The opinion of the court was delivered by: Savage, J.
In this securities fraud action brought by the Securities and Exchange
Commission ("SEC") based upon a misappropriation theory of liability
under § 10(b) of the Securities Exchange Act of 1934*fn1
and SEC Rule 10b-5,*fn2 defendants Timothy
McGee, Michael Zirinsky and Robert Zirinsky have moved to dismiss the
complaint. They contend that the complaint does not sufficiently
allege the existence of a relationship of trust and confidence, an
essential element of an insider trading cause of action under the
misappropriation theory. As he did in his motion to dismiss the
indictment in his related criminal action,*fn3 McGee
argues that the SEC's defining the requisite relationship in Rule
10b5-2*fn4 exceeded its rulemaking authority. The
remaining defendants join in McGee's motion. Michael and Robert
Zirinsky additionally argue that the complaint does not
adequately plead that they acted with scienter. Kellie Zirinsky,
Jillynn Zirinsky, Geraldine Zirinsky and Mary Zirinksy challenge their
status as relief defendants. They argue that they are not "proper
relief defendants" because they have a legitimate property interest in
the profits they realized from selling the stock purchased for them by
We conclude that the complaint alleges facts, which if proven, would demonstrate that the SEC has stated a cause of action for violations of § 10(b) of the Securities Exchange Act of 1934 against McGee and Michael Zirinsky. Specifically, it recites that McGee shared a relationship of trust and confidence with the insider; breached his duty of trust arising out of that relationship; used, without disclosing to the insider, material nonpublic information he received during the course of the relationship to trade in stock; and passed the information to Michael Zirinsky who also used to it trade in the stock and to tip a friend and his family members. The complaint also alleges that Michael Zirinksy and his father, Robert Zirinsky, knew or should have known that the information was from an insider in violation of the law.
On the other hand, the complaint falls short of pleading facts supporting a plausible inference that Michael's father, Robert, acted with the requisite scienter. There are no allegations from which one could infer that Robert is a sophisticated trader like his son, nor are there any identifying the source of the information he acted upon to trade in the stock. Therefore, we shall deny the motions to dismiss of McGee and Michael Zirnisky, and grant Robert's motion and dismiss the complaint as to Robert.
Assuming the truth of the well-pleaded factual allegations in the complaint, the profits the relief defendants realized after selling their shares were the ill-gotten gains of trading based on misappropriated material, nonpublic information. Because the relief defendants do not have a legitimate property interest in those profits, the SEC may seek disgorgement. Therefore, the relief defendants' motions to dismiss will be denied.
The Allegations in the Complaint
The complaint alleges that McGee, a registered stock broker, used material, 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 complaint, McGee obtained information in July, 2008 about the pending acquisition of Philadelphia Consolidated Holding Corporation ("PHLY"), a company publicly traded on the NASDAQ, from a senior executive at PHLY who was involved in the merger process. McGee used the information to trade in shares of stock and to tip his friend and co-worker, defendant Michael Zirinsky, who also profited from trading on the information and in turn tipped a friend and family members.
The complaint recites that McGee and the insider, 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.*fn5
During a confidential conversation following an AA meeting, the insider told McGee that he had been drinking as a result of pressure from working on the pending sale of PHLY to another company. McGee "expressed interest in the details of the PHLY sale and questioned the Insider about the details of the impending deal."*fn6
On the basis of information he learned from the insider during several conversations, McGee purchased 10,750 shares of PHLY stock for $359,248.00, at an average cost of approximately $33.00 per share, prior to the July 23, 2008 public announcement of PHLY's sale.*fn7
On the morning of July 17, 2008, McGee tipped his friend and co-worker, Michael Zirinsky, also a registered stock broker. Michael then tipped his friend, Paulo Lam, and his sister, Jillynnn Zirinsky. He also attempted to tip his father, Robert Zirinsky. Michael purchased PHLY stock for three of his own accounts and the accounts of his wife, Kellie; his sister, Jillynn; his mother, Geraldine; and his grandmother, Mary. Michael also purchased PHLY shares for IRA accounts held by Robert and Geraldine.*fn8 That same morning, Robert purchased additional PHLY shares for an account at "Broker B" he held jointly with his wife, Geraldine.*fn9 Collectively, the Zirinksys purchased 21,650 shares of PHLY stock.*fn10
On July 22, 2008, PHLY's board of directors approved the final merger agreement. PHLY stock was trading at $35.55 a share at that time. Between April 22 and July 22, 2008, it traded in the range of $31.22 to $38.64 a share. On July 23, 2008, PHLY publicly announced that Tokio Marine Holdings, Inc. was acquiring it in a cash deal at a price of $61.50 a share. That day, the stock closed at $58.43. Later, when the deal closed, shareholders were paid $61.50 a share.*fn11
Two days after PHLY's sale was publicly announced, McGee sold 3,250 shares for $58.50 per share. He received $61.50 per share for his remaining shares after the PHLY's sale closed on December 1, 2008. In total, McGee realized profits of $292,128.00 from his PHLY trades.*fn12
Within days of the merger announcement, much of the Zirinsky family's PHLY stock was sold. Their remaining shares were held until the merger closed on December 1, 2008.*fn13
Michael realized a profit of $46,396.00;*fn14 his
wife, $49,628.00;*fn15 Robert and Mary jointly,
$53,620.00;*fn16 Jillynn, $30,538.00;*fn17
Robert, $80,688.00 in his IRA account;*fn18
Mary, $194,134.00;*fn19 and Geraldine's IRA account,
$107,669.00.*fn20 In total, the Zirinskys realized a
profit of $562,673.00.*fn21
The SEC alleges that McGee, Michael and Robert violated § 10(b) of the
Securities Exchange Act of 1934 and Rule 10b-5, predicated on a relationship of
trust or confidence as defined in SEC Rule 10b5-2.*fn22
Although it does not claim that the relief defendants
violated securities laws, it seeks disgorgement of their profits from
their PHLY stock sales under an unjust enrichment theory.
The Misappropriation Theory of Insider Trading
Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j, 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. Id. 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 F. 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 information expects that the recipient will maintain its confidentiality," id. at § 240.10b5-2(b)(2); or where the information is shared with a spouse, parent, child, or sibling. Id. at § 240.10b5-2(b)(3).
Because the SEC's theory of liability of all defendants rests upon Rule 10b5-2, we shall start our analysis by considering the challenge to the Rule. If it is valid, we shall address the sufficiency of the complaint as to each defendant.*fn23
McGee challenges Rule 10b5-2 on two grounds. First, he argues that it is an unlawful expansion of § 10(b). Second, he contends that even if the Rule is based on a permissible reading of ...