Illegal Insider Trading
Consider this: "Imagine a boardroom of corporate executives, along with
their lawyers, accountants, and investment bankers, plotting to take over a
public company. The date is set; an announcement is due within weeks. Meeting
adjourned, many of them phone their brokers and load up on the stock of the
target company. When the takeover is announced, the share price zooms up and the
lucky 'investors' dump their holdings for millions in profits." First
things first - insider trading is perfectly legal. Officers and directors who
owe a fiduciary duty to stockholders have just as much right to trade a security
as the next investor. But the crucial distinction between legal and illegal
insider trading lies in intent. What this paper plans to investigate is the
illegal aspects of insider trading. What is insider trading? According to

Section 10(b) of the Securities Exchange Act of 1934, it is "any
manipulative or deceptive device in connection with the purchase or sale of any
security." This ruling served as a deterrent for the early part of this
century before the stock market became such a vital part of our lives. But as
the 1960's arrived and illegal insider activity began to pick up, courts were
handcuffed by this vague definition. So judicial members were forced to
interpret "on the fly" since Congress never gave a concrete
definition. As a result, two theories of insider trading liability have evolved
over the past three decades through judicial and administrative interpretation:
the classical theory and the misappropriation theory. The classical theory is
the type of illegal activity one usually thinks of when the words "insider
trading" are mentioned. The theory's framework emerged from the 1961 SEC
administrative case of Cady Roberts. This was the SEC's first attempt to
regulate securities trading by corporate insiders. The ruling paved the way for
the traditional way we define insider trading - "trading of a firm's stock
or derivatives assets by its officers, directors and other key employees on the
basis of information not available to the public." The Supreme Court
officially recognized the classical theory in the 1980 case U.S. v. Chiarella.

U.S. v. Chiarella was the first criminal case of insider trading. Vincent

Chiarella was a printer who put together the coded packets used by companies
preparing to launch a tender offer for other firms. Chiarella broke the code and
bought shares of the target companies based on his knowledge of the takeover
bid. He was eventually caught, and his case clarified the terms of what has come
to be known as the classical theory of insider trading. However, the Supreme

Court reversed his conviction on the grounds that the existing insider trading
law only applied to people who owed a fiduciary responsibility to those involved
in the transaction. This sent the SEC scrambling to find a way to hold these
"outsiders" equally accountable. As a result, the misappropriation
theory evolved over the last two decades. It attempted to include these
"outsiders" under the broad classifications of insider trading. An
outsider is a "person not within or affiliated with the corporation whose
stock is traded." Before this theory came into existence, only people who
worked for or had a direct legal relationship with a company could be held
liable. Now casual investors in possession of sensitive information who were not
involved with the company could be held to the same standards as CEOs and
directors. This theory stemmed from a 1983 case, Dirks v. SEC, but the existence
of the misappropriation theory had not been truly recognized until U.S. v.

O'Hagan in 1995. The case - U.S. v. O'Hagan - involved an attorney at a

Minneapolis law firm. He learned that a client of his firm (Grand Met) was about
to launch a takeover bid for Pillsbury, even though he wasn't directly involved
in the deal. The lawyer then bought a very sizable amount of Pillsbury stock
options at a price of $39. After Grand Met announced its tender offer, the price
of Pillsbury stock rose to nearly $60 a share. When the smoke finally cleared,

O'Hagan had made a profit of more than $4.3 million. He was initially convicted,
but the verdict was overturned. The case bounced around in the Court of Appeals
for several years before it made its way to the Supreme Court. It is there the

Supreme Court held that O'Hagan could be prosecuted for using inside
information, even if he did not work for Pillsbury or owe any legal duty to the
company. In a 6-3 ruling, the court indicted O'Hagan and, in doing so, upheld
the foundation of the misappropriation theory. I