S.E.C. v. Dorozhko

• Decision Date: 08 January 2008
• Docket Number: No. 07 Civ. 9606 (NRB).,07 Civ. 9606 (NRB).
• Citation: 606 F.Supp.2d 321
• Parties: SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. Oleksandr DOROZHKO, Defendant.
• Court: U.S. District Court — Southern District of New York

606 F.Supp.2d 321

SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. Oleksandr DOROZHKO, Defendant.

No. 07 Civ. 9606 (NRB).

United States District Court, S.D. New York.

January 8, 2008.

Carl Alan Tibbetts, Paul Alan Gumagay, U.S. Securities and Exchange Commission, Washington, DC, Robert B. Blackburn, U.S. Securities and Exchange Commission, New York, NY, for Plaintiff.

Charles Albert Ross, Christopher L. Padurano, Charles A. Ross & Associates, LLC, New York, NY, for Defendant.

MEMORANDUM AND ORDER

NAOMI REICE BUCHWALD, District Judge.

Presently before the Court are (1) the Securities and Exchange Commission's ("SEC") motion for a preliminary injunction freezing the proceeds of trades in put options of IMS Health Inc. ("IMS Health") stock executed on October 17-18, 2007 by Oleksandr Dorozhko, and (2) defendant Dorozhko's motion to dismiss the complaint, pursuant to Fed.R.Civ.P. 12(b)2, 12(b)6, and 9(b). Dorozhko is a Ukranian national and resident who has asserted a Fifth Amendment privilege not to testify in this matter.

On October 29, 2007, the SEC filed the instant complaint alleging that Dorozhko violated § 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") (15 U.S.C. § 78j (b)), and Rule 10b-5 promulgated thereunder (17 C.F.R. § 240.10b-5) by either hacking into a computer network and stealing material non-public information, or through a more traditionally-recognized means of insider trading such as receiving a tip from a corporate insider. (Complaint ¶ 3.) On the same date, the SEC applied for, and this Court granted, a temporary restraining order freezing the proceeds of Dorozhko's trades.

At a preliminary injunction hearing held before this Court on November 28, 2007, the SEC presented evidence that Dorozhko hacked into the computer network of Thomson Financial ("Thomson Financial") at 2:15:28 p.m. (EST) on October 17, 2007.¹ The SEC presented computer logs that showed that at 2:15:28 p.m., an unauthorized user gained access to IMS Health's soon-to-be-released negative earnings announcement, which was scheduled to be released to the public later that day at around 5:00 p.m. The SEC further showed that approximately 35 minutes after the hack occurred, and just a matter of hours before the information was to be released to the public, Dorozhko, who had recently opened an online brokerage account but had not yet used the account, purchased $41,670.90 worth of October 25 series and October 30 series put options in IMS Health stock. The purchases represented about 90% of all customer purchases of the October 25 and October 30 put options of IMS Health stock for the entire six week period between September 4, 2007 and October 17, 2007. (Complaint ¶ 19.) The very next morning, when the market opened, Dorozhko sold the options for $328,571.00, a return overnight of 6971.

The conclusion that Dorozhko is the likely hacker is the result of two undisputed events: (1) the fact of the hack, and (2) the proximity to the hack of the trades by Dorozhko who was the only individual to trade heavily in IMS Health put options subsequent to the hack. As discussed more fully below, the barrier to issuing a preliminary injunction at this stage in the proceedings is that the alleged `hacking and trading'—while illegal under any number of federal and/or state criminal statutes² —does not amount to a violation of § 10(b) of the Exchange Act under existing case law. For, as the SEC even acknowledges, in the 74 years since Congress passed the Exchange Act, no federal court has ever held that the theft of material non-public information by a corporate outsider and subsequent trading on that information violates § 10(b). Uniformly, violations of § 10(b) have been predicated on a breach of a fiduciary (or similar) duty of candid disclosure that is "in connection with" the purchase or sale of securities. See, e.g., Chiarella v. United States, 445 U.S. 222, 227-30, 100 S.Ct. 1108, 63 L.Ed.2d 348 (1980); United States v. O'Hagan, 521 U.S. 642, 653-660, 117 S.Ct. 2199, 138 L.Ed.2d 724 (1997); S.E.C. v. Zandford, 535 U.S. 813, 825, 122 S.Ct. 1899, 153 L.Ed.2d 1 (2002); see also Regents of University of California v. Credit Suisse First Boston (USA) Inc., 482 F.3d 372, 389 (5th Cir.2007). To eliminate the fiduciary requirement now would be to undo decades of Supreme Court precedent, and rewrite the law as it has developed. It is beyond the purview of this Court to do so.

This case highlights a potential gap arising from a reliance on fiduciary principles in the legal analysis that courts have employed to define insider trading, and courts' stated goal of preserving equitable markets. See generally Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 151, 92 S.Ct. 1456, 31 L.Ed.2d 741 (1972) (noting that federal securities law should be "construed not technically and restrictively, but flexibly to effectuate its remedial purposes") (citations omitted). Yet, on further consideration, the gap is not as troublesome as it may appear, since the government retains ample methods of combating inequitable practices of the kind alleged here. Indeed, we would not have to address the tension between the fiduciary requirement and the goal of preserving fair and open markets had the SEC acted on this Court's suggestion at the November 28, 2007 preliminary injunction hearing that a way to avoid a decision that would result in the release of the restrained trading proceeds was to refer this matter to the United States Attorney's Office for criminal investigation. Based on the evidence provided at the November 28, 2007 hearing there would appear to be sufficient basis to conclude that Dorozhko's hack violated the Computer Fraud and Abuse Act, 18 U.S.C. § 1030(a)(4), the mail fraud statute, 18 U.S.C. § 1341 et seq., and the wire fraud statute, 18 U.S.C. § 1341 et seq. See, e.g., Physicians Interactive v. Lathian Systems, Inc., No. 03-1193-A, 2003 WL 23018270, *1 (E.D.Va. Dec. 5, 2003) (granting a temporary restraining order and preliminary injunction under 18 U.S.C. § 1030 because the defendant hacked into a restricted website and stole confidential information). The U.S. Attorney's Office has authority to seize Dorozhko's trading proceeds under 18 U.S.C. § 981(b).

However, since the SEC has apparently declined, for whatever reason, to involve the criminal authorities in this case, we must address an inconvenient truth about our securities laws—an issue that has sent Supreme Court justices into dissent, see Chiarella, 445 U.S. at 245, 100 S.Ct. 1108 (1980) (Blackmun, J. dissenting) and provoked numerous law review articles. See, e.g., Robert A. Prentice, The Internet and Its Challenges for the Future of Insider Trading Regulation, 12 Harv. J.L. & Tech 263, 296-307 (Winter 1999).

Upon a searching review of existing case law, and for the reasons that follow, we believe that we are constrained to hold that Dorozhko's alleged `stealing and trading' or `hacking and trading' does not amount to a violation of § 10(b) and Rule 10b-5 because Dorozhko did not breach any fiduciary or similar duty "in connection with" the purchase or sale of a security. Although Dorozhko may have broken the law, he is not liable in a civil action under § 10(b) because he owed no fiduciary or similar duty either to the source of his information or to those he transacted with in the market. See O'Hagan, 521 U.S. at 656, 117 S.Ct. 2199. As the Supreme Court famously held in Chiarella, and has reaffirmed since, "one who fails to disclose material information prior to the consummation of a transaction commits fraud only when he is under a duty to do so." 445 U.S. at 228, 100 S.Ct. 1108; see also O'Hagan, 521 U.S. at 654-56, 117 S.Ct. 2199.

Thus, we deny the SEC's motion for a preliminary injunction, but we stay the effect of our order until January 14, 2007 to allow SEC to seek a stay pending appeal from the Court of Appeals pursuant to Fed. R.App. P. 8(a)(2).

We also deny Dorozhko's motion to dismiss the complaint at this time as the SEC's complaint adequately pleads a traditional theory of liability under § 10(b), in addition to its novel `hacking and trading' theory, and we believe that the SEC should be allowed to conduct discovery to ascertain whether Dorozhko's trading was the product of a tip from a corporate insider.

FACTS

Defendant Oleksandr Dorozhko is a selfemployed Ukranian national residing in Uzhgorod, Ukraine. (Second Declaration of Paul A. Gumagay, Counsel to the SEC, in Support of a Preliminary Injunction ¶ 3 and Ex. B attached thereto; see also Second Gumagay Decl. ¶ 4 and Ex. C.) On or about October 4, 2007, Dorozhko wiretransferred $42,500 to Interactive Brokers LLC ("Interactive Brokers"), a registered broker-dealer based in Greenwich, Connecticut, to open an online trading account. (Second Gumagay Decl. ¶¶ 4-5 and Ex. C-D.) In his application to open the account, Dorozhko represented that he had an annual income in the range of $45,000—$50,000, and a net worth in the range of $100,000—$250,000. (Second Gumagay Decl. ¶ 4 and Ex. C.)

IMS Health is a publicly-traded company headquartered in Norwalk, Connecticut. On October 17, 2007, IMS Health planned to announce its earnings for its 2007 fiscal year at about 5:00 p.m. (EST) after the close of markets. (Declaration of Michael Fox, Director of Employee and Executive Communications at IMS Health, ¶ 4.) Specifically, IMS Health was set to announce negative earnings growth, a performance well below consensus analyst estimates. (Id.) Although there had been some minor speculation on a health care blog and in an industry chat room back in September 2007 that certain of IMS Health's clients were having reporting errors with IMS market-share data (Dorozhko Reply Memorandum of Law in Further Support of Motion to Dismiss Ex. 5), there were no major media or analyst reports around the time anticipating negative earnings. (Fox Decl. ¶ 4.) In fact, in the months leading up to the release of...