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Published: 2008-03-26

The Return of Insider Trading



This article was originally presented September 8, 1998
at the Practising Law Institute conference
on counseling directors, officers and insiders.

  1. Recent Expansion of and Revisions to Insider Trading Liability
    1. The Classic Theory of Insider Trading
    2. The Misappropriation Theory and O'Hagan: Expanding Liability to "Outsiders"
      1. The misappropriation theory fulfills the " deception" and "connection" requirements for a Rule 10b-5 violation
      2. Limits on the misappropriation theory
        1. Falbo and the duty owed to the source of the information
        2. Disclosure of intent to trade excuses liability
    3. "Use Test" Recently Adopted by the Ninth Circuit in Adler and the Eleventh Circuit in Smith
      1. Both cases born out of prior Supreme Court dicta
      2. "Use test" derived from fraud element of Section 10(b)
      3. Trading while in possession of material nonpublic information raises a "strong inference" of use
      4. Presumption of "use" may be rebutted by evidence of no causal connection between inside information and the trade
      5. Ninth Circuit declines to adopt Adler inference in criminal enforcement action
      6. The extent to which the SEC's enforcement authority is undermined by a "use test" is unclear
    4. Warde and a New "Friendship" Basis for Tippee Liability
    5. Conclusion
  2. Model Corporate Trading Policiies (pdf files)
  1. Recent Expansion of and Revisions to Insider Trading Liability
    Over the past year the courts have revisited and reinvigorated the laws concerning insider trading. This article first examines four recent cases expanding liability under the federal securities laws and Rule 10b-5. The first is the much discussed Supreme Court decision in U.S. v. O'Hagan, 117 S. Ct. 2199 (1997), approving the misappropriation theory as a basis of liability for insider trading. 1 The second is the Eleventh Circuit's decision in SEC v. Adler, 137 F.3d 1325 (11th Cir. 1998), and the third, the Ninth Circuit's decision in U.S. v. Smith, 98 Daily Journal D.A.R 9127 (9th Cir. Aug. 26, 1998). The latter two cases rejected the long-favored SEC belief that "knowing possession" of material nonpublic information by an insider was sufficient to trigger a 10b-5 violation. Instead, they upheld and apply the "use test," requiring evidence that an insider actually based his decision to trade on the material nonpublic information. The fourth and last is SEC v. Warde, 1998 U.S. App. LEXIS 15991 (2d Cir. July 8, 1998), where the Second Circuit applied the standard originally enunciated by the United States Supreme Court in Dirks v. SEC, 463 U.S. 646, 103 S. Ct. 3255 (1983), by stating that a tipper need not receive a specific or tangible benefit in order to impose liability on a tippee. This article addresses each case in turn.

    1. The Classic Theory of Insider Trading
      It is well established that under the classic theory of insider trading, a violation of Section 10(b) 2 and Rule 10b-5 3 occurs "when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information." O'Hagan, 117 S. Ct. at 2107. The Supreme Court had earlier reasoned that there existed "a relationship of trust and confidence 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, 100 S. Ct. 1109, 1114, (1980). The insider thus has a duty to disclose the information or abstain from trading in order not to take unfair advantage of less informed shareholders. Id. at 228-229.

      The classic theory applies not only to officers, directors and other permanent members of a corporation but also was expanded to include attorneys, accountants and others who are temporary fiduciaries of a corporation. See Dirks, 103 S. Ct. at 3262 n.14.

      The Supreme Court has been less sure about extending insider trading liability to "outsiders", those who by virtue of a peripheral relationship to a corporation are able to discover material nonpublic information. The notion that a person, even an outsider, has a duty to abstain from trading or disclose any nonpublic information was first proposed by Chief Justice Burger in his dissent in Chiarella. 100 S. Ct. at 1122 (Burger,
      J., dissenting.) The notion that a "misappropriator" of confidential information should be liable for insider trading was soon seized upon by government prosecutors, however, and in 1981 the Second Circuit in U.S. v. Newman, 664 F.2d 12 (2d Cir. 1981), adopted the misappropriation theory for imposing insider trading liability. The Supreme Court, unable to gather a majority when the theory was first presented in U.S. v. Carpenter, 484 U.S. 19, 108 S. Ct. 316 (1987), split 4-4 over the question of adopting the theory. 4 Circuit Courts generally favored adopting the theory until recently, necessitating that the Supreme Court resolve the issue once and for all. 5

    2. The Misappropriation Theory and O'Hagan: Expanding Liability to "Outsiders"
      By now the facts of the O'Hagan case are notorious. James O'Hagan was a partner in the law firm of Dorsey & Whitney, a firm that represented Grand Met in its tender offer for the Pilsbury Company. Although he did not work on the tender offer, through his position Mr. O'Hagan learned of Grand Met's plans to acquire the company. He proceeded to purchase shares and call options, earning $4.3 million when the tender offer was eventually announced. 117 S. Ct. at 2205. Mr. O'Hagan was convicted of violations of Section 10(b) and Section 14(e), and for mail fraud and money laundering. Id. His conviction was then reversed by the Eight Circuit. 92 F.3d at 627-28.

      Resolving this division among the courts of appeal, the Supreme Court in O'Hagan accepted the misappropriation theory as a basis for liability under 10b-5. "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." 117 S. Ct. at 2207. A person liable under this theory is not necessarily an "insider" of the company, but can be an "outsider" using information gained as part of a peripheral relationship.


      1. The misappropriation theory fulfills the "deception" and "connection" requirements for a Rule 10b-5 violation
        The Supreme Court held that the misappropriation theory satisfied both the "deception" requirement and the "in connection with" requirement in Section 10(b). The Court found that "it [was O'Hagan's] failure to disclose his personal trading to Grand Met and Dorsey, in breach of his duty to do so, that ma[de] his conduct "deceptive" within the meaning of 10(b)" 117 S. Ct. at 2211. The Court further found that the "in connection with" element was satisfied "because the fiduciary's fraud is consummated, not when 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 the duty thus coincide." 117 S. Ct. at 2209.
      2. Limits on the misappropriation theory
        There are two limitations on the misappropriation theory. First, the misappropriator must owe a duty to the source of the information and second, the misappropriator need only disclose his intention to trade on the inside information to the source in order to avoid liability. The nature of the duty owed to the source of the information is not a strict fiduciary duty but encompasses a broader array of relationships and confidences. The disclosure requirement leaves open interesting questions regarding the nature of the duty the corporation may then have to protect its shareholders from any action by the misappropriator.

        1. Falboand the duty owed to the source of the information
          In O'Hagan, the Supreme Court held that the SEC is still required to demonstrate a fiduciary-like relationship between the misappropriator and the source of the information in order to establish liability. The Court recognized that the misappropriation theory applied "to those who breach a recognized duty." 117 S. Ct. at 2214. However, the parameters of this relationship have not yet been defined. 6

          In SEC v. Falbo, No. 92 Civ. 6836 (PKL), 1998 U.S. Dist. LEXIS 11926 (S.D.N.Y. Aug. 5, 1998), the district court explored the "recognized duty" requirement stemming, ironically, from the same Pilsbury acquisition at issue in O'Hagan. In Falbo, the court found that Mr. Falbo, an independent contractor, was liable for insider trading based upon the misappropriation theory. 7

          Mr. Falbo was an electrician installing a security system designed to screen the Pilsbury acquisition team from the rest of Grand Met and thus ensure secrecy of the pending acquisition. He had access to all of the Grand Met offices and used this ability to eavesdrop on executives discussing the acquisition. Based upon this information Mr. Falbo decided to purchase stock and call options. The court, recognizing that "Falbo's association with Grand Met clearly was not one of the traditional relations recognized at common law as inherently fiduciary," nevertheless found Mr. Falbo to have owed a duty to Grand Met, the source of his information. The court reasoned that under the misappropriation theory the duty inquiry does not end with considering "whether there existed a fiduciary relationship but also whether there existed a "similar relationship of trust and confidence", which must be the functional equivalent of a fiduciary relationship." 1998 U.S. Dist. LEXIS 11926 at 37. Whether the government must demonstrate a "recognized duty" as stated by the Supreme Court in O'Hagan, or the "functional equivalent" of such a duty, is an issue ripe for future litigation. 8
        2. Disclosure of intent to trade excuses liability
          O'Hagan also states that a defendant will not be liable if he fully disclosed his intended trades. If the individual has disclosed his planned use of the material nonpublic information, than there is no "deceptive device" upon which liability rests "[b]ecause the deception essential to the misappropriation theory involves feigning fidelity to the source of information; if the fiduciary discloses to the source that he plans to trade on the nonpublic information, there is no "deceptive device" and thus no ' 10(b) violation." 117 S. Ct. at 2209. This selective disclosure by the misappropriator of his intended use of the information does not protect the market or shareholders from his action, but it does seemingly allow him to avoid liability. The practical feasibility of this "excuse" from liability seems dubious given the unlikelihood any corporation would risk prosecution for violating federal and state securities laws and its reputation in the market place by allowing selective insider trading.
          9

    3. "Use Test" Recently Adopted by the Ninth Circuit in Adler and the Eleventh Circuit in Smith
      The Eleventh Circuit in SEC v. Adler, 137 F.3d 1325 (11th Cir. 1998), and the Ninth Circuit in U.S. v. Smith, 98 Daily Journal D.A.R. 9127 (9th Cir. Aug. 26, 1998), recently rejected the "knowing possession" standard as the basis for liability for insider trading. The SEC had long advocated that mere knowledge of material nonpublic information while trading was sufficient to establish insider trading liability. The alternative view, urged in Adler and Smith, is that the SEC must establish a "causal connection" between the knowledge and trades.

      In Adler, the defendant was granted summary judgment by the trial court based upon evidence of a pre-existing plan to sell his stock before he came into possession of material, nonpublic information, which when revealed to the public would cause the price of the stock to drop. 137 F.3d at 1328. The SEC appealed, claiming that the defendant did not actually have to base his decision to trade on the material nonpublic information, but that it was sufficient under Rule 10b-5 to possess such knowledge at the time of the trade. Id. at 1332. Although the Eleventh Circuit reversed the summary judgment order, it also rejected the "mere possession" standard advocated by the SEC. Id. at 1337.

      In Smith, the president of an engineering company was convicted of insider trading under Rule 10b-5. He sold all of his stock (as well as selling short roughly 35,000 additional shares) before the release of disappointing financial information. Smith, 98 Daily Journal D.A.R. at 9127. The defendant also left an ill-advised voicemail with an employee of the company informing her of his decision to sell "because I know it's going to go down a couple of points here in the next week as soon as Lou releases the information about next year's earnings." Id. at 9127. The defendant then appealed his conviction, premised in part upon his contention the jury was erroneously instructed he could be convicted of violating Rule 10b-5 based upon his possession, as opposed to actual use of, material nonpublic information. While agreeing with the defendant that the government must prove actual use, the Ninth Circuit nevertheless held the instruction proper and upheld the conviction. Id. at 9135 (emphasis added).

      Both circuit courts adopted a "use test" requiring the insider actually base his decision to trade on the material nonpublic information gained by virtue of his position. In adopting this test, the courts focussed on the dicta in Supreme Court decisions dealing with insider trading and the language of the statute. They reiterated that liability can only be imposed for a breach of a duty and found that this duty is not breached simply by trading while in the possession of material nonpublic information, but by trading on the basis of this information,
      gathered pursuant to the relationship giving raise to the duty.

      1. Both cases born out of prior Supreme Court dicta
        Both Adler and Smith rely on Supreme Court decisions which have consistently suggested, in dicta, that Rule 10b-5 requires the government prove a causal connection between the trade and the possession of material nonpublic information. 10 Most recently, in O'Hagan, the Court indicated that an insider must actually use the information which he has gained by stating that insider trading is trading "on the basis of" material, nonpublic information, and that "the misappropriation theory targets information of a sort that misappropriators ordinarily capitalize upon to gain no-risk profits through the purchase and sale of securities." 117 S. Ct. at 2209. The Court further observed that "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." Id. at 2209 (emphasis added.)

        The Court's earlier decisions also suggest a causation element. For example, in Dirks v. SEC, the Court discussed an insider's duty "not to trade on" inside information and described a duty to disclose any material nonpublic information "before trading on it and thus mak[ing] secret profits." 103 S. Ct. at 3260 n.10, 3261. Similarly, in Chiarella, the Court referred to violations of Rule 10b-5 arising "where corporate insiders used undisclosed information for their own benefit." 100 S. Ct. at 1115 (emphasis added.) Based upon this Supreme Court dicta, it is not altogether surprising that the Eleventh and Ninth Circuits derived a standard under which the SEC must show a causal connection between the trade and the possession of inside information.
      2. "Use test" derived from fraud element of Section 10(b)
        Both Adler and Smith suggest that the "use test" is more consistent with the language of Section 10(b), which emphasizes "manipulat[ion]" and "decept[ion]." The "fraud" element of Section 10(b) appears to require a certain level of intent not present in the knowing possession standard. One fear expressed by the Eleventh Circuit is that it "did not believe that the SEC's knowing possession test would always and inevitably be limited to situations involving fraud." 137 F.3d at 1338.

        The Ninth Circuit also expressed skepticism about the "knowing possession" standard. "In fact, a knowing-possession standard would, we think go a long way toward making insider trading a strict liability crime. In view of the statutorily authorized ten-year prison sentence that may accompany an insider trading conviction, see 15 U.S.C.S. 78ff(a), any construction of Rule 10b-5 that de facto eliminates the mens rea requirement should be disfavored [citations omitted]." 98 Daily Journal D.A.R. at 9137 n.25. The Supreme Court decisions suggesting a causal connection and the language of '10(b) focusing on a "manipulative or deceptive device" lend weight to the reasoning behind adopting the "use test."
      3. Trading while in possession of material nonpublic information raises a "strong inference" of use
        Both the Smith and the Adler decisions recognized the difficulty the SEC could encounter trying to prove actual use of insider information. In order alleviate the government's evidentiary burden, Adler held that a "strong inference" of actual use of the material nonpublic information arises when an insider trades while in possession of this information. 137 F.3d at 1337. The inference allows the SEC to make a prima facia case without having to prove a causal connection. Id. The defendant then has the burden of proving that no causal connection existed between the possession of the information and the trade. Id.
      4. Presumption of "use" may be rebutted by evidence of no causal connection between inside information and the trade
        Adler went on to hold that the "strong inference" raised by trading while possessing material nonpublic information may be rebutted by presenting evidence that there was no causal connection between the information and trade. 137 F.3d at 1337. "The factfinder would weigh all of the evidence and make a finding of fact as to whether the inside information was used." Id. A defendant may assert, as was true in Adler, that he had a pre-existing plan to trade. Such proof would then negate the presumption that the trade was made "on the basis of" the inside information. Asserting the lack of a causal connection is effectively an affirmative defense, with the practical effect of lessening the chances for an early dismissal.
      5. Ninth Circuit declines to adopt Adler inference in criminal enforcement action
        The Ninth Circuit's decision in Smith involved a criminal enforcement action and not, as in Adler, a civil proceeding. Thus, the Ninth Circuit refused to decide "whether or not an Adler-type presumption may be employed in civil enforcement proceedings under 10b-5." 98 Daily Journal D.A.R. at 9137 n.27. The court's holding was limited to the notion that "the government may not rest upon a demonstration that the suspected inside trader bought or sold while in possession of inside information; rather, it must, at a minimum, prove that the suspect used the information in formulating or consummating his trade." Id. The court, however, acknowledging the SEC's concerns regarding proving actual use, noted the Adler decision's "strong inference" presumption as one way to alleviate the problem, but stopped short of adopting the same test. Id. at 9135. Given its agreement with the Eleventh Circuit's analysis in Adler, it is reasonable to believe the Ninth Circuit would adopt a similar presumption when the issue is presented in a civil proceeding.

        Interestingly, the Smith court found that "it is sufficient, as the district court observed, that the material nonpublic information be a "significant factor" in the insider's decision to buy or sell." Id. at 9137 n.28. Therefore, even if a defendant can produce evidence of a pre-existing plan to trade, the government may still impose liability for insider trading by demonstrating that the material nonpublic information was a "significant factor" in the trade, whether as to the amount ultimately traded or the timing of the trade. For example, if a defendant had a pre-existing plan to sell some shares, liability for insider trading could still be imposed if knowledge of material nonpublic information caused him to alter the timing or volume of the intended trade.
      6. The extent to which the SEC's enforcement authority is undermined by a "use test" is unclear
        While the Eleventh and Ninth Circuits arguably weakened the SEC's enforcement power under Rule 10b-5 by adopting the "use test", their strict application of the test fails to evidence any such weakening in the result. The Eleventh Circuit in Adler reversed each of the defendants' grants of summary judgement, finding that a material issue of genuine fact existed as to the defendants' proffered defense of a pre-existing plan to trade. The Ninth Circuit in Smith affirmed the defendant's conviction and opined that the "use test" "renders criminal prosecutions [only] marginally more difficult for the government to prove." 98 Daily Journal D.A.R. at 9135. Furthermore, the Ninth Circuit suggested that the government need only prove the inside information was a "significant factor," not the "sole factor" for the trade. Id. at 9137 n.28. Thus, there may not be a significant loss of enforcement power by the adoption of the "use test".
    4. Wardeand a New "Friendship" Basis for Tippee Liability
      In SEC v. Warde, Docket No. 97-6190 1998 U.S. App. LEXIS 15991 (2d Cir. July 8, 1998), the Second Circuit clarified the standard first enunciated in Dirks v. SEC, holding that a tipper did not in fact have to receive a tangible benefit to be liable for insider trading. In Warde, defendant Thomas Warde was a "good friend" of Edward Downe a director of Kidde, Inc. ("Kidde"). Throughout the spring of 1987, the management of the company discussed various options concerning the company's future ranging from the possibility of a takeover bid, a buyout by another company or a leveraged buyout by Kidde management. The company was ultimately acquired by another large conglomerate causing a large increase in the value of the stock. 1998 U.S. App. LEXIS 15991 at *3. Both Downe and Warde profited from the warrants they purchased during this period of discussion and negotiation. Id. at *5. Warde was found liable for insider trading based on the theory of "tippee" liability. He appealed, contending, among other things, that his "tipper", Downe, had not received a "benefit" as ostensibly required under Rule 10b-5 to impose liability on a tippee. Id. at *15.

      Under Section 10(b) a tippee is liable for insider trading if
      1. the tipper, an insider, possessed material, nonpublic information that was then
      2. disclosed to the tippee who then
      3. traded on that information although
      4. the tippee knew or should have known the tipper had violated his fiduciary duty in providing that information and
      5. the tipper benefited by disclosing the information. Id. at *8-*9 (emphasis added).



      As previously explained by the Supreme Court in Dirks, "[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient." 103 S. Ct. at 3266. In Warde, the court made short work of defendant's argument the that tipper received no "benefit" by citing the above language in Dirks and concluding that the close friendship between the tipper and the tippee demonstrated that tipper's action was "intended to benefit" himself, and therefore allow a jury to find that the tipper breached a duty under '10(b)." 1998 U.S. App. LEXIS 15991 at *15.

      The SEC is already taking the position that the clarification and application of this "benefit" standard will make it easier for the SEC to pursue friends and relatives of tippers. See Paul Beckett, Appeals-Court Decision May Aid SEC In Going After Insider-Trading Cases, Wall St. J., July 13, 1998 at B6. What remains to be seen is whether this ruling will aid the SEC in pursuing stock analysts who trade on information before it becomes public, if based upon a tip from a company executive for no other intended benefit than more-favorable analyst coverage. See id.

    5. Conclusion
      The above survey gives a sense of the recent renewal of the courts' interest in the law of insider trading. While the misappropriation theory is now firmly established, the limits of the "duty" necessary to trigger liability under the misappropriation theory have yet to be identified. It also remains to be seen whether the seeming contraction of governmental power by the adoption of the "use test" will result in a more difficult evidentiary burden for the government. Finally, the Second Circuit's reiteration that a tipper need not receive a tangible benefit under tippee liability will likely encourage enforcement under this theory.

  2. Model Corporate Trading Policiies (pdf files)
    Securities Law Compliance Manuals developed for corporate clients are intended both to educate corporate personnel and to state the Company's policies concerning the wide range of securities laws which impose restrictions upon the officers and directors of publicly-traded companies in connection with their open-market trading in the Company's securities and their participation in Company stock plans. There are a multitude of approaches possible, and no "right" or "wrong" approach. Depending upon the needs and style of management, these manuals may offer only overviews of applicable laws or, alternatively, contain more comprehensive directives concerning company policy. We have included portions of a very simple approach to stating a corporate trading policy ( Sample A) and a more detailed example ( Sample B). These excerpts are not intended to be exhaustive or authoritative, and are merely examples of how such policies might be drafted.

Footnotes

1. See e.g., A.C. Pritchard, United States v. O'Hagan: Agency Law and Justice Powell's Legacy for the Law of Insider Trading, 78 B.U.L. Rev 13 (1998); David M. Zornow and Keith D. Krakaur, Insider Trading After 'O'Hagan'; Questions Remain About Scope of Conduct Falling Within Misappropriation Theory, N.Y. L.J., Feb. 2, 1998; Harvey L. Pitt and Karl A. Groskaufmanis, The Supreme Court Has Upheld the Misappropriation Theory, But How Far the SEC Will Take the Ruling Is Anything But Clear, Nat'l L.J., Aug. 4, 1997; John C. Coffee, Jr., Is Selective Disclosure Now Lawful?, N.Y. L.J., July 31, 1997. Back

2. Section 10(b) of the Securities Exchange Act of 1934 makes it unlawful for any person "[t]o use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe." 15 U.S.C. ' 78j(b). Back

3. Rule 10b-5 provides in part: It shall be unlawful for any person, directly or indirectly to., (a) employ any device, scheme or artifice to default, (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 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. Back

4. Justice Powell had retired from the Court in June 1987 before the argument in U.S. v. Carpenter was heard. Given the fact that in a draft dissent to the Court's original decision to deny certiorari to the case, Powell expressed disapproval of the misappropriation theory, it is possible that had the Justice remained on the Court to decide the case, the misappropriation theory would have been rejected in Carpenter in 1987. See A.C. Pritchard, United States v. O'Hagan: Agency Law and Justice Powell's Legacy for the Law of Insider Trading, 78 B.U.L. Rev. at 34. Back

5. The misappropriation theory was first accepted by the Second Circuit in U.S. v. Newman, 664 F.2d 12 (2d. Cir. 1981), and reaffirmed in SEC v. Materia, 745 F.2d 197 (2d. Cir. 1984) and United States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986,) aff'd, 108 S. Ct. 316 (1987) (the Court divided 4-4 on the misappropriation theory). This theory of Rule 10b-5 liability was also accepted by the Third Circuit in Rothberg v. Rosenbloom, 771 F.2d 818 (3d. Cir. 1985,) cert. denied 481 U.S. 1017 (1987), the Ninth Circuit in SEC v. Clark, 915 F. 2d 439 (9th Cir. 1990), and the Seventh Circuit in SEC v. Cherif, 933 F.2d 403 (7th Cir. 1991). The Fourth Circuit in U.S. v. Bryan, 58 F.3d 933 (4th Cir. 1995) and ultimately the Eighth Circuit's decision in U.S. v. O'Hagan, 92 F.3d 612 (8th Cir. 1995), rev'd, 117 S. Ct. 2199 (1997), both rejected the theory. Back

6. Several subsequent decisions have cited O'Hagan. U.S. v. Cusimano, 123 F.3d 83 (2d Cir. 1997) (refused to consider defendant's argument to reverse the Second Circuit's long standing acceptance of the misappropriation theory after the acceptance of the theory by the Supreme Court in O'Hagan); SEC v. Mayhew, 121 F.3d 44 (2d Cir. 1997) (finding that a two-month gap between a tip and a tender offer was not too long to impose liability under '14(e)); SEC v. Jakubowski, No. 97-4010, 1998 U.S. App. LEXIS 16275 (7th Cir. July 16, 1998) (citing O'Hagan as an example of an expansive definition of the "in connection with" requirement); and Sing v. Scott, 134 Wash. 2d 24 (1997) (Talmadge, J., dissenting) (Justice Talmadge of the Washington Supreme Court analogized a deceptive sales practice to the misappropriation theory. The dissent argued for the position that a real estate saleswoman "misappropriated" sales information from another sales person in her office to her own advantage and thus committed a deceptive act in violation of Washington's Consumer Protection Act.) Back

7. Mr. Falbo was also found to have been a tippee of his wife, who worked for Grand Met's CEO and was privy to confidential information about the Pilsbury acquisition. The court found Mr. Falbo not only had a duty not to trade as a tippee, but that he also had an independent duty to Grand Met by virtue of his job. 1998 U.S. Dist. LEXIS 11926 at 36. Back

8. A broad reading of the duty requirement is not new under the misappropriation theory. In the Ninth Circuit's 1990 opinion in Clark, the court referred to the duty as "an established relationship of trust and confidence" and later stated that the misappropriation theory relies on the notion that "by becoming part of a fiduciary or similar relationship, an individual is implicitly stating that she will not divulge or use to her own advantage information entrusted to her in the utmost confidence." 915 F.2d at 447-48. Back

9. Another interesting aspect of the disclosure requirement under the misappropriation theory is the duty it may impose on the corporation to act once an individual discloses he intends to trade. Take for instance Mr. Falbo. He was an independent contractor working on a discreet project for Grand Met. If he had disclosed his intentions to trade on the information gained by his eavesdropping, what action could or should Grand Met have taken to protect itself and its shareholders? It is unclear what steps if any a company must take once it is informed of an individual's plan to trade on inside information. Back

10. See U.S. v. O'Hagan, 117 S. Ct. 2199, 2209 (1997); SEC v. Dirks, 103 S. Ct. 3255, 3261 (1983); Chiarella v. United States, 100 S. Ct. 1109, 1115 (1980). Back