securities analysts and other
market professionals often gain at least temporary informational
advantages over other traders in the public markets. The analyst
knows she is not an insider in the traditional sense. But whether
information she has gained through research or through her relationship with employees or executives in the companies she follows is deemed misappropriated will often be a difficult judgment
call.
Consider also the daughter of the chief financial officer of that
same company.20 If she overhears a phone call between her father
and a member of the company's board of directors, can she trade
on the information? It would depend on whether she owes her father a duty, and whether, in this context, she was obligated not to
use what she learned, whether inadvertently or not, for her personal gain. Finally, would the psychologist who treats the wife of
that employee be liable if he traded on information learned from
204 See, e.g., United States v. Reed, 601 F. Supp. 685 (S.D.N.Y. 1985) (discussed supra in
text accompanying note 163).
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CRITIQUE OF MISAPPROPRIATION THEORY
79
his patient, as in United States v. Willis?0 5 While the relationship
between the doctor and his patient is certainly based on confidence, it is not a fiduciary relationship of the kind referred to in
O'Hagan. We cannot even predict with any certainty how Chiarella would be decided today, in that the relationship between a
financial printer's markup man and its customer may be based on
confidence, but it is not a fiduciary relationship. 7 In short, the
Supreme Court's opinion, while certainly allowing the use of the
misappropriation theory in a traditional context, does little to
clarify the scope or extent of the theory. Thus, the Court does not
satisfy its own test as the misappropriation theory as set out in
O'Hagan fails to provide "'certainty and predictability'.., to
those who provide services to participants in the securities busi208
ness."
This broad view of fraud employed by the misappropriation
theory renders application of the securities laws difficult to predict.2 9 Section 10(b) and Rule 10b-5 may be read to encompass
205 737 F. Supp. 269 (S.D.N.Y. 1990). For discussion of Willis, see supra note 170 and
accompanying text.
206 For discussion of Chiarella,see supra notes 58-76 and accompanying text.
207 The result in a case like Chiarella may depend on whether or not the printer had
promulgated a formal rule in the workplace forbidding its employees from trading on customer information.
208 Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164, 188 (1994) (quoting
Pinter v. Dahl, 486 U.S. 622, 652 (1988)).
209 Reliance on the SEC to provide predictability and reasonable limitations is not only
improper in the context of criminal prosecution, but is also historically unreliable. See
Dirks v. SEC, 463 U.S. 646, 664 n.24 (1983) ("Without legal limitations, market participants are forced to rely on the reasonableness of the SEC's litigation strategy, but that can
be hazardous, as the facts of this case make plain."). As SEC Commissioner Hamer
Budge stated:
Turning to the realm of possible defendants in the present and potential civil actions, the Commission certainly does not contemplate suing every person who
may have come across inside information. In the Texas Gulf action neither tippees nor persons in the vast rank and file of employees have been named as defendants. In my view, the Commission in future cases normally should not join
rank and file employees or persons outside the company such as an analyst or
reporter who learns of inside information.
Commissioner Hamer Budge, Speech to the New York Regional Group of the American
Society of Corporate Secretaries, Inc. (Nov. 18, 1965), quoted in Dirks, 463 U.S. at 664-65
n.24. Compare id. with Director of the Division of Enforcement John R. Fedders, Address
at the Compliance and Legal Seminar of the Securities Industry Association (Apr. 26,
1982) (stating that the SEC's goal is to eliminate, under the banner of unfairness, all trading by persons in possession of material, nonpublic information). See also Dirks Victory in
Supreme Court Will Have Limited Impact, SEC Says, 15 Sec. Reg. & L. Rep. (BNA) 129394 (July 8, 1983) (reporting that SEC states that the Supreme Court's decision in Dirks
would not inhibit its enforcement efforts); Senate Hearings on S.910 Before the Senate
Subcomm. on Securities, 18th Cong., 2d Sess. 15 (1984) (asserting that insider traders include persons who misappropriate information) (statement of John S.R. Shad, Chairman,
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any activity that can conceivably be described as fraudulent or unfair and that involves subsequent trading on information that is
"wrongfully" obtained. By injecting unclear notions of unfairness
into the federal securities laws, the misappropriation theory fails to
provide a clear or rational standard for determining whether trading on the basis of informational advantages may lead to liability.210
This raises a significant constitutional concern. Due process requires that people be fairly apprised whether certain actions are
illegal. "The underlying principle is that no man shall be held
criminally responsible for conduct which he could not reasonably
understand to be proscribed."21' While the courts have also found
the principle of fair notice to be violated in the civil context,"' the
threat of criminal liability, with its attendant loss of liberty and/or
property, requires heightened due process scrutiny." 3
A corollary concern addressed by the fair notice requirement
of due process is the inhibiting effect that unclear application of
laws can cause. "Uncertain meanings inevitably lead citizens to
"'steer far wider of the unlawful zone".., than if the boundaries
of the forbidden areas were clearly marked."'214 In the securities
context, this translates into market inefficiency, with traders acting
overly cautious in their use of superior information for fear of liability. The Supreme Court has recognized this as an "inhibiting
influence on the role of market analysts"
presenting a threat to
21 5
market."
healthy
a
of
"the preservation
SEC). But cf. Dirks, 463 U.S. at 658 n.17 ("Unless the parties have some guidance as to
where the line is between permissible and impermissible disclosures and uses, neither corporate insiders nor analysts can be sure when the line is crossed.").
210 In the misappropriation cases, the employer almost always has resort to civil remedies against the employee who breaks rules of confidentiality. As the securities aspect of
these cases is merely incidental to the wrongful conduct, it is questionable whether they
present situations that should be addressed by federal law, rather than state law.
211 United States v. Harriss, 347 U.S. 612, 617 (1954) (footnote omitted).
212 See, e.g., Cramp v. Board of Pub. Instruction, 368 U.S. 278, 285-288 (1961) (holding
statute requiring state employees to take broadly-worded loyalty oath unconstitutionally
vague); Connally v. General Constr. Co., 269 U.S. 385, 391 (1926) (holding that unclear
civil statute "violates the first essential of due process of law"); Georgia Pac. Corp. v. Occupational Safety & Health Review Comm'n, 25 F.3d 999, 1005-06 (11th Cir. 1994) (holding civil safety regulation unconstitutionally vague).
213 See Papachristou v. City of Jacksonville, 405 U.S. 156 (1972) (applying strict due
process scrutiny to criminal statute and holding it unconstitutionally vague); Coates v. City
of Cincinnati, 402 U.S. 611 (1971) (same); Lanzetta v. New Jersey, 306 U.S. 451,458 (1939)
(same); Cline v. Frink Dairy Co., 274 U.S. 445, 465 (1927) (same); International Harvester
Co. of Am. v. Kentucky, 234 U.S. 216, 223-24 (1914) (same).
214 Grayned v. City of Rockford, 408 U.S. 104, 109 (1972) (quoting Baggett v. Bullit, 377
U.S. 360, 372 (1964)) (footnote omitted).
215 Dirks v. SEC, 463 U.S. 646, 658 (1983) (footnote omitted). Even the Second Cir-
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CRITIQUE OF MISAPPROPRIATION THEORY
81
CONCLUSION
While it is true that the traditional fraud-based theory of insider trading has failed to prohibit all instances of unfair informational advantages in the securities markets, the misappropriation
theory, with its elastic construction of section 10(b)'s deception
and in connection with requirements, has substantial problems of
its own. By severing the link between the fraud and the securities
trade at issue, the misappropriation theory brings within its scope
parties who have no connection with issuers or their shareholders,
while premised upon breaches of duty that have nothing to do with
the securities markets. It creates irrational distinctions, where
some forms of familial, employment, or professional relationships,
ranging from the implicit to the highly formalized, may create a
duty to disclose or refrain from trading, whereas other relationships in which the expectations of trust are deemed diminished do
not create such a duty. The end result is that the application of the
federal securities laws is less predictable and market participants
are given insufficient guidance regarding when it is proper to buy
or sell securities while possessing nonpublic information.
cuit-the Court with the longest history of supporting the misappropriation theory-has
recognized the due process problems inherent in the theory. Rejecting misappropriation
convictions based on inter-family communications, the Court in United States v. Chestman
described due process as meaning that reliance on "an elastic and expedient definition of
confidential relationships.., has no place in the criminal law." 947 F.2d 551, 570 (2d Cir.
1991); see also id. at 582 (Miner, J., concurring) (noting confusion over reach of section
10(b) if extended to family relationships and concluding that "[t]he [liability] net would be
spread wider than appropriate in a criminal context" (citation omitted)).