1. Identify and explain the two types of insider training liability under Rule 10b-5.

2. Explain how O’Hagen violated Rule 10b-5.

3. What is the purpose behind the “misappropriation theory” of insider trading?

James O’Hagan was a partner in the law firm of Dorsey & Whitney in Minneapolis, Minnesota. In July 1988, Grand Metropolitan PLC, a company based in London, England, retained Dorsey & Whitney as local counsel to represent Grand Met regarding a potential tender offer for the common stock of the Pillsbury Company headquartered in Minneapolis. O’Hagan did no work on the Grand Met representation. Dorsey & Whitney withdrew from representing Grand Met on September 9, 1988. Less than a month later, on October 4, 1988, Grand Met publicly announced its tender offer for Pillsbury stock. Previously, on August 18, 1988, while Dorsey & Whitney was still representing Grand Met, O’Hagan began purchasing call options for Pillsbury stock. Each option gave him the right to purchase 100 shares of Pillsbury stock by a specified date in September. Later, in August and September, O’Hagan purchased additional Pillsbury call options. By the end of September, he owned 2,500 unexpired Pillsbury options, apparently more than any other individual investor.

O’Hagan also purchased, in September 1988, some 5,000 shares of Pillsbury common stock at a price just under $39 per share. When Grand Met announced its tender offer in October, the price of Pillsbury stock rose to nearly $60 per share. O’Hagan then sold his Pillsbury call options and common stock, making a profit of more than $4.3 million.

O’Hagan was charged and convicted of securities fraud in violation of Section 10(b) and Rule 10b-5. On appeal, he claimed that he was not a “misappropriator,” for he had no fiduciary duty to the Pillsbury shareholders from whom he purchased calls and stock; in fact, he had not even worked on the transaction at the law firm. From the reversal of the conviction by the Eighth Circuit Court of Appeals, the U.S. Supreme Court granted certiorari.

JUDICIAL OPINION

GINSBURG, J.… Under the “traditional” or “classical theory” of insider trading liability, § 10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information. Trading on such information qualifies as a “deceptive device” under § 10(b), we have affirmed, because “a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation.” Chiarella v. United States, 445 U.S. 222, 228, (1980). That relationship, we recognized, “gives rise to a duty to disclose [or to abstain from trading] because of the ‘necessity of preventing a corporate insider from … tak[ing] unfair advantage of … uninformed … stockholders.’” Id., at 228–229, (citation omitted). The classical theory applies not only to officers, directors, and other permanent insiders of a corporation, but also to attorneys, accountants, consultants, and others who temporarily become fiduciaries of a corporation. See Dirks v. SEC, 463 U.S. 646, 655, n. 14, 103 S. Ct. 3255, 3262, 77 L.Ed.2d 911 (1983).

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. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company’s stock, the misappropriation theory ……………..