UNITED STATES OF AMERICA, PETITIONER v. JAMES HERMAN O'HAGAN

 

No. 96-842

 

1996 U.S. Briefs 842

 

October Term, 1996

 

February 27, 1997

 

ON WRIT OF CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE EIGHTH CIRCUIT

 

BRIEF FOR THE UNITED STATES

 

RICHARD H. WALKER, General Counsel, PAUL GONSON, Solicitor, JACOB H. STILLMAN, Associate General Counsel, ERIC SUMMERGRAD, Principal Assistant General Counsel, RANDALL W. QUINN, Senior Litigation Counsel, ADAM C. PRITCHARD, Attorney, Securities and Exchange Commission, Washington, D.C. 20549, WALTER DELLINGER, Acting Solicitor General, MARK M RICHARD, Acting Assistant Attorney General, MICHAEL R. DREEBEN, Deputy Solicitor General, PAUL R.Q. WOLFSON, Assistant to the Solicitor General, JOSEPH C. WYDERKO, Attorney, Department of Justice, Washington, D.C. 20530-0001, (202) 514-2217

 

QUESTIONS PRESENTED

1. Whether respondent's trading in securities on material, nonpublic information that he misappropriated in breach of his fiduciary duties violated Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. 78j(b), and Rule 10b-5 thereunder, 17 C.F.R. 240.10b-5.

2. Whether the Securities and Exchange Commission validly exercised its rulemaking authority under Section 14(e) of the Securities Exchange Act of 1934, 15 U.S.C. 78n(e), in promulgating Rule 14e-3(a), 17 C.F.R. 240.14e-3(a), an insider trading rule relating to tender offers.

3. Whether respondent's trading in securities on material, nonpublic information that he misappropriated in breach of his fiduciary duties violated the mail fraud statute, 18 U.S.C. 1341, even if his conduct did not violate the securities laws.

ARGUMENT

I. TRADING IN SECURITIES ON MISAPPROPRIATED INFORMATION VIOLATES SECTION 10(b) OF THE EXCHANGE ACT AND RULE 10b-5

A. The Misappropriation Theory Falls Within Section 10(b)'s Coverage Of "Deceptive Devices" "In Connection With" Securities Transactions

B. The Misappropriation Theory Is Consistent With The Decisions Of This Court

C. The Misappropriation Theory Furthers Important Policies Of The Securities Laws And Has Been Accepted As Valid In Amendments To Those Laws

Trading on misappropriated information strikes at the heart of investor confidence in fair and honest securities markets, and it discourages legitimate investment in information gathering and analysis. Those concerns plainly implicate the "public interest" that the SEC may protect by forbidding trading on misappropriated information under Section 10(b) and Rule 10b-5. Congress has confirmed that view by enacting legislation that builds on the misappropriation theory That legislation further supports the validity of the misappropriation theory.

1. "In the wake of the 1929 stock market crash and in response to reports of widespread abuses in the securities industry, the 73d Congress enacted two landmark pieces of securities legislation: the Securities Act of 1933 (1933 Act,) and the Securities Exchange Act of 1934 (1934 Act)." Central Bank, 511 U.S. at 170-171. The "basic goals" of the Exchange Act are "to provide fair and honest mechanisms for the pricing of securities, to assure that dealing in securities is fair and without undue preferences or advantages among investors, * * * and to provide, to the maximum degree practicable, markets that are open and orderly." H.R. Conf. Rep. No.-229, 94th Cong., 1st Sess. 91-92 (1975).

An essential goal of the Exchange Act is the promotion of investor confidence in the fairness of the markets. See 15 U.S.C. 78h (regulation necessary "to insure the maintenance of fair and honest markets") Section 10(b) furthers that aim by permitting the Commission to prohibit those "manipulative and deceptive practices which have been demonstrated to fulfill no useful function." S. Rep. No. 792, 73d Cong., 2d Sess. 6 (1934). The SEC has made the judgment that trading on misappropriated information "undermines the integrity of, and investor confidence in, the securities markets." 45 Fed. Reg. 60,412 (1980). That judgment is sound. If investors knew that the SEC and the federal securities laws could not protect the markets against the use of illegally acquired information, and that no amount of research or skill could overcome their informational disadvantage, many would decline to participate in the markets at all, for they would know that they were playing a game in which the dice might, at any time, be loaded.[1] See Victor Brudney, Insiders, Outsiders, and Informational Advantages Under the Federal Securities Laws, 93 Harv. L. Rev. 322, 356 (1979); Nicholas Georgakopoulos, Insider Trading a.s a Transactional Cost: A Market Microstructure Justification and Optimization of Insider Trading Regulation, 26 Conn. L. Rev. 1, 19, 33 (1993) Other investors might demand risk premiums to compensate for the fear of overreaching, or engage in corrupt actions to overcome their informational disadvantages. "None of those responses is socially useful." Brudney, 93 Harv. L. Rev. at 356; see id. at 334-335. And capital formation would be impaired if investors left the securities markets because of lost confidence in the fairness of those markets (or demanded premiums to compensate for the risk of unfairness)--a point noted twice recently by congressional committees in the course of the enactment of increased sanctions for insider trading. H.R. Rep. No. 355, 98th Cong., 1st Sess. 2 (1983); H.R. Rep. No. 910, 100th Cong., 2d Sess. 8 (1988).[2]

The unfair advantage gained by misappropriation of information could also discourage securities analysts from competing lawfully for information and providing investors with valuable insights into the worth of specific companies. Indeed, the use of misappropriated information in the securities markets may discourage the creation of such information in the first place. See Frank H. Easterbrook, Insider Trading, Secret Agents, Evidentiary Privileges, and the Production of Information, 1981 Sup. Ct. Rev. 309, 313. And advance trading on misappropriated information can drive up the cost of transactions by increasing the price that the acquiring company must pay for tendered shares. See Bradford Cornell & Erik Sirri, The Reaction of Investors and Stock Prices to Insider Trading, 47 J. Fin. 1031, 1032-10,23, 1045-1046 (1992); SEC v. Maio, 51 F.3d 623, 634 n.12 (7th Cir. 1995); United States v. Newman, 664 F.2d 12, 17-18 (1981), aff'd after remand, 722 F.2d 729 (2d Cir.) (Table), cert. denied, 464 U.S. 863 (1983). All those consequences harm the public interest, and all support the conclusion that liability for deceptive trading on misappropriated information is consistent with Section 10(b).

Accordingly, there is no basis for concluding that the misappropriation theory is inconsistent with Section 10(b).

II. THE SEC VALIDLY PROMULGATED RULE 14e-3(a) PURSUANT TO ITS RULEMAKING AUTHORITY IN SECTION 14(e) OF THE EXCHANGE ACT

III. RESPONDENT'S MISAPPROPRIATION OF CONFIDENTIAL INFORMATION TO TRADE IN SECURITIES VIOLATED THE MAIL FRAUD STATUTE

CONCLUSION

The judgment of the court of appeals should be reversed.

Respectfully submitted.

RICHARD H. WALKER, General Counsel, PAUL GONSON, Solicitor, JACOB H. STILLMAN, Associate General Counsel, ERIC SUMMERGRAD, Principal Assistant General Counsel, RANDALL W. QUINN, Senior Litigation Counsel, ADAM C. PRITCHARD, Attorney, Securities and Exchange Commission, WALTER DELLINGER, Acting Solicitor General, MARK M RICHARD, Acting Assistant Attorney General, MICHAEL R. DREEBEN, Deputy Solicitor General, PAUL R.Q. WOLFSON, Assistant to the Solicitor General, JOSEPH C. WYDERKO, Attorney

FEBRUARY 1997



[1] The role of the SEC is vital to investor confidence, because, as this Court has noted, "Congress recognized that efficient regulation of securities trading could not be accomplished under a rigid statutory program. As part of the 1934 Act Congress created the Commission, which is provided with an arsenal of flexible enforcement powers." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 195 (1976).

[2] See also American Bar Ass'n, Comm. on Federal Regulation of Securities, Report of the Task Force on Regulation of Insider Trading, 41 BUS. LAW. 223, 228 (1985); Steven R. Salbu, Tipper Credibility, Noninformational Tippee Trading, and Abstention From Trading: An Analysis of Gaps in the Insider Trading Laws, 68 Wash. L. Rev. 307, 328 n.117 (1993); John W. Bagby, The Evolving Controversy Over Insider Trading, 24 Am. Bus. L.J. 571, 579 n.55 (1987) (quoting Arthur Levitt, Jr., then chairman of the American Stock Exchange).