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Class 7.1 Insider Trading
Dirks; United States v. OHagan
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Objectives
Understand basic rule prohibiting insidertrading.
Understand tippee liability for insidertrading.
Discuss why current insider trading rulesmay be inefficient.
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Facts?
Issues?
Arguments?
Reasoning?
Holding?
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Insider trading Basic rules andtippee liability
Dirks Secrist works at insurance company Equity
Funding.
Company was doing bad stuff. Forgery parties,workers passing around fake insurance contracts foreach other to sign.
Secrist tries to report, no one believes him. Finallycalls Dirks, an investment analyst.
Dirks investigates, discovers its true, informs WallStreet Journal, probably California insuranceauthorities.
Also tells his clients, who trade on that information.
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Was Dirks an insider?
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Insider trading Basic rules andtippee liability
Dirks Was Dirks an insider?
No.
SEC is pursuing him for tippee liability under Rule 10b-5 (theSEC recognized that the common law in some jurisdictionsimposes on corporate insiders, particularly officers,directors, or controlling stockholders an affirmative duty ofdisclosure when dealing in securities. The SEC found thatnot only did breach of this common-law duty also establishthe elements of a Rule 10b-5 violation, but that individualsother than corporate insiders could be obligated either todisclose material nonpublic information before trading or toabstain from trading altogether.
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What if Dirks had been walking along thesidewalk, behind the Chairman of the Board
of Equity Funding, when the chairmandropped an internal report detailing massivefraud at Equity Funding would Dirks be ableto trade on that information?
Discuss
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The general rule is that a corporate insiderwho is in possession of material nonpublic
information must disclose that informationbefore trading on it.
Can you justify this rule in terms of 10(b)sprohibition on trading in any security using any
manipulative or deceptive device? Discuss.
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What does the Court mean when it says notall breaches of fiduciary duty in connection
with a securities transaction, however, comewithin the ambit of Rule 10b-5?
Discuss.
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What is the source of liability for tippeeinsider trading?
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What is the source of liability for tippeeinsider trading?
There must be some fiduciary duty.
What does the SEC argue was Dirks fiduciaryduty?
Discuss.
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Insider trading Basic rules andtippee liability
Dirks What is the source of liability for tippee insider
trading?
There must be some fiduciary duty. What does the SEC argue was Dirks fiduciary duty?
Again, you should see how this entire course relates to agencytheory.
Without some relationship that is at least analogous to agency,the court is reluctant to impose liability on a tippee.
The SEC argues that the tippee violates some kind of fiduciaryduty by trading while in possession of material nonpublicinformation.
Seeks a level playing field.
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What rule does the Court adopt with respectto tippee liability?
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What rule does the Court adopt with respectto tippee liability?
A tippee violates Rule 10b-5 if: (1) the tipper violates a fiduciary duty to the firms
shareholders in giving the tip; and
(2) the tippee knew or should have known of that breach.
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How could Secrist have violated a fiduciaryduty in reporting the fraud?
Discuss.
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How could Secrist have violated a fiduciaryduty in reporting the fraud?
If the tipper receives a benefit for the breach offiduciary duty (note that this only implicates theduty of loyalty, not the duty of care).
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What if Dirks had been a lawyer for EquityFunding? Our lawyers immune from trading
on their clients inside information? Discuss.
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What if Dirks had been a lawyer for EquityFunding? Our lawyers immune from trading
on their clients inside information? Discuss.
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Why did the court absolve Secrist ofwrongdoing?
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Why did the court absolve Secrist ofwrongdoing?
The court holds that Secrist had every right todisclose the fraud because he did not personallybenefit from the disclosure.
Consider an alternative rule why might it be more
efficient to permit Secrist (and others) to trade onthe basis of their inside information?
Discuss.
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Insider trading Basic rules andtippee liability
U.S. v. OHagan
Facts?
Issues?
Arguments?
Reasoning?
Holding?
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U.S. v. OHagan This case provides your first major introduction to the
tender offer process.
In the 1950s and 1960s, the most common way totake over a firm was a proxy fight. An insurgentgroup who believed that their policies would yieldhigher profits and returns for investors would seekto elect an insurgent slate of directors to replace theincumbent board.
This process is cumbersome.
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Insider trading Basic rules andtippee liability
U.S. v. OHagan This case provides your first major introduction to the
tender offer process.
The proxy fight has largely been replaced by the
tender offer as a mechanism for corporate takeovers. In a tender offer, an acquiror:
Purchases up to 5% of the targets stock on the market.
Announces that it will buy a certain percentage of shares at aspecified price that are tendered by the closing date of the
tender offer. Contingent on tender of certain percentage of shares
(usually a controlling block).
Board may recommend for or against tendering, but they cantprohibit the tender offer.
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Insider trading Basic rules andtippee liability
U.S. v. OHagan OHagan is a partner at Dorsey & Whitney. D&Ws
client (handled by another partner) Grand Metplanned a tender offer for Pillsbury Co.
OHagan began purchasing call options for Pillsburystock in August 1988 at $39 per share.
Grand Met publicly announces the tender offer on
October 4, 1988. Pillsbury stock rises to $60 pershare.
OHagan sells Elsberry call options and commonstock, making profit of more than $4.3 million.
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What were the SECs theories of liabilityagainst OHagan?
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What were the SECs theories of liabilityagainst OHagan?
OHagan violated 10(b) / Rule 10b-5 by trading inpossession of material nonpublic information.
Fraudulent trading in connection with a tender offerin violation of Rule 14e-3(a).
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What is the misappropriation theory ofinsider trading liability?
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What is the misappropriation theory ofinsider trading liability?
The misappropriation theory holds that a personcommits fraud in connection with a securitiestransaction, and thereby violates 10(b) and Rule10b-5, when he misappropriates confidential
information for securities trading purposes, inbreach of a duty owed to the source of theinformation. @503
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What is the misappropriation theory ofinsider trading liability?
Under this theory, a fiduciarys undisclosed, self-serving use of a principals information to purchaseor sell securities, in breach of a duty of loyalty andconfidentiality, defrauds the principle of the
exclusive use of that information. @503
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If the misappropriation theory is really just abreach of fiduciary duty of loyalty i.e.
stealing the principals right to exclusive useof its information why do we botherimposing liability on the basis of securitiesfraud (instead of fiduciary duty)?
Discuss.
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Why does the Court hold here that OHaganmisappropriated the tender offer information?
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U.S. v. OHagan Why does the Court hold here that OHagan
misappropriated the tender offer information?
OHagan owed a fiduciary duty of loyalty to his lawfirm, and through the law firm to the client.
He had no right to that information.
Additionally, the courts opinion is informed by itsdesire to maintain the integrity of the securitiesmarkets.
Is this desire realistic? Are there better ways to obtainthis goal?
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Note that Rule 14d-3(a) which prohibitsfraud in connection with any tender offer
does not require any breach of a fiduciaryduty.
Thus, misappropriation theory really doesnt applyhere.
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Insider trading Basic rules andtippee liability
Problem: Bob Smith is a director and the president of a publicly traded
technology company. As part of his compensation package,Bob receives annual stock options priced at the date of hisannual review. The options can be exercised no sooner than oneyear from the date of issuance.
To maintain a diversified portfolio, Bob wishes to exercise hisoptions regularly and to reinvest 40% of the proceeds in mutualfunds and the stocks of other companies.
As part of his job duties, Bob is responsible for preparing annualand quarterly reports on the financial condition of the companyfor filing with the SEC. Consequently, he is regularly in
possession of material nonpublic information. Take 10 minutes and develop a proposal for Bob to accomplish
his diversification goals without incurring insider-trading liability. Assume as an alternative that Bob is a lawyer for the company.