Supreme Court to Review Who Is an Insider Trader
James H. O’Hagan, a Minneapolis lawyer, made his millions the easy way.
When a law partner told him that a British conglomerate planned to buy Pillsbury Co. in 1988, he bought up shares in the food company. Six weeks later, after the purchase was made public, he sold his shares for a $4.3-million profit.
O’Hagan’s case comes before the Supreme Court today, and it has the potential to make this get-rich-quick scheme legal.
For at least 20 years, the high court, along with legal scholars, has been divided over what is meant by “insider trading.”
Congress could have resolved the matter by passing a law that spelled it out. During the takeover boom of the 1980s, lawmakers were pressed by federal regulators to do just that, but they could not agree on a clear definition.
One theory has maintained that a ban on insider trading should apply to anyone who has a duty to keep stock-related information confidential, even if he or she is not a corporate insider. But this has led to bizarre results:
A psychiatrist who heard a stock tip from a patient--the wife of an American Express executive--was convicted of insider trading by one court. But if the woman had told her hairdresser, that person could have traded on the tip, according to the court. Why? Because the hairdresser, unlike the psychiatrist, had no professional duty to keep secrets.
Stock analysts also urged Congress to tread cautiously because their jobs involve ferreting out information about a company’s prospects and passing it on to investors. That should not be a crime, they said.
Perplexed, Congress backed away from writing a new law and simply urged federal securities regulators to continue to go after insider trading, however defined.
Regulators looked to the Securities Exchange Act of 1934. Passed in the wake of the great stock market crash, this measure makes it illegal to use “any deceptive device” to buy or sell stocks. It also empowered the Securities and Exchange Commission to enforce this provision.
Since the 1960s, the SEC has maintained that trading on inside information was a type of deception forbidden by the 1934 law.
However, the Supreme Court has grown increasingly skeptical of the government’s aggressive use of this loosely written law. Chief Justice William H. Rehnquist once described the SEC’s enforcement rules as “a judicial oak which has grown from little more than a legislative acorn.”
In 1980, the court on a 5-4 vote overturned the insider-trading conviction of a New York printer who had learned about takeover targets from the papers he was printing. The printer had no “special relationship of trust” that barred him from using the information, the court said. Three years later, the justices threw out insider-trading charges against an investment analyst who was informed of a company’s troubles and advised his clients to sell their stock.
Next, the court took up the case of Wall Street Journal reporter Foster Winans, who gave his broker advance word on what would appear in his “Heard on the Street” column. The reporter and the broker were convicted of insider trading--not for trading on inside information on the companies Winans wrote about but, rather, for violating the newspaper’s trust by trading on the information that was to appear in the column.
Winans’ case came before the high court in the fall of 1987, when the defeated nomination of Judge Robert H. Bork had left one vacancy on the bench. With the remaining justices split 4 to 4, the court could not rule on whether the reporter’s use of inside information violated the securities laws.
Since then, thanks to inaction by Congress and the ambivalence of the Supreme Court, the law on insider trading has become mired “in a sad state of confusion,” wrote a former federal prosecutor involved in securities cases.
The federal courts in New York and California have continued to uphold the SEC’s policy of prosecuting people who “misappropriate” inside information and use it to buy or sell stocks. But appeals courts for the mid-Atlantic states and the Midwest have thrown out such convictions and said the SEC has no legal authority to go after someone who is not a true corporate insider.
A company executive has a duty to the stockholders not to enrich himself by trading their stock based on inside information. However, in the case of U.S. vs. O’Hagan, 96-842, the Supreme Court must decide whether that duty extends to others who learn of such information.
A partner in the largest law firm in Minneapolis, O’Hagan had stolen as much as $1 million from his client’s accounts and apparently needed a fast infusion of cash to repay them before he got caught. He saw an opportunity when a colleague chatting in the hallway mentioned he was working on Grand Metropolitan’s secret bid to buy Pillsbury.
Stock in the locally based food company was selling for $39 per share when O’Hagan put in his buy orders. Grand Met, a British food and spirits company, eventually paid $66 a share to buy Pillsbury.
State prosecutors charged O’Hagan with the theft of his clients’ funds, and he served a 30-month prison term for his conviction.
Then the U.S. attorney in Minneapolis separately brought federal securities charges against him for insider trading, saying O’Hagan had “defrauded his clients, his firm and investors in the market.” He was convicted on 57 counts, sentenced to nearly four more years in federal prison and ordered to forfeit his profits.
But last year, the U.S. appeals court in St. Louis voided the entire federal case against O’Hagan. The 2-1 ruling characterized him as an outsider who took advantage of a tip.
Because O’Hagan did not work for Pillsbury as an employee or a lawyer, he had no “fiduciary duty” to its stockholders, the court said, adding that while O’Hagan’s conduct may have been “immoral and unethical,” it did not violate the securities laws.
In their appeal to the high court, lawyers for the Justice Department and the SEC say the stock market could be rattled if this ruling is upheld.
“Trading on misappropriated information strikes at the heart of investor confidence in fair and honest securities markets,” they said in their brief. Investors may well abandon the markets if they believe “they are playing a game in which dice might be loaded.”
Last year, the SEC says it took to court 42 cases of insider trading and undertook another 322 investigations involving allegations of inside trading.
Regulators say they pick their targets based on computer data showing unusual trades prior to a major announcement or because they get inside information--a tip from a whistle-blower.
“These are circumstantial cases. We see that a person has been trading in advance of an announcement. We ask questions, learn you played golf the day before the trade with the CEO of the company, and we put it together piece by piece,” said Richard H. Walker, the SEC’s general counsel.
The justices will hear arguments in the case Wednesday and issue a ruling by late June.
Columbia University law professor John C. Coffee Jr. said it will be “a major blow to the SEC” if O’Hagan wins in the high court.
“There are gray-area cases, but this is not one of them. O’Hagan eminently deserves the criminal sanctions,” said Coffee, who joined a friend-of-the-court brief filed by a group of law professors and legal scholars urging that the conviction be upheld.
However, a second group of professors and lawyers urged the justices to throw out the charges because no federal law clearly makes insider trading illegal.
Walker said he hopes the high court upholds the principle that federal prosecutors can go after lawyers, accountants and other officials who abuse their positions of trust to enrich themselves. He stressed that it is not always illegal to use inside information.
“If you go into a restaurant and overhear Ron Perelman [the billionaire investor] boasting about his next acquisition, well, God bless you, go for it! You can use that because you have no duty to the person at the next table,” Walker said.
