The opinion of the court was delivered by: Savage, J.
Defendant Timothy McGee, who is charged in a two-count indictment with insider trading in violation of § 10(b) of the Securities Exchange Act of 1934*fn1 and Securities and Exchange Commission ("SEC") Rules 10b-5 and 10b5-2,*fn2 and perjury,*fn3 has moved to dismiss the securities fraud count. He contends that the indictment does not sufficiently allege the existence of a confidential relationship essential to an insider trading offense based upon a misappropriation theory of liability, and that the SEC exceeded its rulemaking authority when it promulgated Rule 10b5-2, broadly defining the nature of the relationship required to impose liability under the misappropriation theory. Alternatively, he contends that the rule is void for vagueness.
Opposing the motion, the government argues that the indictment sufficiently alleges a crime under both the insider trading statute and Rule 10b5-2. It also maintains that the rule was a valid exercise of the SEC's rulemaking authority granted by Congress.
We conclude that the indictment sufficiently alleges the elements of an offense under § 10(b) and Rule 10b-5, and sufficiently alleges facts making out a relationship of trust or confidence as defined in Rule 10b5-2, which was validly promulgated by the SEC pursuant to its congressionally-delegated rulemaking authority. Therefore, we shall deny the motion to dismiss.
The indictment charges that McGee used confidential, nonpublic information he obtained from a corporate insider during the course of a confidential relationship between himself and the source of the information. According to the indictment, in July, 2008, McGee obtained information about the pending acquisition of Philadelphia Consolidated Holding Corporation ("PHLY"), a company publicly traded on the NASDAQ, from a senior executive at PHLY involved in the merger process. It further alleges that McGee used the information to purchase 10,750 shares of PHLY stock, which were sold for a $292,128.00 profit after the public announcement of the pending acquisition. He also tipped his friend and co-worker who in turn tipped others. Like McGee, those who received the nonpublic information about the pending acquisition also purchased and later sold PHLY stock for a profit.
The indictment recites that McGee and his source of the information, the senior PHLY executive, were members of Alcoholics Anonymous ("AA"). They formed a close personal relationship, which engendered mutual trust and confidence arising out of their AA membership. During a confidential conversation, the executive revealed that he was under a great deal of stress as a result of the pending acquisition of PHLY by another company, Tokio Marine Holdings, Inc. As a result of the stress, he was struggling with his alcoholism.
According to the indictment, McGee had an "agreement to keep
confidential information learned from fellow AA members,"*fn4
and that he "knew and reasonably should have known that the
Executive expected that MCGEE would maintain the confidentiality of
any material nonpublic information MCGEE learned from the
Bases of Insider Trading Liability
Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j (2006), proscribes using a deceptive device in connection with the purchase or sale of securities in contravention of rules prescribed by the SEC. Pursuant to this Congressional delegation, the SEC promulgated Rule 10b-5, 17 C.F.R. § 240.10b-5. The Rule proscribes, in relevant part, "employ[ing] any device, scheme, or artifice to defraud" or "engag[ing] in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security." 17 C.F.R. § 240.10b-5(a), (c).
There are two bases for insider trading liability under § 10(b) and Rule 10b-5. The "traditional" or "classical theory" applies where a corporate insider trades in securities of the corporation using material, nonpublic information he obtained as a result of his insider position. United States v. O'Hagan, 521 U.S. 642, 651-52 (1997). An insider is anyone connected to the corporation, including not only officers, directors and employees, but also those working in a fiduciary capacity for the corporation, such as attorneys and accountants. Id. (citing Dirks v. SEC, 463 U.S. 646, 655 n.14 (1983)). The "misappropriation theory" holds an outsider liable. It applies to one who, while owing a duty of loyalty and confidentiality to the insider source of the information, uses that nonpublic information to trade in securities. O'Hagan, 521 U.S. at 652. The difference between the two theories is that the traditional theory is based on the defendant's relationship to the corporation, whereas the misappropriation theory focuses on the defendant's relationship to the insider, not the corporation.
Both bases of liability are premised on deception and a breach of duty. Id. In the traditional scenario, the insider deceives the corporation and breaches his duty to the corporation's shareholders with whom he has a fiduciary relationship. Id. In the misappropriation setting, the person using the information deceives the source of the information, breaching his duty of loyalty and confidentiality to that person. Id. The deception occurs when the confidant fails to disclose to the source that he intends to rely on the nonpublic information to trade in the securities or share the information with others. Id. at 652-53.
Determining who is an insider for purposes of applying the classical theory of § 10(b) liability poses little difficulty and is typically self-evident. One's employment position or professional relationship to the corporation usually makes it an easy task. Who is a confidant under the misappropriation theory is not always as simple and apparent. Indeed, whether one was in a requisite relationship has produced conflicting decisions. Compare, e.g., SEC v. Kirch, 263 F. Supp. 2d 1144, 1147, 1151 (N.D. Ill. 2003) (finding that because the defendant and insider were members of a business roundtable that had an express policy and understanding that business discussions were to be kept confidential, the defendant owed the insider a duty sufficient to impose misappropriation theory liability), with United States v. Kim, 184 F. Supp. 2d 1006, 1008, 1012 (N.D. Cal. 2002) (finding that although the defendant and insider signed confidentiality agreements as members of a business organization, the defendant lacked the requisite duty to impose liability for tipping others and trading on nonpublic information shared by the insider). Because the recipient of the information under the misappropriation theory is not an insider, but actually an outsider, the contours of the relationship must be carefully scrutinized.
Following the Supreme Court's approval of the misappropriation theory in O'Hagan, the SEC promulgated Rule 10b5-2, 17 C.F.R. § 240.10b5-2, to clarify the types of relationships giving rise to a duty of trust or confidence. Selective Disclosure and Insider Trading, 64 Fed. Reg. 72590, 72602 (Dec. 28, 1999). The Rule codified a non-exhaustive list of "duties of trust or confidence," the breach of which can form the basis of liability under the misappropriation theory. The duty arises where there is an agreement to keep the information confidential, id. at § 240.10b5-2(b)(1); when the parties to the communication have "a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic ...