Third Circuit Rejects Claim that Fiduciary Duty Required For Insider Trading

Insider trading cases frequently turn on the nature of the relationship between the trader and the person who is the source of information. The breach of that relationship of trust and confidence can supply the statutory element of deception, the predicate for a violation of Exchange Act Section 10(b). In Rule 10b5-2 the SEC defined three instances when a duty of trust and confidence exists: 1) When a person agrees to maintain information in confidence; 2) When there is a history, pattern or practice of sharing confidences giving rise to an expectation of such on the part of the communicator; and 3) when the information comes from a spouse, parent, child or sibling. In U.S. v. McGee, No. 13-3183 (3rd Cir. Decided August 14, 2014) the Court rejected a claim that the SEC exceeded its authority when enacting Rule 10b5-2 because it did not require a fiduciary duty.

Timothy McGee was convicted by a jury of insider trading. That conviction is based on the misappropriation theory. Between June and July 2008 he obtained material non-public information regarding the then pending sale of Philadelphia Consolidated Holding Corporation or PHLY from Christopher Maguire, an insider at the company. Mr. McGee then borrowed about $226,000 to purchase 10,750 shares of PHLY. After the deal announcement he had trading profits of $292,128.

Messrs. McGee and Maguire met between 1999 and 2001 while attending meetings of Alcoholics Anonymous. Over the next several years Mr. McGee informally mentored Mr. Maguire at AA. During that time the two men frequently exchanged confidential information. In 2008 Mr. Maguire was closely involved in the negotiations to sell PHLY. During the period he suffered sporadic alcohol relapses. After one meeting Mr. McGee inquired about frequent missed meetings by Mr. Maguire. In response Mr. Maguire blurted out the inside information. Following the conversation Mr. McGee made the stock purchases. A jury convicted him of insider trading based in part on Rule 10b5-2. The district court rejected Mr. McGee’s challenge to the Rule as exceeding the SEC’s authority.

The traditional model of insider trading is based on the corporate executive who trades in the shares of his or her company while in possession of inside information, the Court began. That trading is a deceptive practice within the meaning of Exchange Act Section 10(b) since the insider violates a relationship of trust and confidence. In contrast, the misappropriation theory of insider trading focuses on outsiders who owe no duty to shareholders. Those outsiders do, however, owe a duty to the source of the information. Under either theory, deception through nondisclosure is the crux of insider trading liability.

The Supreme Court has provided limited guidance on the precise limits of the duty. In U.S. v. O’Hagan the Court noted only that it has to be a recognized duty. This has spawned inconsistent decisions in the lower courts. For example, in U.S. v. Kim the district court held that there was no duty of confidentiality between members of a social group of CEO’s despite club rules emphasizing confidentiality. Yet in SEC v. Kirch another district court concluded that the necessary duty was present between members of a group of software executives because the need for confidentiality was understood.

Here Mr. McGee challenges Rule 10b5-2(2), arguing that it exceeds the SEC’s authority since a fiduciary duty is required. Turing to the question of whether the SEC is entitled to difference under Chevron, the Court first sought to determine if Section 10(b) is ambiguous on the precise question. Section 10(b), the Court concluded, is ambiguous since it does not define “deceptive device” and, in fact, does not mention insider trading much less define the necessary type of relationship.

The critical question then becomes whether judicial precedent foreclosed the action taken by the SEC. Mr. McGee claimed that Supreme Court precedent precluded the action taken by the SEC with respect to the Rule. The Court disagreed, however, noting that O’Hagan and other decisions by the Supreme Court in this area do not specifically define the type of relationship necessary. While those decisions frequently discuss fiduciary relationships, they do not specifically require such a relationship.

Since there is no specific judicial precedent defining the necessary relationship, the question is if the SEC’s construction is one it permissibly could have adopted. Considering the purpose of the Act the Court determined that “Rule 10b5-2(2) is based on a permissible reading of ‘deceptive device[s]’” under Section 10(b) of the Exchange Act. The Court concluded by noting that “Although we are not without reservations concerning the breath of misappropriation under Rule 10b502(2), it is for Congress to limit its delegation of authority to the SEC or to limit misappropriation by statute.”

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