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.