When does friendship become a source of securities fraud liability? According to a recent decision in the Eastern District of Pennsylvania, it happens when two friends who met through Alcoholics Anonymous (AA) talk about work and one of them trades on information learned in those conversations.
On Sept. 12, 2012, in SEC v. McGee,1 Judge Timothy J. Savage of the Eastern District of Pennsylvania denied defendant Timothy McGee's motion to dismiss the SEC's complaint asserting insider-trading claims against him stemming from trades he allegedly made based on information about a potential acquisition he learned about from his friend and fellow AA memberwho was an executive (the Insider) at the company being acquired. Invoking the misappropriation theory of insider trading,2 the SEC alleged that McGee and the Insider's friendship and their membership in AA gave rise to a "duty of trust and confidence" such that McGee could not trade on the information about the potential acquisition that the Insider had shared.3 Denying McGee's motion to dismiss, the court held that the SEC at the pleading stage had met its burden because the complaint adequately alleged that McGee and the Insider "had a history of sharing and maintaining confidences."4
Courts have generally declined to hold that sharing of "generic confidences" suffices to give rise to a duty of trust and confidence on which insider trading can be premised and instead have focused on whether there has been a practice of sharing confidential business information. Though there are certain aspects of McGee that may distinguish it from the "generic confidences" situation, McGee appears to take a step towards holding that personal information shared among friends in confidence may subject individuals to liability for insider trading. In this article, we briefly summarize the development of the law of insider trading under the misappropriation theory, discuss the SEC's allegations with respect to McGee and the Insider's relationship in the context of established precedent, and offer observations on the meaning of McGee for future insider trading prosecutions.
Misappropriation Theory Framework
After the Supreme Court endorsed the misappropriation theory of insider trading in its landmark decision in United States v. O'Hagan,5 the SEC enacted Rule 10b-5(2) to resolve the "unsettled issue" as to "under what circumstances certain non-business relationships, such as family and personal relationships, may provide the duty of trust or confidence required under the misappropriation theory."6 Before Rule 10b-5(2), courtsparticularly in the Second Circuitgenerally applied the misappropriation theory in circumstances where an individual traded on information received in the context of "'hornbook' fiduciary relationships," (e.g., attorney-client, psychiatrist-patient, principal-agent, and senior corporate officer-shareholder), or "similar relationship[s] of trust and confidence."7 The Second Circuit was particularly "cautious in extending the misappropriation theory to new relationships, lest [its] efforts to construe Rule 10b-5 lose method and predictability, taking over the whole corporate universe." Id. at 657 (internal quotations omitted) (emphasis added). Seeking to reign in equity's "boundless nature of relations of trust and confidence" that had "no place in the criminal law," the Second Circuit defined a fiduciaryor similar relationship (i.e., a relationship of trust and confidence)as one that involves "discretionary authority and dependency."8
A key factor in both the Supreme Court's and the Second Circuit's acceptance of the misappropriation theory pre-Rule 10b-5(2) was that it brought within its ambit only relationships evidencing a pattern of exchanging businessor securities-relatedconfidences. See O'Hagan, 521 U.S. at 656 ("The misappropriation theory targets information of a sort that misappropriators ordinarily capitalize upon" to profit from purchasing securities.); United States v. Chestman, 947 F. 2d 551, 569-71 (distinguishing "the repeated disclosure of business secrets" from the "shar[ing] and maintain[ing] [of] generic confidences"); United States v. Kim, 184 F. Supp. 2d 1006, 1013 (N.D. Cal. Jan. 15, 2002) (considering whether a history of exchanging confidential business information created a duty of confidentiality amongst members of a young professionals social club); cf., SEC. v. Kirch, 263 F. Supp. 2d 1144, 1150-51, (N.D. Ill. June 20, 2003) (applying the misappropriation theory where young professionals group had express confidentiality constraints in place because of the frequent disclosures of material nonpublic business information).
The SEC then sought to codify the "bases for determining that a duty of trust and confidence was owed by a person receiving information" in Rule 10b-5(2) to resolve differing approaches among the lower courts for determining when the duty existed.9 The rule articulates a "non-exclusive list of three situations in which a person has a duty of trust or confidence for purposes of the 'misappropriation' theory": (i) a person agrees to keep information in confidence, (ii) two individuals 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," or (iii) in certain enumerated family relationships, unless the recipient of the information can establish that under the circumstances no duty of trust or confidence actually existed.10
As the body of caselaw interpreting the rule continues to expand, one common thread has remained: Courts consider the substance of the information conveyed as a key factor in determining whether a relationship of trust and confidence existed. Just as the Second Circuit in Chestman refused to apply the misappropriation theory in circumstances where only "generic (i.e., non-business related) confidences" were shared, courts post-Rule10b5-(2) have generally continued to look for a pattern or history of sharing business-related confidences specifically in order to find the requisite duty. See, e.g., United States v. Corbin, 729 F. Supp. 2d 607, 616 (S.D.N.Y. Oct. 21, 2010) (looking to whether the insider and tippera married couplehad "a practice of sharing business confidences sufficient to serve as a predicate for criminal misappropriation liability") (emphasis added); SEC v. Lyon, 529 F. Supp. 2d 444, 451-53 (S.D.N.Y. Jan. 2, 2008) (finding that a defendant could owe a duty to the insiderwho disclosed confidential information regarding a private equity offering"where the customary practice among participants in the private-placement market is to be bound and abide by the confidentiality provisions stated in the offering memoranda"); SEC v. Kornman, 391 F. Supp. 2d 477, 489-91 (N.D. Texas Sept. 29, 2005) (same); SEC v. Talbot, 430 F. Supp. 2d 1029, 1061 at n.91, 1062 (C.D. Cal. Feb. 14, 2006) (finding no history of sharing confidential business information between the insider and the tippee); cf., SEC v. Yun, 327 F.3d 1263, 1273 (11th Cir. 2003) (finding its holding that "a history or practice of sharing [and maintaining] business confidences" between spouses likely gives rise to a "reasonable expectation of confidentiality" was "bolstered by statements the SEC  made" in enacting Rule 10b5-2).11
'SEC v. McGee'
Examining the McGee complaint in the context of this caselaw, it is short on allegations that McGee and the Insider shared the type of confidences that courts have historically considered sufficient for liability under the misappropriation theory. According to the SEC complaint, the Insider began attending AA meetings in 1999 and met McGee at an AA meeting.12 The SEC alleged that, "[a]s their relationship developed, the Insider shared information with McGee about personal, family and professional matters in his life that were impacting his ability to stay sober," and that the "Insider considered McGee to be a 'confidante.'"13 The SEC particularly emphasized the personal nature of the information shared among the friends, alleging that McGee "also confided in the Insider about private and personal matters in his life," including about "his family, his personal relationships, his business, and his ability to stay sober."14 The SEC alleged that the men understood that the personal matters shared would be kept confidential, alleging that McGee "told the Insider that he could confide anything to him."15
The complaint also emphasized the confidentiality expectations attendant to AA: "Individuals who participate in AA and share information at meetings or in private discussion with other AA members are asked to abide by a policy of anonymity, which is the 'Twelfth Tradition' of AA."16 Further,
[t]he confidentiality of information shared between members of the AA program is underscored at each meeting, where participants are reminded that "what is discussed here stays here." Confidentiality is integral to the operation of AA, and those who attend meetings and participate in AA, including the Insider and McGee, understand the importance of confidentiality.17
In the context of that relationship, the SEC then alleged that in "the spring and early summer of 2008, while the Insider participated in the negotiations to sell [the company], he was under significant pressure to ensure a successful sale," and that, "[w]ith the pressure increasing as negotiations progressed, the Insider resumed regularly attending AA meetings" at the end of June 2008 (he had not attended consistently during the previous three years).18 The SEC alleged:
In early July 2008, immediately after an AA meeting…the Insider confided to McGee that he had been drinking as a result of mounting pressure, and revealed to [him] that the source of the pressure was ongoing confidential negotiations to sell [the company]. The Insider told McGee that the stress generated from his participation in the negotiations was affecting his ability to remain sober and that his recent drinking was having a negative impact on his personal life.19