==========================================START OF PAGE 1====== UNITED STATES COURT OF APPEALS FOR THE EIGHTH CIRCUIT ____________________________________________ Nos. 94-3714 and 94-3856 _____________________________________________ UNITED STATES OF AMERICA, Appellee/Cross-Appellant, v. JAMES HERMAN O'HAGAN, Appellant/Cross-Appellee. ____________________________________________ ON APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF MINNESOTA _____________________________________________ BRIEF OF THE SECURITIES AND EXCHANGE COMMISSION, AMICUS CURIAE, IN SUPPORT OF THE PETITION OF THE UNITED STATES FOR REHEARING AND SUGGESTION FOR REHEARING IN BANC _____________________________________________ The United States has filed a petition seeking rehearing, and suggesting rehearing in banc, of the panel decision in this case reversing defendant O'Hagan's convictions for securities fraud and other securities law violations, for mail fraud, and for money laundering. The Securities and Exchange Commission urges this Court to vacate the panel decision and rehear the case. By a two-to-one vote, the panel invalidated two tools which have been central to the government's efforts to fight insider trading. Judge Fagg, dissenting, would have upheld the validity ==========================================START OF PAGE 2====== of both tools, and affirmed the convictions. The panel majority erred in both holdings. -[1]- The first tool invalidated was the so-called "misappropriation theory" of insider trading. The theory, which has been adopted by three courts of appeals, and rejected by one other court of appeals, is a linchpin in the efforts of the United States and of the Securities and Exchange Commission to combat insider trading. The theory has in the past fifteen years been used in scores of civil and criminal cases. These cases include some of the most notorious securities fraud cases of that period. -[2]- It is of particular importance in the civil law enforcement efforts of the Commission, in which the wire and mail fraud statutes are not available. Were the panel's rejection of the theory to be widely accepted, it would substantially cripple the Commission's efforts to protect investors and the integrity of the securities markets against insider trading. ---------FOOTNOTES---------- -[1]- Although the Commission addresses in this brief only the issues that are within its area of expertise -- the securities law violations -- the Commission supports the petition of the United States to rehear the mail fraud and money laundering issues. -[2]- See, e.g., SEC v. Drexel Burnham Lambert Inc., [1989 Transfer Binder] Fed. Sec. L. Rep. (CCH) 94,474 (S.D.N.Y. June 20, 1989)(consent judgment); SEC v. Siegel, [1987 Transfer Binder] Fed. Sec. L. Rep. (CCH) 93,123 (S.D.N.Y. Feb. 13, 1987)(consent judgment); SEC v. Boesky, No. 86 Civ. 8767 (S.D.N.Y. Nov. 14, 1986)(consent judgment); SEC v. Levine, No. 86 Civ. 3726 (S.D.N.Y. May 12, 1986)(consent judgment). ==========================================START OF PAGE 3====== Under the misappropriation theory a person commits securities fraud in violation of the antifraud provisions of Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. 78j(b), and Rule 10b-5 thereunder, 17 C.F.R. 240.10b-5, when he deceitfully misappropriates material non-public information in connection with securities trading. The violation occurs when that person, who has been entrusted with confidential information by another, misappropriates the information by trading in breach of a fiduciary or similar duty of confidentiality owed to the other person. -[3]- The theory has been an essential tool in the situation presented here -- where a person entrusted with confidential information by a bidder about a takeover bid buys securities in the target company. The theory applies where the person is not an insider of the target, and therefore is not liable under the so-called "classical" theory of insider trading because he owes no duty to the target's shareholders. Under that theory corporate insiders (including temporary insiders such as lawyers) owe their shareholders (or prospective shareholders) a duty not to disadvantage them and to make full disclosure when trading in the company's securities with them, and thus commit fraud by trading with them without disclosing the non-public information. See Chiarella v. United States, 445 U.S. 222 (1980). ---------FOOTNOTES---------- -[3]- A violation could also occur where the person first misappropriates the information and then trades. ==========================================START OF PAGE 4====== The misappropriation theory has been applied to officers and directors of the bidding company, and persons, such as officials of brokerage and investment banking firms, and lawyers, retained by the bidder, who purchase securities in the target. That is the situation here. Defendant O'Hagan misappropriated information from his law firm and its client about the client's plans to make a tender offer for securities of the target company in which O'Hagan traded. Three courts of appeals -- the Second, Seventh, and Ninth Circuits -- have expressly adopted the misappropriation theory. -[4]- Congress, in two amendments to the insider trading remedy provisions of the securities laws, has confirmed that the misappropriation theory is in accord with Section 10(b), a ---------FOOTNOTES---------- -[4]- See, e.g., SEC v. Cherif, 933 F.2d 403 (7th Cir. 1991), cert. denied, 502 U.S. 1071 (1992); SEC v. Clark, 915 F.2d 439 (9th Cir. 1990); United States v. Libera, 989 F.2d 596 (2d Cir.), cert. denied, 510 U.S. 976 (1993); SEC v. Materia, 745 F.2d 197 (2d Cir. 1984), cert. denied, 471 U.S. 1053 (1985); United States v. Newman, 664 F.2d 12 (2d Cir. 1981), cert. denied, 464 U.S. 863 (1983). See also Rothberg v. Rosenbloom, 771 F.2d 818, 822 (3d Cir. 1985), rev'd after remand, 808 F.2d 252 (1986), cert. denied, 481 U.S. 1017 (1987). The misappropriation theory had its genesis in the Supreme Court's decision in Chiarella. In Chiarella, the theory had not been presented to the jury and thus was not ruled upon in the opinion for the Court. Four Justices addressed the theory in concurring and dissenting opinions, and suggested that insider trading liability could be premised on a theory of stolen or misappropriated information about upcoming stock market events. ==========================================START OF PAGE 5====== circumstance overlooked by the panel. -[5]- In 1995, the Fourth Circuit rejected the theory as inconsistent with the requirements of Section 10(b). United States v. Bryan, 58 F.3d 933, 945 (4th Cir. 1995). In rejecting the theory in the present case the panel majority, relying heavily on the Fourth Circuit's Bryan decision, erred in two fundamental respects. First, it incorrectly believed that the misappropriation theory applies to non- deceptive conduct. To the contrary, the theory does require deception, and deception was alleged and proven here. Second, the panel held that the fraud here was not "in connection with" the purchase or sale of securities, as required under Section 10(b) and Rule 10b-5. But O'Hagan misappropriated information about a client's plans to make a tender offer -- a securities ---------FOOTNOTES---------- -[5]- The House Report accompanying the Insider Trading Sanctions Act of 1984 cited the Second Circuit's decision in Newman with approval, noting that the law in this area is "well developed." H.R. Rep. No. 355, 98th Cong., 1st Sess. 13 (1983). The Report explained that "[i]n other areas of the law, deceitful misappropriation of confidential information by a fiduciary * * * has consistently been held to be unlawful," and added that Congress "has not sanctioned a less rigorous code of conduct under the federal securities laws." Id. at 5. See also H.R. Rep. No. 910, 100th Cong., 2d Sess. 26-27 (1988), accompanying Insider Trading and Securities Fraud Enforcement Act of 1988 (the misappropriation theory "fulfills appropriate regulatory objectives in determining when communicating or trading while in possession of material nonpublic information is unlawful"). Whatever the original intent of the 1934 Congress that passed the Securities Exchange Act, modern Congresses have ratified the interpretations of the courts of appeals that the panel of this Court rejected. ==========================================START OF PAGE 6====== purchase -- for the very securities in which O'Hagan traded. Such fraud on a market participant plainly is "in connection with" a securities purchase. Moreover, the panel did not address the argument, accepted by other courts of appeals, that because the purpose and objective of a misappropriation of confidential information is to use that secret information to buy or sell securities, such conduct satisfies the "in connection with" requirement. The panel also invalidated Commission Rule 14e-3, 17 C.F.R. 240.14e-3, which contains a prohibition against trading while in possession of material confidential information about a tender offer, regardless of whether the trading breaches a duty, as required under Section 10(b) and Rule 10b-5. In so holding, the panel majority disagreed with every other court of appeals to have considered the issue. Those courts -- the Second, Seventh and Tenth Circuits -- all have upheld the rule as within the Commission's rulemaking authority. -[6]- In holding otherwise, the panel erroneously believed that the Commission may only adopt rules under Section 14(e) of the Exchange Act, 15 U.S.C. 78n(e), which prohibit conduct that involves a breach of duty. The panel misconstrued that section's rulemaking grant, disregarding the express language in Section 14(e), overlooking ---------FOOTNOTES---------- -[6]- United States v. Chestman, 947 F.2d 551, 564 (2d Cir. 1991)(en banc), cert. denied, 503 U.S. 1004 (1992); SEC v. Maio, 51 F.3d 623 (7th Cir. 1995); SEC v. Peters, 978 F.2d 1162 (10th Cir. 1992). ==========================================START OF PAGE 7====== its derivation, and overlooking Congressional statutory endorsement of the rule. ARGUMENT I. THE PANEL MAJORITY INCORRECTLY BELIEVED THAT THE MISAPPROPRIATION THEORY DOES NOT REQUIRE DECEPTION, AND THAT FRAUD ON A TENDER OFFEROR IS NOT "IN CONNECTION WITH" SECURITIES TRADING. The panel majority's rejection of the misappropriation theory is based on two critical errors. First, the panel incorrectly believed that the theory applies to non-deceptive conduct, and thus does not require a showing of fraud. The panel overlooked clear language in decisions adopting the theory that it only applies to deceptive acts, and Supreme Court authority that the conduct at issue is fraudulent. Second, the panel adopted a unique restricted interpretation of the requirement in Section 10(b) and Rule 10b-5 that the fraud be "in connection with" the purchase or sale of securities. Although even the Bryan court recognized that fraud on a market participant satisfies that requirement, 58 F.3d at 949-50, and the panel purported to agree with Bryan, it held that O'Hagan's fraud on a tender offeror for the very securities in which he traded did not suffice. a. The panel incorrectly held (Op. 10) that the misappropriation theory "does not require 'deception,'" but rather allows individuals to be punished for mere breaches of fiduciary duty. The theory does require deception. In the seminal Second Circuit misappropriation case, United States v. Newman, 664 F.2d 12, 17 (2d Cir. 1981), cert. denied, 464 U.S. ==========================================START OF PAGE 8====== 863 (1983), the court stated that "[t]he wrongdoing charged against appellee and his cohorts was not simply internal corporate mismanagement." Rather, the court expressly characterized the misuse of information entrusted in confidence as a "deceptive practice[]." See also Clark, 915 F.2d at 448. b. The panel correctly noted that under Santa Fe Indus. v. Green, 430 U.S. 462 (1977) and Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), Section 10(b) "deception cannot be premised on the mere breach of a fiduciary duty, without an accompanying misrepresentation or lack of disclosure" (Op. 10). The panel majority mistakenly believed that misrepresentation or nondisclosure was not required here: the misappropriation theory bases liability upon the mere misappropriation of material nonpublic information in breach of a fiduciary obligation and subsequent use of that information in a securities transaction. * * * By its very definition then, it does not require either a material misrepresentation or nondisclosure. Id. at 11 (citation omitted). Deceit is a fundamental element of every misappropriation case. If a fiduciary disclosed to his beneficiary that he was improperly using confidential information to make an illicit profit from securities trading, his scheme would be exposed and would fail. In every misappropriation case, the trading has been concealed from the victim of the misappropriation. Such conduct constitutes either misrepresentation or actionable nondisclosure. The misappropriator can be viewed either as falsely presenting himself as a faithful custodian of the information, or as failing, in the face of a duty to do so, ==========================================START OF PAGE 9====== to disclose his use of the information. However viewed, the secret use of confidential information by a trustee amounts to more than a mere breach of duty -- it amounts to fraud. In Carpenter v. United States, 484 U.S. 19 (1987), the Supreme Court unanimously affirmed a mail fraud conviction based on the same sort of conduct at issue here -- the secret use of confidential information, by one to whom it had been entrusted, for securities trading. The Court held: the words "to defraud" in the mail fraud statute have the "common understanding" of "'wronging one in his property rights by dishonest methods or schemes,' and 'usually signify the deprivation of something of value by trick, deceit, chicane or overreaching.'" * * * The concept of "fraud" includes the act of embezzlement, which is "'the fraudulent appropriation to one's own use of the money or goods entrusted to one's care by another.'" Grin v. Shine, 187 U.S. 181, 189 (1902). 484 U.S. at 27 (first citation omitted). The Court in Carpenter also made clear that this conduct involved misrepresentations or nondisclosures. The defendant "continued in the employ of the [Wall Street] Journal, appropriating its confidential business information for his own use, all the while pretending to perform his duty of safeguarding it." Id. at 28. There is no basis to conclude that the term "deception" should have a more restricted meaning under Section 10(b) and Rule 10b-5 than it has under the mail fraud statute. Section 10(b) broadly makes unlawful "any manipulative or deceptive device or contrivance" (emphasis added), in contravention of Commission rules. Rule 10b-5 likewise broadly makes it unlawful to employ "any device, scheme, or artifice to defraud" or "[t]o ==========================================START OF PAGE 10====== engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person." It is impossible to conceive how this language is any narrower than the proscription in the mail fraud statute against "any scheme or artifice to defraud." -[7]- c. Of course, Section 10(b) and Rule 10b-5 do have one additional requirement not present in the mail fraud statute -- the fraud must be "in connection with the purchase or sale" of securities. The panel incorrectly held (Op. 11) that the misappropriation theory "fails" on the "obvious" basis that it does not meet that requirement. The panel itself recognized (Op. 13), as had the Bryan court, that the "in connection with" requirement is broad enough to extend to fraud perpetrated on "market participants." But it overlooked the fact that unlike in Bryan, where the victim of fraud did not trade in the securities at issue, the victim of the fraud in this case -- O'Hagan's client Grand Met -- was a market participant. The very information which O'Hagan misused was Grand Met's plan imminently to enter the market and buy the very security which O'Hagan purchased. The secrecy of that plan was critical to Grand Met, as it is to any tender offeror, since ---------FOOTNOTES---------- -[7]- Although the panel noted (Op. 17) that Santa Fe, 430 U.S. at 471-72, cautioned against importing into the securities laws all concepts of fraud appearing in all other statutes, the Supreme Court has never suggested that no other statutes can be looked to, and the panel offers no principled reason why the wire or mail fraud statutes should not be looked to. ==========================================START OF PAGE 11====== premature disclosure of the plan would cause other persons to buy the securities and increase the cost of the offer. O'Hagan's fraud directly conflicted with Grand Met's plan to purchase securities, and posed the risk of making Grand Met's securities purchases more costly. The panel majority does not explain how this fraud was not in connection with the purchase or sale of securities by Grand Met. In any event, the panel recognized (Op. 15 n.7) that the Supreme Court has held that in order to satisfy the "in connection with" requirement the fraud must simply "touch" the purchase or sale of securities. Superintendent of Insurance v. Bankers Life & Casualty Co., 404 U.S. 6, 12-13 (1971). Even if the person from whom the information is taken is not a market participant, the misappropriation touches the defendants' own trading. To the defendant the misappropriated information has value precisely because of its utility "'in connection with' his subsequent purchase of securities." SEC v. Materia, 745 F.2d at 203. II. THE PANEL MAJORITY MISCONSTRUED THE SCOPE OF THE COMMISSION'S AUTHORITY TO PROMULGATE RULES TO DEFINE AND PREVENT FRAUD IN TENDER OFFERS UNDER SECTION 14(e) OF THE EXCHANGE ACT. The panel concluded that Rule 14e-3 was invalid based on its conclusion that Section 14(e) of the Act, like Section 10(b), requires a breach of a fiduciary duty. Op. 26. This conclusion ignores the fact that the Commission has broader rulemaking authority under Section 14(e) for tender offers than it has under ==========================================START OF PAGE 12====== Section 10(b) for securities transactions generally. Rule 14e-3 fits well within the Commission's authority under Section 14(e). Section 10(b) merely makes it unlawful to engage in fraudulent conduct in contravention of Commission rules. Section 14(e), in contrast, authorizes the Commission to "define, and prescribe means reasonably designed to prevent," fraudulent conduct. These "plain language" differences between Sections 14(e) and 10(b) are hardly the "minor discrepancies" they were termed by the panel. In fact, the Commission's rulemaking authority under Section 14(e) was modeled not after Section 10(b), but after Section 15(c)(2) of the Exchange Act. See S. Rep. No. 1125, 91st Cong., 2d Sess. 4 (1970). Section 15(c)(2), originally enacted in 1936 because of the inadequacy of the authority that the Commission already had under Section 10(b), authorizes the Commission to "define" fraud with respect to broker-dealers in the over-the-counter market. It was enacted to subject broker-dealers to more than "the general concepts of fraud which are already in the statute." Unlisted Securities: Hearings on S. 4023 before the Comm. on Interstate and Foreign Commerce, 74th Cong., 2d Sess. 14 (1936) (testimony of Commission Chairman Landis). The Commission's power was broadened again when Section 15(c)(2) was amended in 1938 to allow the Commission to "prescribe means reasonably designed to prevent" over-the- counter broker-dealer fraud. -[8]- The panel's ---------FOOTNOTES---------- -[8]- By this grant, Congress intended to "broaden[] the power of the Commission by rules and regulations (continued...) ==========================================START OF PAGE 13====== interpretation of Section 14(e) ignores Congress's intent to give the Commission the same broad rulemaking authority in the tender offer context that it already had for broker-dealers. The panel decision guts the Commission's rulemaking authority, allowing it only to "identify" (op. 24) practices already proscribed by the self-operative provision of Section 14(e) enacted in 1968. That provision existed before Congress amended Section 14(e) in 1970 to give the Commission rulemaking authority. The panel's construction of Section 14(e) frustrates Congress's intention to grant the Commission "full rulemaking powers" in the area of tender offers -- authority that Congress considered an "utmost necessity." 116 Cong. Rec. 3024 (Feb. 10, 1970). -[9]- In fact, under the panel's decision, the grant of rulemaking power to the Commission would be unnecessary, since it would be coextensive with the self-effectuating portion of Section 14(e). The panel construed the rulemaking authority in Section 14(e) to be coextensive with that in Section 10(b) based on a misreading of the Supreme Court's decision in Schreiber v. Burlington Northern, Inc., 472 U.S. 1 (1985). Schreiber involved ---------FOOTNOTES---------- -[8]-(...continued) to prevent fraudulent, manipulative, and deceptive acts and practices." H.R. Rep. No. 2307, 75th Cong., 3d Sess. 11 (1938). -[9]- Congress's grant of express rulemaking authority in Section 14(e) affords rules promulgated by the Commission under that authority "legislative effect." Thus, those rules are "entitled to more than mere deference." Batterton v. Francis, 432 U.S. 416, 425-426 (1977) (emphasis supplied). ==========================================START OF PAGE 14====== a claim of manipulation in a tender offer in circumstances not covered by Rule 14e-3. Thus, the issue of the validity of Rule 14e-3, or the scope of the Commission's rulemaking authority under Section 14(e), was not before the Court. The sole issue was the scope of Section 14(e)'s self-operative antifraud provision. That part of Section 14(e) bears a textual similarity to Section 10(b), as the Court in Schreiber recognized; but, contrary to the panel's view, the Court did not find any such similarity with respect to Section 14(e)'s separate rulemaking authority. Indeed, the Schreiber Court stated, in what the panel dismissed as dictum, that the 1970 grant of rulemaking power gave "the Securities and Exchange Commission latitude to regulate nondeceptive activities as a 'reasonably designed' means of preventing manipulative acts, without suggesting any change in the meaning of the term 'manipulative' itself." Id. at 12 n.11 (emphasis added). The panel did not dispute that Rule 14e-3 serves to prevent fraudulent activity. Advance knowledge of confidential information about a possible tender offer provides a ready means to make almost certain profits by using the information for securities trading. Such conduct may involve not only fraud under the misappropriation theory, but also under the undisputedly valid "classical" theory of insider trading. -[10]- A flat prohibition on trading while in possession ---------FOOTNOTES---------- -[10]- That would be the case, for example, where a target company insider, knowing of a planned (continued...) ==========================================START OF PAGE 15====== of such information, as provided in Rule 14e-3, is a means reasonably designed to prevent the fraudulent practices that often occur in this context. Finally, the panel ignored Congress's ratification of the Commission's rules on insider trading, including Rule 14e-3, when it passed the Insider Trading and Securities Fraud Enforcement Act of 1988. Congress declared in its statutory findings: [T]he rules and regulations of the Securities and Exchange Commission under the Securities Exchange Act of 1934 governing trading while in possession of material, nonpublic information are, as required by such Act, necessary and appropriate in the public interest and for the protection of investors * * *. Pub. L. No. 100-704, Sec. 2. This was not a mere statement in legislative history, but a finding enacted as part of the law itself. Congress did not merely acquiesce in Rule 14e-3, but "ratified it with positive legislation." Red Lion Broadcasting Co. v. Federal Communications Comm n, 395 U.S. 367, 381-82 (1969). Having been ratified by Congress, Rule 14e-3 should not be set aside by this Court as inconsistent with legislative intent. See United States v. Chestman, 704 F. Supp. 451, 457 (S.D.N.Y. 1989), aff'd as modified, 947 F.2d 551 (2d Cir. 1991), cert. denied, 503 U.S. 1004 (1992). CONCLUSION For the foregoing reasons, rehearing should be granted, and the case should be reheard in banc. ---------FOOTNOTES---------- -[10]-(...continued) tender offer, buys his own company's securities, breaching his duty to the company shareholders with whom he trades without making disclosure. ==========================================START OF PAGE 16====== Respectfully submitted, RICHARD H. WALKER General Counsel JACOB H. STILLMAN Associate General Counsel ERIC SUMMERGRAD Principal Assistant General Counsel RANDALL W. QUINN Senior Litigation Counsel ADAM C. PRITCHARD Of Counsel Attorney PAUL GONSON Solicitor Securities and Exchange Commission Washington, D.C. 20549 Dated: September 16, 1996 ==========================================START OF PAGE 17====== UNITED STATES COURT OF APPEALS FOR THE EIGHTH CIRCUIT ____________________________________________ Nos. 94-3714 and 94-3856 _____________________________________________ UNITED STATES OF AMERICA, Appellee/Cross-Appellant, v. JAMES HERMAN O'HAGAN, Appellant/Cross-Appellee. ____________________________________________ ON APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF MINNESOTA _____________________________________________ CERTIFICATE OF SERVICE I hereby certify that on this 13th day of September, 1996, I caused two copies of the Brief of the Securites and Exchange Commission, Amicus Curiae to be served by first-class United States mail on appellant\cross-appellee and appellee\cross-appellant, addressed to counsel as follows: Christopher J. Bebel Assistant United States Attorney 234 U.S. Courthouse 110 South Fourth Street Minneapolis, MN 55401 John D. French FAEGRE & BENSON 2200 Norwest Center 90 South Seventh Street Minneapolis, MN 55402-3901 Adam C. Pritchard Attorney Securities and Exchange Commission Washington, D.C. 20549