The Supreme Court’s new chance to remake insider-trading law

February 19, 2015

Timothy McGee, a onetime Ameriprise financial advisor, contends that he never would have been found guilty of insider trading if the Securities and Exchange Commission hadn’t revised its interpretation of securities fraud law in 2000. On Friday, the U.S. Supreme Court is scheduled to consider McGee’s argument when the justices conference on his petition for review of his 2013 conviction. And there’s a good chance that McGee’s appeal will catch the attention of Justices Antonin Scalia and Clarence Thomas, who invited insider trading defendants to challenge the SEC’s authority in a statement last November in an appeal by a different convicted inside trader, Douglas Whitman.

A federal jury in Philadelphia convicted McGee for trading shares of the Philadelphia Consolidated Holding Company after he learned about an impending sale of the company from an insider, Christopher Maguire. McGee and Maguire had met at Alcoholics Anonymous and became running and cycling buddies. When the stress of the corporate sale led Maguire to relapse, he told McGee why he had started drinking again. Maguire later testified that he believed he could trust his old friend with advance word of the sale since the two had a history of sharing confidences about their efforts to stay sober.

McGee took out a $226,000 bank loan and bought more than 10,000 shares of Maguire’s company. After the sale was announced, he sold his stake and cleared nearly $300,000 in profits. The SEC launched an investigation. Despite McGee’s claim that he never received inside information from Maguire, he was indicted and eventually convicted for both perjury and insider trading based on the so-called misappropriation theory.

Unlike classic insider trading cases, which are based an insider’s breach of duty to the corporation, misappropriation cases claim that the defendant breached a duty of trust to the source of the information. To cite the most prominent example of a misappropriation case: In its 1997 opinion in U.S. v. O’Hagan, the Supreme Court ruled that a Dorsey & Whitney partner could be held criminally liable for buying options in Pillsbury stock when he found out his law firm was working on a tender offer for the company. The key difference between the two theories is whose expectation of trust has been violated. “In lieu of premising liability on a fiduciary relationship between company insider and (the) purchaser or seller of the company’s stock,” the Supreme Court said in O’Hagan, “the misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information.”

It’s important to note that the O’Hagan opinion referred to the violation of a fiduciary relationship in its description of both classic and misappropriation insider trading theories. That was too narrow a reading of relations of trust for the SEC. So after O’Hagan, the SEC revised its regulations to “clarify and enhance” the definition of a duty of trust in misappropriation cases. The new rule, adopted in 2000, said that there needn’t be a fiduciary relationship between the source of information and the defendant who misappropriates it. Insider trading, according to the revised SEC rule, takes place “whenever the person communicating the material nonpublic information and the person to whom it is communicated 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.”

McGee’s lawyers at Ballard Spahr argued at trial and on appeal that the SEC’s rule is at odds with Supreme Court precedent requiring a fiduciary relationship between the source and recipient of insider information. The 3rd U.S. Circuit Court of Appeals disagreed. In August 2014, the appeals court upheld McGee’s conviction, ruling that the SEC’s interpretation of securities fraud law on insider trading is entitled to deference under the test the Supreme Court laid out in the 1984 case Chevron. v. Natural Resources Defense Council.

But Justices Scalia and Thomas don’t seem to be so sure of that. In a statement accompanying the Supreme Court’s decision not to review the 2012 insider trading conviction of former hedge fund manager Douglas Whitman, the two justices said there’s an important difference between civil and criminal enforcement of laws that implicate both kinds of proceedings, such as securities fraud laws. (Scalia wrote the statement and Thomas joined it.) Only legislatures – not executive agencies – are supposed to define crimes, and ambiguity is supposed to be decided in favor of defendants. So according to Scalia and Thomas, even though agencies’ interpretations are entitled to deference in civil enforcement proceedings, judges overseeing criminal cases need not defer to their interpretations of the law.

Whitman hadn’t properly raised the deference issue in his appeal at the 2nd Circuit, so Scalia and Thomas agreed his case wasn’t a proper vehicle. They said, however, that they would be “receptive” if another defendant squarely presented the question of whether a “court owes deference to an executive agency’s interpretation of a law that contemplates both criminal and administrative enforcement.”

The justices’ statement in the Whitman case came out right before the deadline for McGee to file his petition for Supreme Court review, so the petition refers only fleetingly to the Whitman case. The Justice Department, in its opposition to McGee’s petition, argued that McGee hadn’t properly teed up the issue because he didn’t call on the 3rd Circuit to reject the entire Chevron deference test. As a result, the government said, McGee had forfeited the issue.

McGee’s reply brief, filed on Jan. 29, said that, to the contrary, McGee has challenged the SEC’s authority to define the crime of insider trading in every lower-court brief in the case. McGee would not have been convicted if the SEC hadn’t changed its interpretation of securities fraud law, the brief said. That makes his case precisely the right vehicle for the court to take up the problem Scalia and Thomas are worried about.

The justices conferred three times on the Whitman case before denying his cert petition. Maybe McGee will benefit from the thought they’ve already put into insider trading prosecution.

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