SEC v. Rocklage, 2006 WL 3290965, is a recent First Circuit decision in which the SEC brought a misappropriation theory-based insider trading charge against the spouse of a CEO who had passed material nonpublic information about her husband's company to her brother and his friend who then traded. As the court summarized the issue:
The defendants' view is that a pre-tip disclosure to the source of an intention to trade or tip completely eliminates any deception involved in the transaction. They rely on O'Hagan's language that "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." Id. at 655. The defendants argue that O'Hagan put no qualifiers on what is meant by "disclos[ure] to the source" of a plan to trade on nonpublic information, and so the SEC is not free to qualify the concept.
The SEC disagrees, arguing that the disclosure referenced in O'Hagan must mean disclosure that is "useful" to the fiduciary's principal. The SEC draws support from a footnote in O'Hagan which may be read as implying that disclosure enables a source to take remedial action. See id. at 659 n. 9 (explaining that "once a disloyal agent discloses his imminent breach of duty, his principal may seek appropriate equitable relief under state law"). As the SEC sees it, disclosure to the source serves a useful purpose when "the source of material non-public information reasonably could be expected to, and reasonably could, prevent the unauthorized use of the information for securities trading."
The First Circuit rejected both positions; instead, the court opined that:
Unlike this case, O'Hagan was not a case which involved the deceptive acquisition of information. Arguably, the language in O'Hagan can be read to create a "safe harbor" if there is disclosure to the fiduciary principal of an intention to trade on or tip legitimately acquired information. This is because under O'Hagan's logic such a "safe harbor" applies, if at all, when the alleged deception is in the undisclosed trading or tipping of information. In those cases, disclosure of the intent to trade arguably will eliminate the sole source of deception. But a case of deceptive acquisition of information followed by deceptive tipping and trading is different. It makes little sense to assume that disclosure of an intention to tip using deceptively acquired information would necessarily negate the original deception.
As I see it, this reading of O'Hagan guts the possibility that a brazen misappropriator can escape liability. If the "safe harbor" is limited to cases in which the alleged misappropriator "legitimately" acquires the information, the vast majority of misappropriation cases likely will be ineligible for the safe harbor.
Suppose for example the following: CEO discloses to CLO material nonpublic information. At the time the CLO receives the information, she plans to trade on the basis of it, but she does not disclose that intent to the CEO at that time. Sometime later, just as the CLO is about to trade, she discloses her plans to the CEO. My guess is that the First Circuit would tell us that the failure to disclose her intentions at the time she first received the information meant that she committed deception in acquiring the information and that her subsequent disclosure therefore does not preclude liability.
Rocklage also strikes me as raising some basic questions of policy and federalism. I have long argued that the law of insider trading ought to be about protection of property rights. (See, e.g., Insider Trading Regulation: The Path Dependent Choice between Property Rights and Securities Fraud.) The O'Hagan-based notion that a brazen misappropriator could escape liability, however, clearly was inconsistent with the property rights justification for regulating insider trading. Requiring the prospective misappropriator to disclose his intentions before trading provides only weak protection of the source of the information’s property rights therein. To be sure, in cases in which the disclosure obligation is satisfied, the difficult task of detecting improper trading is eliminated. As the majority pointed out, moreover, the source may have state law claims against the misappropriator. In some jurisdictions, however, it is far from clear whether inside trading by a fiduciary violates state law. Even where state law proscribes such trading, moreover, the Supreme Court’s approach means that in brazen misappropriator cases we lose the comparative advantage the SEC has in litigating insider trading cases and the benefit of the well-developed and relatively liberal remedy under rule 10b-5. Rocklage's requirement that the information be acquired legitimately in order for the inside trader to escape liability, however, jibes somewhat with a property rights approach, because it suggests that theft of the information (by deception) results in liability even if there is subsequent disclosure.
On the other hand, the property rights rationale would bring insider trading law into conflict with the federalism principles articulated in Santa Fe Indus. v. Green. As I explained in Insider Trading Regulation:
The insider trading prohibition co-exists uneasily with [federalism] principles. In Santa Fe, for example, the court held that rule 10b-5 did not reach claims “in which the essence of the complaint is that shareholders were treated unfairly by a fiduciary.” But this is the very essence of the complaint made in insider trading cases. The court also held that extension of Rule 10b-5 to breaches of fiduciary duty was unjustified in light of the state law remedies available to plaintiffs. Insider trading plaintiffs likewise have state law remedies available to them. Granted, those remedies vary from state to state and are likely to prove unavailing in many cases, but the same was true of the state law remedy at issue in Santa Fe. Finally, the court expressed reluctance “to federalize the substantial portion of the law of corporations that deals with transactions in securities, particularly where established state policies of corporate regulation would be overridden.” But this is precisely what the federal insider trading prohibition did.
Santa Fe thus is a serious doctrinal problem for proponents of an insider trading prohibition grounded in securities fraud. The Santa Fe “problem” in fact figured prominently in Bryan’s rejection of the misappropriation theory. Unfortunately, Santa Fe is also a serious obstacle for those of us who favor a property rights-based justification for the insider trading prohibition. As the Fourth Circuit put it: “the misappropriation theory transforms section 10(b) from a rule intended to govern and protect relations among market participants who are owed duties under the securities laws into a federal common law governing and protecting any and all trust relationships.” This is precisely what a property rights approach mandates, but it also amounts to “the effective federalization of [fiduciary] relationships historically regulated by the states,” which is precisely what Santa Fe was intended to prevent.
Ginsburg finessed this problem in Santa Fe by refocusing insider trading from the trade itself to the failure to disclose that one intends to trade. By focusing on whether the defendant legitimately acquired the information, does Rocklage raise Santa Fe concerns? Presumbaly not, because the court appears adqeuately to have equated the legitimacy of how the information was acquired with deception. In other words, unless there was deception in the manner by which the defendant acquired the information, there should be no liability.