Hacker Can Be Sued for Fraud Under Securities Exchange Act, Says 2nd Circuit

A man who hacked into a computer network to gain advance information about a company's financial reports can be sued for fraud under the Securities Exchange Act of 1934 even though he owed no fiduciary duty to the company, the 2nd U.S. Circuit Court of Appeals has ruled.

The circuit said there is nothing in the case law that "expressly imposes a fiduciary-duty requirement on the ordinary meaning of 'deceptive' where the alleged fraud is an affirmative misrepresentation rather than a nondisclosure."

The ruling in Securities and Exchange Commission v. Dorozhko, 08-0201-cv, reversed a decision by Southern District Judge Naomi Reice Buchwald refusing to grant a preliminary injunction to the SEC that would freeze the alleged hacker's trading gains.

Buchwald had found that computer hacking cannot be considered "deceptive" unless there is a breach of fiduciary duty.

The appeal was decided by Judges Jose A. Cabranes and Peter W. Hall and, sitting by designation, Southern District Judge Richard J. Sullivan.

Ukranian national Oleksandt Dorozhko invested $42,500 through his online trading account in October 2007 and spent almost all of it on "put" options in IMS Health, Inc., betting the company's quarterly earnings would disappoint and the stock price would drop.

IMS Health Inc., which had hired Thomson Financial Inc. to provide investor relations and Web-hosting services, was set to announce earnings on Oct. 17, 2007, at 5 p.m.

The SEC alleges that Dorozhko made $286,456 on the put options when the company's earnings came in below the expectations set by Wall Street analysts. They also allege he was the one who hacked into Thomas Financial's secure server and downloaded critical information about IMS Health in advance of the earnings call.

Buchwald denied the SEC's motion for preliminary injunction freezing Dorozhko's proceeds from the transaction on the theory that computer hacking cannot be "deceptive" within the meaning of §10(b) of the Securities Exchange Act of 1934.

Cabranes, writing for the panel on the SEC's appeal, said the court recognized "that the SEC's claim against defendant -- a corporate outsider who owed no fiduciary duties to the source of the information -- is not based on either of the two generally accepted theories of insider trading": either where a corporate insider trades the securities of his own company based on material, non-public information or where someone misappropriates information through violation of a fiduciary duty and trades on it.

The district court, he said, relied on three U.S. Supreme Court decisions when it insisted on the presence of a fiduciary duty: Chiarella v. United States, 455 U.S. 222 (1980), United States v. O'Hagan, 521 U.S. 642 (1997) and SEC v. Zandford, 535 U.S. 813 (2002).

"Chiarella, O'Hagan and Zandford all stand for the proposition that nondisclosure in breach of a fiduciary duty" satisfies the act's requirement of a deceptive device or contrivance, Cabranes said. "However, what is sufficient is not always what is necessary, and none of the Supreme Court opinions considered by the district court require a fiduciary relationship as an element of an actionable securities claim under §10(b)."

Cabranes said that here the SEC "has not alleged that defendant fraudulently remained silent in the face of a 'duty to disclose or abstain' from trading."

"Rather, the SEC argues that defendant affirmatively misrepresented himself in order to gain access to material, nonpublic information, which he then used to trade," the judge said. "We are aware of no precedent of the Supreme Court or our Court that forecloses or prohibits the SEC's straightforward theory of fraud."

The panel then remanded the case to Buchwald to determine "whether the computer hacking in this case involved a fraudulent misrepresentation that was 'deceptive' within the ordinary meaning of §10(b)."

Mark Pennington, assistant general counsel, appeared for the SEC.

Charles A. Ross of Charles A. Ross & Associates appeared for Dorozhko.

"We're considering options with regard to further proceedings including a petition for certiorari" to the U.S. Supreme Court, Ross said.

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