Master Supreme Court embraced the misappropriation theory of insider trading under §10(b)/Rule 10b-5 and upheld SEC Rule 14e-3’s tender-offer trading prohibition. with this comprehensive case brief.
United States v. O’Hagan is the Supreme Court’s definitive endorsement of the misappropriation theory of insider trading. Before O’Hagan, insider trading liability under §10(b) and Rule 10b-5 centered on the classical theory—where a corporate insider (or tippee) breaches a fiduciary duty to the company’s shareholders by trading on material nonpublic information. That framework left a gap: what about outsiders who wrongfully trade on confidential information stolen or misused from its source, but who owe no duty to the shareholders of the issuer whose securities they trade? O’Hagan answers that question by recognizing that §10(b)’s “deceptive device” extends to those who secretly appropriate confidential information in breach of a duty to its source for the purpose of securities trading.
Equally significant, the Court upheld SEC Rule 14e-3, a prophylactic rule prohibiting trading while in possession of material nonpublic information relating to tender offers, even absent a fiduciary breach to anyone. Together, these holdings expand the reach of federal securities antifraud provisions to preserve market integrity and investor confidence, and they form bedrock doctrine for enforcement and compliance in modern securities practice.
521 U.S. 642 (U.S. Supreme Court 1997)
James O’Hagan was a partner at the Minneapolis law firm Dorsey & Whitney. The firm represented Grand Metropolitan PLC in connection with a planned tender offer for the Pillsbury Company. Although O’Hagan did no work on the engagement, he learned of the impending tender offer through his position at the firm. Without disclosing his intended trading to his firm or to Grand Met, O’Hagan quietly bought a large number of Pillsbury call options and shares before the tender offer was announced. When the offer became public, Pillsbury’s stock price rose sharply, and O’Hagan sold his positions for a profit of approximately $4.3 million. A federal grand jury indicted him on multiple counts, including securities fraud under §10(b)/Rule 10b-5 (based on the misappropriation theory), fraudulent trading in connection with a tender offer under Rule 14e-3, mail fraud, and money laundering. A jury convicted him, but the Eighth Circuit reversed the §10(b)/Rule 10b-5 convictions on the ground that the misappropriation theory was invalid and held Rule 14e-3 exceeded the SEC’s authority. The Supreme Court granted certiorari.
1) Does §10(b) of the Securities Exchange Act and SEC Rule 10b-5 reach trading on confidential information by an outsider who misappropriates that information in breach of a duty owed to the source of the information? 2) Did the SEC act within its authority under §14(e) in promulgating Rule 14e-3, which prohibits trading on material nonpublic information relating to tender offers without requiring proof of a fiduciary breach?
Misappropriation theory under §10(b)/Rule 10b-5: A person commits securities fraud when, in breach of a duty of trust and confidence owed to the source of confidential information, he misappropriates that information for securities trading purposes and fails to disclose his intended use to the source. The deception lies in feigning loyal use of the information while secretly exploiting it for personal gain; the §10(b) “in connection with” requirement is satisfied because the deceptive nondisclosure facilitates securities trading. If the fiduciary fully discloses to the source his intent to trade on the information, the deception element is negated (though other laws may apply). Rule 14e-3: Section 14(e) authorizes the SEC to define and prescribe means reasonably designed to prevent fraudulent, deceptive, or manipulative acts in connection with tender offers. Rule 14e-3 validly prohibits trading (and tipping) while in possession of material nonpublic information relating to a tender offer, regardless of a fiduciary breach, as a prophylactic measure to protect the tender-offer market.
Yes. The Supreme Court held that the misappropriation theory is a proper basis for §10(b)/Rule 10b-5 liability: an outsider who breaches a duty of trust and confidence to the source of confidential information and trades on that information commits a deceptive act “in connection with” a securities transaction. The Court also held that SEC Rule 14e-3 is within the Commission’s statutory authority under §14(e) and is valid even though it does not require proof of a fiduciary breach.
Section 10(b) prohibits “any manipulative or deceptive device or contrivance” in connection with the purchase or sale of any security. The Court reasoned that misappropriation fits this text because the trader engages in deception by pretending fidelity to the source of the information while secretly converting that information to personal use for trading. This deception is actionable even though it is directed at the information source rather than market counterparties; §10(b) does not confine fraud to misrepresentations to trading partners. The scheme’s deceptive nondisclosure is “in connection with” a securities transaction because the object of the breach is to trade, and the trading consummates the fraud. The Court drew support from prior decisions recognizing similar deception-based liability (e.g., Chiarella and Dirks acknowledging duties as predicates for insider-trading liability, and Carpenter recognizing mail/wire fraud predicated on misappropriation of confidential information). The Court rejected the Eighth Circuit’s view that §10(b) requires a breach owed to shareholders of the traded issuer. The classical theory addresses insider/trade-counterparty deception; misappropriation addresses deception of the information’s source. Both theories are consistent with §10(b)’s text and purposes of promoting honest markets and investor confidence. The Court also emphasized a limiting principle: if the fiduciary fully discloses to the source an intent to trade on the information, the deception element disappears, and §10(b) liability under misappropriation does not attach (though other liabilities may). As to Rule 14e-3, the Court held that §14(e) empowers the SEC to adopt prophylactic measures reasonably designed to prevent fraud in tender offers. Given the unique time-sensitive and susceptible nature of tender-offer trading, the SEC reasonably forbade trading and tipping while in possession of material nonpublic tender-offer information without requiring a showing of fiduciary duty or deception in each case. The rule’s possession standard and duty-less framework are permissible methods to deter and prevent practices likely to be fraudulent or manipulative in the tender-offer context. The Court also concluded that the rule and the misappropriation theory provide fair notice and are not unconstitutionally vague when applied to O’Hagan’s conduct.
O’Hagan is the cornerstone of modern insider-trading law for outsiders. It closes the gap left by Chiarella and Dirks by recognizing that liability can rest on a duty owed to the source of information, not just to trading counterparties or issuer shareholders. The decision empowers both criminal prosecutions and civil enforcement of trading based on misused confidential information obtained through fiduciary or similar relationships (e.g., lawyers, bankers, consultants, employees, or others entrusted with nonpublic information). It also validates Rule 14e-3’s prophylactic regime for tender offers, a crucial tool in deterring abuses in fast-moving takeover markets. For students, O’Hagan clarifies the elements: a relationship of trust/confidence with the source, a deceptive breach via nondisclosure, trading on material nonpublic information, scienter, and the “in connection with” nexus. It remains a foundational case on exams, in compliance counseling, and in understanding tipper–tippee and outsider liability.
The classical theory penalizes an insider (or a tippee who inherits the insider’s duty) who breaches a fiduciary duty to the issuer’s shareholders by trading on material nonpublic information. The misappropriation theory, by contrast, targets outsiders who owe no duty to the issuer’s shareholders but who obtain confidential information through a relationship of trust and confidence with its source (e.g., a client, employer, or firm) and deceptively exploit it for trading. The deception in classical theory runs to the shareholders; in misappropriation, it runs to the source of the information.
The duty is owed to the source of the confidential information—the person or entity entrusting the information (such as a client or employer) or with whom the trader has a relationship of trust and confidence. Liability arises when the trader fails to disclose to that source his intent to use the information for trading and then trades, thereby committing a deceptive breach.
Yes. O’Hagan’s key limiting principle is that if the fiduciary fully and timely discloses to the source an intent to trade on the information, the deception element is negated. Without deception, there is no §10(b) violation under misappropriation theory. However, the trader may still face contractual, ethical, or other legal consequences (e.g., breach of confidentiality agreements, theft of trade secrets).
Rule 14e-3, upheld in O’Hagan, prohibits any person from trading while in possession of material nonpublic information relating to a tender offer, or from tipping such information, if they know or have reason to know it came from the tender-offer participants. Unlike §10(b) misappropriation, Rule 14e-3 does not require proof of a fiduciary breach or deception. It is a prophylactic rule designed to prevent abuses in the tender-offer context, so mere possession plus trading (or tipping) can suffice.
While formulations vary, common elements are: (1) material, nonpublic information; (2) obtained through a relationship of trust and confidence with the source; (3) a deceptive breach of duty to the source via nondisclosure of intended trading (or tipping); (4) scienter (intent to deceive, manipulate, or defraud); (5) use of the information in connection with a securities trade; and (6) interstate commerce or exchange use. In criminal cases, willfulness must also be shown.
United States v. O’Hagan fundamentally reshaped insider-trading law by recognizing misappropriation as a deceptive device within §10(b)’s reach and by sustaining the SEC’s robust prophylactic authority in tender offers through Rule 14e-3. The decision prevents outsiders from evading liability merely because they owe no duty to a traded issuer’s shareholders, thereby safeguarding market integrity.
For law students and practitioners, O’Hagan provides the doctrinal architecture for analyzing outsider trading: identify a relationship of trust/confidence with a source, test for deceptive nondisclosure in the face of trading, ensure the “in connection with” nexus, and distinguish tender-offer cases where Rule 14e-3’s possession standard applies. It remains essential for exam analysis, compliance counseling, and enforcement strategy.