Insider information passed between two members of Alcoholics Anonymous is sufficient to sustain allegations that one of them violated the Securities Exchange Act, a federal judge has ruled.
U.S. District Judge Timothy Savage of the Eastern District of Pennsylvania denied Timothy McGee’s motion to dismiss the securities fraud charges against him, which were filed after he allegedly made a $292,000 profit from the sale of Philadelphia Consolidated Holding Corp. shares following the company’s merger with Tokio Marine Holdings in 2008. McGee learned about plans for the merger shortly before it was made public in the summer of that year when a friend he made through Alcoholics Anonymous confided in him that he was struggling with his alcoholism because of the stress he was under at work because of the merger. He was a senior executive at Philadelphia Consolidated Holding.
According to the Securities and Exchange Commission’s rule under which McGee is charged, “if McGee agreed to maintain information in confidence or had a history of sharing and maintaining confidential information with the insider, he and the insider had a relationship of trust or confidence. … The indictment alleges that McGee agreed to keep information shared by members of AA confidential, McGee and the insider had a history of sharing and maintaining confidences and McGee understood that the insider shared information about PHLY’s pending sale in confidence,” Savage said in his opinion in United States v. McGee. PHLY is the trading symbol for Philadelphia Consolidated Holding.
The Securities Exchange Act offers two avenues for insider trading liability under Section 10(b), according to the opinion. The first is the “classical theory,” which applies when a company insider trades on nonpublic information he or she received as a result of his or her own position. The second is the “misappropriation theory,” which covers a person who trades on nonpublic information that he or she has gotten from a company insider to whom he or she has a “duty of loyalty and confidentiality,” according to the opinion.
“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,” Savage said. “Both bases of liability are premised on deception and a breach of duty.”
While it’s easy to identify insiders under the scope of the “traditional theory,” Savage said, “who is a confidant under the misappropriation theory is not always as simple and apparent.”
After the U.S. Supreme Court accepted the theory of misappropriation in its 1997 opinion in United States v. O’Hagan, the SEC clarified what relationships qualify as having a reasonable expectation of confidentiality. They include those that 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 the recipient will maintain its confidentiality,’” Savage quoted from the SEC’s rule.
McGee’s relationship with the Philadelphia Consolidated Holding executive through Alcoholics Anonymous clearly falls within that scope, Savage held.
McGee, though, argued that the rule itself is invalid. He claimed that “the rule impermissibly includes nonfiduciary relationships not previously recognized as triggering a duty of trust or confidence,” according to the opinion.
The government, citing the U.S. Supreme Court’s 1984 opinion in Chevron v. Natural Resources Defense Council, responded that an agency is entitled to deference when Congress has authorized it to administer a statute, as it did in this case.
Savage sided with various courts of appeal that have rejected arguments similar to McGee’s, he said, “holding that the predicate relationship is not always a recognized, fiduciary relationship in the pure legal sense.”
The SEC was within its rights to establish categories of relationships that give rise to a “duty of trust or confidence” in order to challenge an investor’s use of nonpublic information, Savage said.
“In holding that subsections (b)(1) and (2) of Rule 10b5-2 are not arbitrary, capricious or manifestly contrary to Section 10(b), we join the numerous courts that have rejected challenges to the rule and those that have held that a relationship of trust or confidence may be based on either an agreement or a history of sharing and maintaining confidential information,” Savage said.
Arthur Makadon, of Ballard Spahr in Philadelphia, represented McGee and said he would not comment on the case because it is an ongoing matter.
Similarly, Patricia Hartman, spokeswoman for the U.S. Attorney’s Office in Philadelphia, said, “the office declines to comment about this ongoing matter.”
(Copies of the 17-page opinion in United States of America v. Timothy McGee, PICS No. 12-1787, are available from The Legal Intelligencer. Please call the Pennsylvania Instant Case Service at 800-276-PICS to order or for information.) •