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RECENT DEVELOPMENTS IN
FEDERAL SECURITIES LITIGATION
HENRY H. ROSSBACHER
ROSSBACHER & ASSOCIATES
LOS ANGELES, CALIFORNIA
Like Gaul, enforcement of the federal securities laws against fraud in the United States is divided into three parts: criminal prosecutions by the United States Department of Justice for securities laws violations; enforcement actions by the Securities and Exchange Commission seeking civil penalties, injunctive relief, restitution and, in major frauds, appointments of receivers; and civil litigation by private parties. Recently there have been interesting developments in each of these areas.
The most significant development in criminal enforcement has been the recent decision by the United States Supreme Court to round out its delineation of criminal insider trading law in the controversial O'Hagan case.(1) A Minnesota lawyer, a partner in a prominent international law firm, Dorsey & Whitney, LLP, bought shares and call options on Pillsbury Company stock based on unauthorized use of inside information gained from the law firm's representation of London-based Grand Met PLC in a projected takeover of Pillsbury. O'Hagan made a $4 million profit when the tender offer was announced in October of 1988. He was indicted and convicted after a jury trial of 57 counts of mail fraud,(2) money laundering(3) and violating section 10(b) and Rule 10b-5(4) and section 14(e) and Rule 14e-3(a)(5) of the Securities Exchange Act of 1934.
The case is of major import because the Circuit Courts of Appeal had disagreed sharply over whether conduct like O'Hagan's violates the Act and the Rules. The Supreme Court had defined the so-called "classical theory" of insider trading in Chiarella v. United States(6) and Dirks v. SEC.(7) In "classical theory" cases, stock traders affiliated with the corporation whose stock was purchased, "insiders," were prosecuted for capitalizing on material, non-public information. The criminal violations were founded on the direct breach of fiduciary duties running to the selling shareholders.
The "classical theory" had no application to O'Hagan as he had no duty to Pillsbury's shareholders; his duties were solely to the potential purchaser of Pillsbury shares, his client, Grand Met. The conviction rested solely on the "misappropriation theory" which extends Rule 10b-5 to trading based on "deceitful misappropriation of confidential information by a fiduciary" to a party not affiliated with the corporation whose stock is traded.(8) The Eighth Circuit, over an adamant dissent, followed the Fourth Circuit(9) and rejected in total O'Hagan's conviction, the SEC's promulgation of Rule 14e-3(a) (which had created explicit duties and prohibitions in tender offers) and the contrary holdings of at least three, if not four, fellow Circuits.(10)
The Supreme Court's long-awaited decision(11) upholding the "misappropriation theory" defines acceptable conduct in America's securities markets, particularly for takeover and merger participants. A six-member majority of the Court, in an extremely clear decision by Justice Ginsburg, endorsed completely the principle that "trades for personal profit, using confidential information in breach of a fiduciary duty to the source of the information" constitute crimes under section 10b and Rule 10b-5. The Court found the requisite fraud to be misuse by the trader of the principal's valuable and secret information.(12) Since the victim of the fraud is the source, the Court found that disclosure of the use of the information to the trader's source "forecloses" criminal liability. Thus, deception of an identifiable purchaser or seller is irrelevant to the offense. It is the deception of the source and the simultaneous harm to public investors through the use of the secret information that satisfies the Act's requirement that the use be "in connection with the purchase or sale of [a] security." The "misappropriation theory," thus, complements the "classical theory," creating for a different set of actors in the securities markets potential and actual criminal liability.
A seven-member majority then went on to uphold O'Hagan's convictions for violation of section 14(e) and Rule 14e-3(a). The Act and Rule prohibit trading "on the basis of material non-public information concerning a tender offer that [the trader] knows or has reason to know has been acquired directly or indirectly from an insider of the offerer or issuer or someone working on their behalf." The rule is a "disclose or abstain from trading requirement."(13) The Rule was expressly designed both to create a duty in those not bound by fiduciary obligations and to obviate the need to charge and prove those obligations even as to fiduciaries. The Eighth Circuit had struck down the Rule, finding that only trading in violation of a fiduciary duty could be penalized.(14)
The Court had little difficulty upholding the Rule as a proper exercise of the Commission's power to prevent with "prophylactic measures" fraudulent trading on material non-public information. The Court upheld the Commission's power to "prohibit acts", not themselves fraudulent under the common law or section 10(b) where "the prohibition is 'reasonably designed to prevent ... acts and practices [that] are fraudulent.'"(15)
The O'Hagan decision is a clear victory for the Commission. Circuit Courts of Appeal have shown an increasing appetite for "technical" arguments limiting civil and criminal liability for securities fraud. At least in this context, it appears that there is a solid majority on the Supreme Court for enforcing broad proscriptions.
The SEC's enforcement actions, previously aimed primarily at people actually committing and profiting from securities frauds, have taken a new tack in recent months. Perhaps motivated by inadequate enforcement budgets and staff, rampant stock speculation and what seems to be a regulatory failure to effectively combat the geometric increase in fraudulent scams, the SEC seems to have a new tactic: attack the professionals under the new Private Securities Litigation Reform Act of 1995.(16)
Section 104 of the new Act clarified the authority of the SEC to bring injunctive actions against "any person that knowingly provides substantial assistance to another person" in violating the securities laws.(17) Money penalties are also authorized.(18) Doubt as to the SEC's authority to act had been created by the Supreme Court's decision in Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 114 S.Ct. 1439, 129 L.Ed.2d 119 (1994), which disallowed private actions under section 10(b) against aiders and abettors.
The SEC had started down this road in California before the Central Bank decision and the subsequent adoption of the new Act. In November of 1992, the SEC brought an injunction against an eminent securities lawyer, H Thomas Fehn, alleging he had aided and abetted violations, inter alia, of sections 10(b) and 15(d) of the Securities Exchange Act through provision to his client of what the SEC regarded as incorrect legal advice. The case resulted in a permanent injunction and a sweeping opinion by the United States Court of Appeals for the Ninth Circuit, SEC v. Fehn.(19)
Fehn argued, based upon a well known case in the Second Circuit, United States v. Matthews,(20) that his client had a Fifth Amendment privilege not to make certain disclosures as they would be incriminatory of past violations. The Circuit, although admitting that it had "not yet applied these principles in the securities regulation context," after an extensive discussion showing the incorrectness of this legal advice, upheld the legal principle that rendering this advice could constitute both "substantial assistance" in the client's commission of the substantive violation and the required scienter for aiding and abetting liability. The Circuit refused to allow a good faith defense because the Court found the regulatory requirements to be so clear that the advice was not "reasonable." The Circuit went on to adopt the SEC's argument "that effective regulation of the issuance and trading of securities depends, fundamentally, on securities lawyers . . . properly advising their clients . . . ." It is not clear whether advice at odds with the SEC's views of the laws will draw this draconian response in the future.
The SEC's action and Circuit's decision here make clear that attorneys advising market participants in situations involving both past violations and ongoing actions risk both liability and sanctions should their advice be found not to be "reasonable."(21) It appears that the SEC's frustration level may lead it to target more outside professionals. The Ninth Circuit's decision provides no comfort that these new targets of regulatory sanctions will receive a sympathetic hearing in the courts.
PRIVATE CIVIL LITIGATION
The most unusual private securities case of recent months involves the extraterritorial reach of the Racketeer Influenced and Corrupt Organizations Act ("RICO").(22) The European and Panamanian holding companies which owned and sold the stock of Saudi European Bank, now Societe de Banque Privee and Societe d'Analyses et d'Etudes Bretonneau, to French investment banking groups came into federal District Court in Manhattan alleging claims under RICO and New York State law. The two complaints and RICO statements recounted a lurid tale replete with allegations of bribery, extortion and general economic thuggery. The RICO claims were grounded in alleged fraud violations of the mail and wire fraud statutes,(23) the Hobbs Act,(24) the Travel Act,(25) and the New York Penal Law.(26) The gravamen of the charges was that the France-based purchasers corrupted the bank's general manager in Paris in order to artificially understate the bank's financial statements and bring down French regulatory pressure to force a sale at artificially depressed prices. Additional allegations concerned concealments and diversions of contingent payments due the sellers from New York to Paris. As the federal district judge described the case: This is a dispute among foreigners over business activities in France.(27)
The District Court, following the apparently clear dictates of the Second Circuit's decision in Alfadda v. Fenn,(28) held that subject matter jurisdiction over RICO claims requires satisfaction by the underlying predicate acts of either the "conduct" or "effects" tests applied in the extra-territorial analysis of securities claims.(29) The District Court went on to demonstrate convincingly that plaintiffs could meet neither.
The Circuit's decision, however, has muddied the waters considerably. Plaintiffs appealed solely the District Court's decision under the conduct test, apparently conceding their failure to demonstrate substantial effects in the United States from the allegedly criminal conduct. The Circuit had no qualms in affirming the District Court:(30)
[W]e have no doubt that the district court was without jurisdiction over a controversy involving foreign victims who sold a foreign entity to foreign defrauders in a foreign transaction lacking significant and material contact with the United States.
What the Circuit put in play was the propriety of the conduct test itself. The opinion declined to find Alfadda had settled the issue as to RICO extraterritoriality since "we were concerned primarily with subject matter jurisdiction over the plaintiffs' securities fraud claims under the conduct test."(31) The Circuit deferred to a later date, the "delicate work" of "specifying the test for extraterritorial application of RICO."(32) In short, the Circuit disavowed Alfadda as establishing that the conduct test applies to RICO litigations.
The case does not merely demonstrate the futility of attempting to cram a foreign securities fraud case into an American court. It also signals a willingness on the part, at least, of the Second Circuit to reexamine the extraterritorial reach of RICO, the United States' most punitive civil remedy.
1. United States v. O'Hagan, __U.S.__, 1997 WL345229 (June 25, 1997, No. 96-842), reversing, 92 F.3d 612 (8th Cir. 1996).
2. 18 U.S.C. § 1341. O'Hagan was separately disbarred and incarcerated for thirty months for "invading clients' trust funds." O'Hagan, 92 F.3d at 628 and 1997 WL345229 at p.21, fn.3.
3. 18 U.S.C. §§ 1956(a)(1)(B)(i) and 1957.
4. 15 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5.
5. 15 U.S.C. § 78n(e); 17 C.F.R. § 240.14e-3(a).
6. 445 U.S. 222, 100 S.Ct. 1108, 63 L.Ed.2d 348 (1980).
7. 463 U.S. 646, 103 S.Ct. 3255, 77 L.Ed.2d 911 (1983).
8. United States v. Newman, 664 F.2d 12, 16-19 (2d Cir. 1981).
9. United States v. Bryan, 58 F.3d 933 (4th Cir. 1995).
10. O'Hagan, 92 F.3d at 620. The Second, Seventh and Ninth Circuits have clearly embraced the misappropriation theory. See Newman, supra; SEC v. Maio, 51 F.3d 623 (7th Cir. 1995); SEC v. Clark, 915 F.2d 439 (9th Cir. 1990). A debate lingers as to whether the Third Circuit unequivocally joined in Rothberg v. Rosenbloom, 771 F.2d 818 (3d Cir. 1985).
11. An evenly divided Supreme Court affirmed a "misappropriation theory" conviction in Carpenter v. United States, 484 U.S. 19, 108 S.Ct. 316, 98 L.Ed.2d 275 (1987), without deciding or discussing the issue. The Court unanimously affirmed wire and mail fraud convictions for the same conduct, use of the Wall Street Journal's confidential information (knowledge of forthcoming stock recommendations) to trade, on the theory that the traders had embezzled the Journal's property right to use the information first.
12. The Court found O'Hagan's conduct to be "fraud of the same species" as the information embezzlement in Carpenter, supra, note 11.
13. O'Hagan, 1997 WL345229 at p.11.
14. The Eighth Circuit's decision contradicted the prior decisions of the Second Circuit in United States v. Chestman, 947 F.2d 551 (2nd Cir. 1991)(en banc), cert. denied, 503 U.S. 1004, 112 S.Ct. 1759, 118 L.Ed.2d 422 (1992), the Seventh Circuit in Maio, supra, n.10, and the Tenth Circuit in SEC v. Peters, 978 F.2d 1162 (10th Cir. 1992).
15. O'Hagan, 1997 WL345229 at p.12.
16. § 104, Pub.L. 104-67, 109 Stat. 737 (1995) codified as 15 U.S.C. § 781. Commissioner Johnson, noting that the SEC's "capabilities" are "stretched to the limits" with a 250% growth in enforcement actions in 16 years, addressed the topic of suits against lawyers and did not reassure the Bar. See Address by Securities and Exchange Commissioner Norman S. Johnson, American Bar Association Federal Securities Law Committee (Nov. 8, 1996) (available at http://www.sec.gov/news/speeches/spch13).
17. 15 U.S.C. § 78t(f). See James D. Cox, Just Desserts for Accountants and Attorneys After Bank of Denver, 38 Ariz. L. Rev. 519, 536-540 (1996).
18. 15 U.S.C. §§ 78a(d)(1) and (3).
19. 97 F.3d 1276 (9th Cir. 1997), petition for certiorari filed, 65 USWL 3815 (May 22, 1997) (No. 96-1883). The Solicitor General has filed an Opposition. The case directly upheld the authority of the SEC under the new Act to bring actions against alleged aiders and abettors. 97 F.3d at 1282-1287.
20. 787 F.2d 38, 49 (2nd Cir. 1986). The Second Circuit had premised its reversal of a conviction for violation of the Securities Exchange Act for failure to disclose incriminatory information in a proxy statement in analogous circumstances in part on "concerns about the self-incrimination implications" of enforcing disclosure. The legal advice given relied upon those concerns. The Fehn decision dismisses Matthews in a footnote, failing even to mention the Second Circuit's Fifth Amendment discussion or distinguish it in the main text's treatment of the Fifth Amendment claim. 97 F.3d at 1290, fn.12.
21. 97 F.3d at 1293-1295.
22. 18 U.S.C. § 1961 et seq.
23. 18 U.S.C. §§ 1341, 1343.
24. 18 U.S.C. § 1951.
25. 18 U.S.C. § 1952.
26. N.Y. Penal Law § 155.40-2(a).
27. North South Finance Corp. v. Al-Turki, 1996 WL 50526 (SDNY), aff'd 100 F.3d 1046 (2d Cir. 1996).
28. 935 F.2d 475 (2d Cir.), cert. denied, 502 U.S. 1005, 112 S.Ct. 638, 116 L.Ed.2d 656 (1991), discussed at 1996 WL 50526, *8.
29. Briefly, the "conduct test" confers jurisdiction where conduct material to the completion of the fraud occurred in the United States. The "effects test" upholds jurisdiction whenever a predominantly foreign transaction has substantial effects within the United States.
30. 100 F.3d at 1052.
31. 100 F.3d at 1052, fn.7. It is somewhat difficult to understand the Circuit's doubt "that the conduct test, as it has developed in foreign securities fraud cases, governs in cases involving the extraterritorial application of RICO" given the Alfadda decision. 100 F.3d at 1052. The unanimous panel in Alfadda determined that the conduct test justified taking jurisdiction over the securities violations alleged as the predicate acts under the conduct test. The Court then rejected a "parochial application" of RICO finding the securities violations "were predicate acts which occurred primarily in the United States, and hence, serve as a basis of subject matter jurisdiction for the RICO claims." 935 F.2d at 479-480.
32. 100 F.3d at 1052.
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