Twelve Steps to Insider Trading

October 8, 2012

292292_alcoholics_anonymous.jpgUsing information learned from a fellow Alcoholics Anonymous ("AA") member to make money in the stock market may be morally dubious. Should it be a federal crime, however? A recent case in the Eastern District of Pennsylvania, United States v. McGee, Crim. No. 12-236, deals with this very question.

The defendant, Timothy McGee, was a member of AA. He and a senior executive of Philadelphia Consolidated Holding Corporation ("PHYL") formed a close personal relationship while attending AA meetings, whereby they shared confidences in their struggles with alcoholism. The senior PHYL executive revealed to McGee that he was under a great deal of stress due to the pending acquisition of PHYL. McGee then purchased shares of PHYL which he sold for a $292,128.00 profit after the acquisition was announced. McGee was indicted for insider trading.

There are two bases for insider trading. The first is the classic situation where a corporate insider trades in securities using material, nonpublic information he or she obtains as a result of his or her insider position. The second, the misappropriation theory, occurs when an outsider, who has a "duty of loyalty and confidentiality" to an inside source of nonpublic information, uses information learned from that insider to trade in securities. Determining the existence of such "a duty of loyalty and confidentiality" is tricky. To help define when such "duty of loyalty and confidentiality" exists, the SEC promulgated Rule 10b5-2, codified at 17 C.F.R. 240.10b-5. According to Rule 10b5-2(b)(1) and (2), such duty arises where there is an agreement to keep the information confidential, and/or when the parties 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." In order to prove a violation of the misappropriation theory, the government must prove that the defendant knew that his conduct was unlawful.

In McGee, the government contended that, as part of AA's tradition, AA members agree to keep information they share confidential. The government further contended that there existed a history of shared confidences between McGee and the insider. Thus, the government argued, McGee had a "duty of loyalty and confidentiality" to keep information learned form the insider confidential. McGee moved to dismiss, arguing that there existed no duty precluding him from trading on the information and that he did not know that he was breaking the law when he traded on the information. The court denied the motion and held that the jury would have to decide whether McGee's relationship with the corporate insider featured a "duty of loyalty and confidentiality" and whether the information about the acquisition was disclosed within the confines of that relationship.