PUSHING THE EDGES OF INSIDER TRADING: CUBAN AND DOROZHKO

The SEC seems to be pushing the limits of insider trading theory. Last week, the Commission lost the Cuban insider trading case, as discussed here. There, the SEC tried to bring an insider trading case based on the misappropriation theory using a complaint which alleged only that Mr. Cuban agreed at the beginning of a conversation with the CEO of a company in which he was a shareholder to keep the content of their talk confidential. The court rejected Mr. Cuban’s claim that the SEC had to establish that he breached a fiduciary duty. Rather, the court concluded that under certain circumstances a contractual duty would suffice. The SEC’s complaint however was held deficient. Whether the Commission will replead or push what is clearly an aggressive interpretation of the misappropriation theory remains to be seen.

In contrast, yesterday the SEC prevailed in an other cutting edge insider trading case, SEC v. Dorozhko, Case No. 08-0201-cv, Slip op. (2nd Cir. July 22, 2009). There, the Second Circuit reversed the denial of a preliminary injunction in the “computer hacker” case and remanded for further proceedings.

Dorozhko centers on a claim that the defendant, Oleksandr Dorozhko, a Ukrainian national and resident, traded on inside information in the securities of IMS Health, Inc. According to the SEC, in early October 2007 IMS announced it would release its third-quarter earnings during a conference call after trading on October 17, 2007. The company hired Thomson Financial to provide investor relations and web-hosting services including the release of its online earnings reports.

In the early afternoon of October 17, a computer hacker succeeded after several attempts in hacking into the secure server at Thomson and located the data regarding IMS. Shortly before 3:00 that afternoon defendant, who had opened but not used, a brokerage account at Interactive Brokers, purchased over $41,000 worth of IMS put options set to expire on October 25 and 30, 2007. These purchases represented about 90% of all such purchases.

After the close of the market, IMS announced its EPS were 28% below street expectations. When the market opened the next morning IMS shares went down 28%. Within six minutes of the market opening, defendant sold all of his options, realizing a profit of over $286,000.

The SEC brought a civil injunctive action against Mr. Dorozhko on October 29, 2007. The district court granted a freeze order over the trading profits. Subsequently, however the court denied the Commission’s request for a preliminary injunction. The court concluded that a breach of a fiduciary duty is a required element under Section 10(b). SEC v. Dorozhko, 660 F. Supp. 2d 231 (S.D.N.Y. 2008). That conclusion is based on the decisions of the Supreme Court in Chiarella v. U.S., 445 U.S. 222 (1980), U.S. v. O’Hagan, 521 U.S. 642 (1987) and SEC v. Zanford, 535 U.S. 813 (1997).

Before the Second Circuit, the SEC argued that the fraud consisted of the defendant’s alleged computer hacking, which involves misrepresentations. Specifically, the Commission “argues that defendant affirmatively misrepresented himself in order to gain access to material, nonpublic information, which he then used to trade.” The misrepresentations occurred because computer hacking “means to trick, circumvent, or bypass computer security in order to gain unauthorized access to computer systems . . .” Thus, the hacker either uses a false identification to masquerade as another user or exploits a weakness in an electronic code to cause it to malfunction. Stated differently, hacking equals a misrepresentation.

The Circuit Court concluded that neither Chiarella, O’Hagan or Zanford requires a fiduciary duty as an element of every violation of Section 10(b). The theory of fraud in each of these cases, unlike here, was silence or nondisclosure, not an affirmative misrepresentation. Thus, while the three decisions stand for the proposition that nondisclosure in breach of a fiduciary duty meets the Section 10(b) deception requirement, that does not mean that a fiduciary duty is required in every case. To the contrary, where the theory of fraud is based on an affirmative misrepresentation, such a duty is not necessary or required.

In this case, the SEC contends that the defendant affirmatively misrepresented himself to gain access to inside information which was then used to trade. The court went on to note that “[a]bsent a controlling precedent that ‘deceptive’ has a more limited meaning than its ordinary meaning, we see no reason to complicate the enforcement of Section 10(b) by divining new requirements.” Since the district court did not determine whether the ordinary meaning of deceptive covers computer hacking as argued by the SEC, the case was remanded for further proceedings.

Dorozhko and Cuban are similar in two fundamental ways. First, both cases read Chiarella and O’Hagan as not requiring a breach of fiduciary duty. In a silence case, Cuban holds that an agreement incorporating certain features may supply the necessary relation between the parties, the breach of which constitutes Section 10(b) deception. In a misrepresentation case, Dorozhko raises the question of whether computer hacking is a misrepresentation that constitutes Section 10(b) deception, a question the district court will analyze on remand.

Second, both illustrate the aggressive posture of SEC enforcement in this area. Cuban pushes the edge regarding the kind of relationship required. At the moment the “push” appears to have been too far. Dorozhko pushes the edge regarding what constitutes a misrepresentation. Whether that “push” was too far remains to be seen.

NOT THE USUAL SEC CASES AGAINST MARKET PROFESSIONALS

The SEC filed two actions yesterday naming market professionals. The first, against Tennessee-based broker dealer Morgan Keegan & Company, tracks many others — but unlike its predecessors it did not settle and was filed shortly after a Wells Notice. SEC v. Morgan Keegan & Co., Inc., Civil Action No. 09-CV-1965 (N.D. Ga. Filed July 21, 2009). The second, against New York City investment adviser Perry Corp., involved allegations similar to those in the high profile CSX/Children’s Defense Fund case from last year and did settle. In the Matter of Perry Corp., Admin. Proc. File No. 3-13561.

The civil injunctive action filed against Morgan Keegan is based on claims that the broker dealer made misrepresentations when selling auction rate securities to its customers between November 1, 2007 to March 20, 2008. Specifically, the complaint alleges that during the period shortly prior to the crash of the auction rate securities market, the firm misrepresented the risks of ARS, selling them as safe and highly liquid investments comparable to money market funds. Morgan Keegan failed to tell its customers that there were increasing concerns about the safety of the ARS market in the months before the crash and that there were auction failures. Rather, the complaint, which alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(c), claims that the firm sold over $900 million ARS during this period.

The allegations in the Morgan Keegan complaint echo those of other actions the Commission has brought based on the collapse of the ARS. See, e.g., SEC v. Banc of America Securities LLC, Civil Action No. 09-CIV-5170 (S.D.N.Y. June 3, 2009) (settled ARS in which settlement required buyback on specific terms); SEC v. Deutsche Bank Securities, Inc., No. 09-CIV-5174 (S.D.N.Y. Filed June 3, 2009) (same) (both discussed here). It is however, the first such action filed by the SEC against a seller of ARS that was not settled at the time of filing. Indeed, many of the settlements in these cases were preceded by agreements in principle and frequently involved the resolution of similar claims with state regulators. It is also unusual for a regulated entity such as Morgan Keegan to litigate a civil injunctive action with the Commission. See also Litig. Rel. 21143 (Jul. 21, 2009).

Morgan Keegan follows the filing of an 8-K last week by Regions Financial Corp., the parent of the broker dealer. The filing states that on July 9, 2009 Morgan Keegan and three of its employees received a Wells Notice. The staff’s investigation, and apparently the predicate for its proposed enforcement action, is “certain mutual funds formerly managed by Morgan Asset Management, Inc.” according to the 8-K.

Perry Corp., centers on a claim that the investment adviser intentionally failed to file a Schedule 13D after acquiring nearly a 10% stake in Mylan Laboratories, Inc., which was in discussions to acquire King Pharmaceuticals, Inc. Perry failed to file, according to the Order for Proceedings, because it did not want to alert the market place about its holdings. Ultimately the proposed 2004 Mylan-King deal failed.

At the time the merger talks were under way, Perry Corp. implemented a strategy known as “merger arbitrage,” according to the Order. Under this strategy, the firm’s profit depended on the spread in value between the shares of the acquirer and the target company. That spread would be a function of how the market viewed the likelihood that the transaction would be consummated. As the likelihood of closure increases, the spread narrows. Perry intended to acquire Mylan shares and vote in favor of the transaction.

In acquiring the Mylan shares, Perry sought to minimize risk. Accordingly, the firm entered into a series of swap transactions designed to fully hedge its financial exposure from the Mylan shares. The transactions provided that Perry would be reimbursed for any decrease in the market price of Mylan shares by the counterparty who received a fee. Through these swap transactions Perry was able to acquire the voting rights to nearly 10% of Mylan’s shares without any economic risk.

Perry chose not to file a Schedule 13D based on advice it obtained after shopping for legal opinions. A Schedule 13D at the time had to be filed within ten days by any person who acquired beneficial ownership of more than 5% of a voting class of equity securities registered under Exchange Act Section 12. If however, a market professional such as Perry acquires the shares in the ordinary course of its business a Schedule 13G can be filed, which has a longer filing period. Perry shopped for and obtained legal advice from outside counsel stating that it could file a Schedule 13G. That opinion was based on the notion that the securities were acquired in the ordinary course of business. Perry’s regular outside counsel, as well as another firm, told the investment adviser that a Schedule 13D should be filed.

To settle the action Perry consented to the entry of a censure and a cease and desist order from committing or causing any violations and any future violations of Section 13(d) and Rule 13d-1. In addition, the firm agreed to pay a civil penalty of $150,000. In the Matter of Perry Corp. , Admin. Proc. File No. 3-13561 (Jul. 21, 2009) (available here).

A similar case last involving efforts to conceal a significant holding of voting shares from the market place through the use of synthetic securities was CSX v. Children’s Investment Fund, No. 08-2899 (2nd Cir. Sept. 15, 2008) (discussed here). There the court found violations of Section 13(d) where two hedge funds did not legally own, but effectively controlled the voting power of shares through the use of equity swaps. That action involved a proxy contest for seats on the board of CSX by two hedge funds as discussed here. The hedge funds contended they did not have to file a Schedule 13D, a position supported in a letter from the Division of Corporation Finance.