LAW638 White Collar Crime

WEEK 7
SECURITIES FRAUD
Securities Fraud
Insider Trading
o Traditional Theory
o Misappropriation
Tipper/Tippee Liability
Cady Robers Rule
Wilfulness – Get out of jail!

Federal White Collar Crime p 597 – 664

Rationale for Insider Trading Prohibition
Donald C. Langevoort, Insider Trading: Regulation, Enforcement and Prevention
1:2 to 1:6, at 1-8 to 1-17 (West 2002)
No economic harm done – suppose that the friend buys 1000 shares at $7 as a
result of a tip, thus being able to make a quick $5000 profit, when unknown to the
public, the acquiring company is prepared to pay $12 per share in a friendly
merger
Were insiders permitted to profit from trading, they would have an incentive to
delay disclosure of information until their personal profit from the information
has been captured
Unfair exploitation of information that properly belongs to somebody else
Traditional Theory
They have a duty to the shareholders of the company.
(i) Principal Liability
Chiarella v United States
455 US 222 (1980)
Facts Petitioner was hired by the Tender Company. He did not have any
shares of the Tender Company – but he would buy stocks of the
Target Company. He owes no duty to the Target Company
While working for a financial printer, petitioner handled
announcements of corporate takeover bids. While these documents
were delivered to the printer, the identities of the acquiring and
target corporations were concealed by blank spaces or false names.
The true names were sent to the printer on the night of the final
printing. The petitioner, however, was able to deduce the name of
the target companies before the final printing from other
information contained in the documents.
Without disclosing his knowledge, petitioner purchased the
targeted companies stock, selling the shares immediately after the
takeover attempts were made public.
Ruling The Court held that petitioner had not violated the duty to disclose
material information where no relationship of trust or confidence
existed between petitioner and the shareholders.
While noting that silence in connection with the purchase or sale of
securities could have been fraud under § 10(b), the Court held that
petitioner had not violated § 10(b) where he was under no
affirmative duty to disclose the information before trading.
Because petitioner was not an agent or fiduciary of the sellers, the

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Court found that he had no duty to the sellers.

Holding The obligation to disclose or abstain derives from:
o Existence of a relationship affording access to insider
information intended to be available only for a corporate
purpose, and
o Unfairness of allowing a corporate insider to take advantage
of that information by trading without disclosure
Silence in connection with the purchase or sale of securities may
operate as a fraud actionable under 10(b) despite the absence of
statutory language or legislative history specifically addressing the
legality of nondisclosure. But such liability is premised upon a duty
to disclose arising from a relationship of trust and confidence
between parties to a transaction
The petitioner was convicted of violating 10(b) although he was not
a corporate insider and he received no confidential information
from the target company. The “market information” upon which he
relied did not concern the earning power or operations of the target
company, but only the plans of the acquiring company. Petitioner‟s
use of that information was not a fraud unless he was subject to
an affirmative duty to disclose it before trading.
Dissenting Neither party to an arm‟s length business transaction has an
by Chief obligation to disclose information to the other unless the parties
Justice stand in some confidential or fiduciary relation.
Burger Any time information is acquired by an illegal act it would seem
that there should be a duty to disclose that information. CJ read
10(b) and Rule 10b-5 to encompass and build on this principle: to
mean that a person who has misappropriated nonpublic
information has an absolute duty to disclose that information or to
refrain from trading
Notes Cady Roberts Rule: If you have inside information and you
are trading on the market, you have the responsibility to
disclose that information or abstain from trading.
Petitioner owns a duty to the printer, which then owns a duty to
tender company A. It is possible to catch him by misappropriation
A variance! Could someone, after a variance has been proved, can
be liable. Court however held that there was such a variance
between the traditional and misappropriation that he could not be
held liable
(ii) Tipper/Tippee Liability
Dirks v SEC
463 US 646 (1983)
Facts
EFA Seacrist
(Insider) Client

Client
Dirks
(Tippee)
Client

Petitioner was an officer of a broker-dealer firm and specialized in

investment analysis of insurance company securities to investors.
Petitioner received information that a corporation, Equity Funding,

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had vastly overstated assets.

Secrist (insider) gave the tip to Driks
Petitioner discussed this information with clients, and some of
those clients sold holdings in the corporation. When respondent
learned of petitioner's actions, respondent found that petitioner
aided and abetted violations of § 17(a) of the Securities Act of 1933,
and § 10(b) of the Securities Exchange Act of 1934, by repeating the
allegations to members of the investment community. Dirks himself
did not trade
In a divided opinion, the appellate court found against petitioner
and he sought the Court's review. The U.S. Supreme Court held
there was no actionable insider-trading violation by petitioner
where petitioner was a stranger to the corporation, had no fiduciary
duty to corporation's shareholders, did not try to gain corporate
shareholder's confidence, and did not illegally obtain the
information about the corporation. Therefore, petitioner had no
duty to abstain from the use of the inside information, and the
lower court's judgment was reversed.
Issue Whether a tippee is required to disclose the information or refrain
from trading
Holding Unlike insiders who have independent fiduciary duties to
both the corporation and its shareholders, the typical tippee
has no such relationships. In view of this absence, it has been
unclear how a tippee acquires the Cady, Roberts duty to refrain from
trading on insider information
A duty to disclose arises from the relationship between parties, and
not merely from one‟s ability to acquire information because of his
position in the market
Imposing a duty to disclose or abstain solely because a person
knowingly receives material nonpublic information from an insider
and trades on it could have an inhibiting influence on the role of
market analysts, which the SEC itself recognises is necessary to the
preservation of a healthy market
However, some tippees must assume an insider‟s duty to the
shareholders not because they receive inside information, but rather
because it has been made available to them improperly
A tippee assumes a fiduciary duty to the shareholders of a
corporation not to trade on material nonpublic information only
when the insider has breached his fiduciary duty to the
shareholders by disclosing the information to the tippee and the
tippee knows or should know that there has been a breach
Whether disclosure [by the tipper] is a breach of duty…depends in
large part on the purpose of the disclosure (i.e. whether the insider
personally will benefit, directly or indirectly, from his disclosure)
Footnote 14: The Court carves out very important category of
persons potentially subject to insider trading sanctions: “quasi-“ or
“temporary” insiders. Certain persons who are formally “outsiders”
– lawyers, accountants or bankers not employed by an entity but
performing services for it – may be deemed temporary or quasi-
insiders when they have “entered into a special confidential

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relationship in the conduct of the business of the enterprise and are

given access to information solely for corporate purposes”
(iii) Misappropriation Theory
United States v O‟Hagan
521 US 642 (1997)
Facts
GM Pilsbury

Dorsey

O‟Hagan

Respondent was a partner in a law firm which represented a

company regarding a potential tender offer for the common stock of
another company. During the representation, respondent
purchased call options for the other company's stock and sold them
for a significant profit.
After the SEC initiated an investigation into respondent's
transactions, a jury convicted respondent of securities fraud. On
writ of certiorari, the Court held that criminal liability under § 10(b)
of the Securities Exchange Act of 1934 may be predicated on the
misappropriation theory.
Issue Is a person who trades in securities for personal profit, using
confidential information misappropriated in breach of a fiduciary duty
to the soruce of the information, guilty of violating 10(b) and Rule 10b-
5?
Ruling Yes
Holding “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
Willfulness: intentional violation of a known act. If O‟Hagan
subjectively believed that he was not in violation of the law in
doing such a trading, he can present it as a defence and not go to
jail
Under this theory, a fiduciary‟s undisclosed, self-serving use of a
principal‟s information to purchase or sell securities, in breach of a
duty of loyalty and confidentiality, defrauds the principal of the
exclusive use of that information. In lieu of premising liability on a
fiduciary relationship between company insider and purchaser or
seller of the company‟s stock, the misappropriation theory premises
liability on a fiduciary-turned-trader‟s deception of those who
entrusted him with access to confidential information
The misappropriation theory outlaws trading on the basis of
nonpublic information by a corporate “outsider” in breach of a duty
owed not to a trading party, but to the source of the information

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“In connection with the purchase or sale of [a] security”: Satisfied

because 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
Emphasizes the need to interpret 10(b)‟s requirement that a
deceptive device be “used or employed, in connection with the
purchase or sale of any security”: Undisclosed misappropriation
of confidential information would meet such a criteria
Dissenting Unlike the majority, however, I cannot accept the Commission‟s
interpretation of when a deceptive device is “used in connection
with” a securities transaction.
If the relevant test under the “in connection with” language is
whether the fraudulent at is necessarily tied to a securities
transaction, then the misappropriation of confidential information
used to trade no more violates 10(b)than does the misappropriation
of funds used to trade. As the Commission concedes that the latter
is not covered under its theory, I am at loss to see how the same
theory can coherently be applied to the former
SECURITIES FRAUD UNDER 18 USC 1348
Whoever knowingly executes, or attempts to execute, a scheme or artifice--
o (1) to defraud any person in connection with any commodity for future
delivery, or any option on a commodity for future delivery, or any security of
an issuer with a class of securities registered under section 12 of the Securities
Exchange Act of 1934 (15 U.S.C. 78l) or that is required to file reports under
section 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78o(d)); or
o (2) to obtain, by means of false or fraudulent pretenses, representations, or
promises, any money or property in connection with the purchase or sale of
any commodity for future delivery, or any option on a commodity for future
delivery, or any security of an issuer with a class of securities registered
under section 12 of the Securities Exchange Act of 1934 (15 U.S.C. 78l) or that
is required to file reports under section 15(d) of the Securities Exchange Act of
1934 (15 U.S.C. 78o(d));
shall be fined under this title, or imprisoned not more than 25 years, or both.
ACCOUNTING FRAUD
Revenue Recognition
o Incomplete transactions: Seller‟s rights to collect what is owed, or an
obligation to refund what already has been paid, or that the seller still has
substantial performance obligations before that seller can truly say it has
“substantially accomplished what it msut do to be entitled to the benefits
represented by the revenues”
o Round Trippers: Takes place where Companies A and B agree to buy each
other‟s products or services (usually in approximately equal amounts) to
boost the revenues – and sometimes reported profits – of each
o Barter Transactions: Barter, or “non-monetary” transactions are special
version of round trippers where the transaction involves little or no
exchange of cash
o Channel Stuffing: Occurs where a manufacturer that sells through
distributors “makes forecast” by unusually large sales to those
distributors. These transactions often take place at or near quarter end

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