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Second Circuit Rules Hacking May Violate Rule 10b-5


By Karen L. Stevenson, Litigation News Associate Editor – September 11, 2009

Computer hacking may be the next frontier for civil enforcement under Section 10(b) of the Securities and Exchange Act of 1934.


In SEC v. Dorozhko [PDF], the Second Circuit recently held that the Securities and Exchange Commission may proceed with a fraud case against an alleged computer hacker who traded put options on a company’s shares after obtaining earnings information unlawfully downloaded from a secure website even though the alleged hacker owed no fiduciary duty to the company.


The decision has sparked vigorous discussion about the scope of civil enforcement under Rule10b-5.


Is Hacking “Deceptive” Under the SEC § 10 (b)?
In October 2007, Oleksandr Dorozhko short-sold shares of IMS Health, Inc., whose computer system Dorozhko allegedly hacked just before the company publicly disclosed weak earnings.


Approximately 40 minutes after a hacker downloaded the yet unannounced IMS earnings, Dorozhko used an on-line brokerage account to purchase IMS put options. The next morning, after IMS announced its earnings and minutes after the market opened, Dorozhko sold his put-options at a profit of $286,456.59.


The SEC obtained a temporary restraining order freezing Dorozhko’s proceeds. The district court later denied the SEC’s request for a preliminary injunction, ruling that the computer hacking was not “deceptive” under Section 10(b) because Dorozhko owed no fiduciary duty to the company.


Fiduciary Duty Not Required for § 10(b) Violation
On appeal, the Second Circuit disagreed, concluding that while there could be no breach of fiduciary duty by Dorozhko as a corporate outsider, there was nonetheless actionable fraud under Section 10(b) and Rule 10b-5 based on an affirmative misrepresentation.


Relying on the tenet that Section 10(b) should be construed “flexibly to effectuate its remedial purposes,” the Second Circuit remanded for the district court to determine whether hacking involved a fraudulent misrepresentation that was a “deceptive device.”


The Second Circuit carefully distinguished Chiarella v. United States, 445 U.S. 222(1980), U.S. v. O’Hagan, 521 U.S. 642 (1997), and SEC v. Zandford, 535 U.S. 813 (2002), precedents the district court relied upon, by noting that these cases involved a silence or nondisclosure and did not establish a fiduciary duty requirement as a necessary element of a Section 10(b) violation.


Instead, the court observed that the SEC’s theory is that Dorozhko “affirmatively misrepresented himself in order to gain access to material, nonpublic information, which he then used to trade.” In sum, simple theft is actionable whether or not there is a fiduciary duty.


Impact of the Dorozhko Opinion
Dorozhko’s attorney, Charles A. Ross, New York, NY, says the opinion goes too far: “the requirement of a fiduciary duty is a time honored element of Rule 10(b) violations. The Second Circuit overreached to allow the SEC to reach an enforcement goal in a manner that is not consistent with the requirements of 10(b)(5) case law.”


Robert Friese, San Francisco, CA, cochair of the SEC Enforcement Subcommittee of the ABA Section of Litigation Securities Litigation Committee, on the other hand, sees the ruling as fully consistent with the statute’s prohibition on fraudulent securities schemes.


“While the Second Circuit did not mention the word ‘scheme,’ if you focus on [the hacking] as a deceptive ‘scheme,’ you can readily reach the enforcement goal without the district court’s tortured analysis of fiduciary duty,” Friese says. “The Second Circuit seems to point to this in asking the district court to revisit the issue of whether hacking is a ‘deceptive’ device,” he notes.


“The impact of the Dorozhko opinion is difficult to assess at this point because we don’t know how it will turn out on remand,” says Louis Burke, New York, NY, cochair of the Futures & Derivatives Litigation Subcommittee of the Section’s Securities Litigation Committee.


“The statute clearly contemplates a finding that tapping in and stealing non-public information for one’s personal advantage in the markets is a type of ‘fraudulent device’ actionable under Rule 10b-5,” Burke opines.


Robert Friese predicts that “the decision will be expanded upon to narrow any ability by users of fraudulent devices to hide behind the absence of a fiduciary duty.” Until the district court rules on remand, however, it is hard to know whether Dorozhko actually represents a bold step into a new Section 10(b) enforcement frontier or a simple extension of the status quo.


Keywords: Securities, Second Circuit


 
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