The opinion of the court was delivered by: WARD
ROBERT J. WARD, District Judge
In a four count indictment (the "Indictment") filed on August 30, 1984, defendant Thomas C. Reed ("Reed") was charged by a grand jury in the Southern District of New York (the "Grand Jury") with criminal violations in connection with the purchase and sale of stock call options of Amax, Inc. ("Amax"), during the winter of 1981. Specifically, Reed is charged in Count One of the Indictment with securities fraud in violation of sections 10(b) and 32 of the Securities Exchange Act of 1934, (the "Exchange Act"), 15 U.S.C. §§ 78j, 78ff, and rule 10b-5, 17 C.F.R. § 240.10b-5.
Based on the same allegations, Count Two charges that Reed's conduct constituted wire fraud in violation of 18 U.S.C. §§ 2, 1343.
In Count Three of the Indictment it is alleged that Reed lied in a deposition in which he testified in connection with a civil action for securities fraud brought by persons who sold Amax options at the time that, inter alios, Reed traded. Reed is thus charged in Count Three with perjury, in violation of 18 U.S.C. § 1623.
Count Four of the Indictment charges that Reed created and used fraudulent documentation to obstruct justice in the civil proceeding, in violation of 18 U.S.C. § 1503.
Reed now moves, pursuant to Rule 12(b), Fed.R.Crim.P., to dismiss the Indictment, on the grounds that Counts One and Two fail to allege criminal offenses, and that venue for Counts Three and Four does not properly lie in the Southern District of New York. For the reasons hereinafter stated, Reed's motion is granted in part and denied in part, and Counts Three and Four of the Indictment are dismissed.
The Court assumes, as it must, the truth of the facts as alleged in the Indictment and may not consider defendant's contrary assertions of fact. See Boyce Motor Lines, Inc. v. United States, 342 U.S. 337, 343 n.16, 96 L. Ed. 367, 72 S. Ct. 329 (1952); United States v. Pacione, 738 F.2d 567, 568 (2d Cir. 1984); United States v. Von Barta, 635 F.2d 999, 1002 (2d Cir. 1980), cert. denied, 450 U.S. 998, 68 L. Ed. 2d 199, 101 S. Ct. 1703 (1981).
The gravamen of the Government's case against Reed, as charged in the Indictment, is the allegation that, from on or about January 26, 1981, up to and including March 18, 1981, Reed engaged in a fraudulent scheme designed to enrich himself, as well as his friends and associates, by trading in the securities of Amax while he was in possession of material, nonpublic, confidential information. Thereafter, it is alleged, Reed fraudulently and perjuriously attempted to disguise his transgressions. Specifically, it is asserted, that as part of this fraudulent scheme: (a) Reed obtained nonpublic, confidential information concerning the proposed merger of Amax into Standard Oil Company of California ("Socal") from his father, Gordon W. Reed; (b) Reed misappropriated this information and engaged in the purchase and sale of Amax stock call options without first disclosing the confidential information in his possession, in breach of a duty arising from a fiduciary and other relationship of trust and confidence owed by Reed directly to his father, to Amax and to the shareholders of Amax; and (c) Reed thereafter both gave perjurious testimony in a deposition and submitted fraudulent and misleading documentation during the course of discovery proceedings in connection with a civil action brought by options traders against Reed and others based on the sale of Amax call options during the period at issue herein.
At all times relevant to the Indictment, Reed was the president of Quaker Hill Development Corporation ("QHDC") in San Rafael, California. QHDC is a land development company wholly owned by Reed and his family. Reed's father was at this time a member of the Board of Directors of Amax, and chairman of the Amax Petroleum Corporation, a wholly owned subsidiary of Amax. At all times relevant to this action, Amax was a publicly-held corporation engaged in the exploration for and the mining and refining of ores and minerals. Amax stock is traded on the New York Stock Exchange and other exchanges.
During this time, Socal was a publicly-held corporation engaged in world-wide, integrated petroleum operations. Since 1975, Socal has owned approximately twenty percent (20%) of Amax common stock. From in or about September 1980 up to and including March 4, 1981, Amax was engaged in nonpublic, confidential discussions concerning a proposed merger of Amax into Socal. Specifically, on Janaury 26, 1981, the chairman of the Board of Directors of Amax met with the chairman of the Socal Board of Directors to discuss the possibility of a merger of Amax into Socal. These discussions were secret and confidential. Four days later, Reed purchased one hundred "March 45" Amax stock call options in the name of QHDC.
This purchase was made shortly after Reed had participated in a telephone conversation with his father. On the next business day, February 2, 1981, Reed purchased an additional four hundred "March 50" Amax call options in the name of QHDC. On the following day, Reed telephoned Ian K. MacGregor, a member of the Amax Board of Directors in an attempt to obtain further information concerning the likelihood of a merger between Amax and Socal.
The merger discussions continued through February and into early March 1981. On February 25, 1981, the Socal Board of Directors approved in principle a merger proposal pursuant to which Socal offered to acquire all outstanding Amax common stock in exchange for cash and Socal securities worth approximately $78.50 per Amax share. This offer was communicated in confidence to the chairman of the Board of Directors of Amax for consideration by the Amax Board. Information concerning the Socal offer was then disseminated to the members of the Amax Board of Directors, including Gordon Reed. At that time Gordon Reed was vacationing on the Island of Barbados.
On March 2, 1981, and again on March 4, 1981, after Gordon Reed had received news of the Socal offer, Reed spoke by telephone with his father. During those conversations, Reed received nonpublic, confidential information relating to the Socal merger proposal. This information was provided to Reed in confidence and with the firm expectation that Reed would respect this confidence. The relationship between Reed and his father was particularly close; the two men frequently discussed business affairs in the expectation that Reed would keep his father's confidences.
This time, however, Gordon Reed's expectations of confidence were to be disappointed. On March 4, 1981, at 9:42 a.m. (Eastern Standard Time), immediately after the completion of a telephone conversation with his father, Reed placed a series of phone calls to the brokerage firm, Dean Witter Reynolds, Inc. in San Rafael, California, in an attempt to purchase Amax securities while he was in possession of nonpublic, confidential information concerning the Socal merger proposal. Later that morning, after contacting his securities broker, Reed purchased five hundred "March 50" Amax call options on the American Stock Exchange in New York City, at a total cost of $3,346.76.
On the following day, at a special meeting, the Amax Board of Directors considered the Socal merger proposal and determined not to support that offer. This decision of the Amax Board and the details of the Socal merger proposal were publicly disclosed for the first time on that afternoon.
On March 4, 1981, prior to the special meeting of the Amax Board of Directors and to the public disclosure of the Socal merger proposal, Amax common stock was trading at approximately thirty-eight dollars ($38.00) per share. On the same day, a contract for Amax "March 45" call options was trading at twelve and one half cents ($0.125) per share, and a contract for Amax "March 50" call options was trading at six and one quarter cents ($0.0625) per share. On March 6, 1981, the day following the public announcement of the Socal merger proposal, the price of Amax common stock increased from an opening price of thirty-eight dollars ($38.00) to fifty-seven ($57.00) per share. Similarly, the price of Amax "March 45" call options increased from twelve and one half cents ($0.125) to twelve dollars and twenty five cents ($12.25) per share, while the price of Amax "March 50" call options jumped from six and one quarter cents ($0.0625) to eight dollars and seventy-five cents ($8.75) per share.
On or about March 6, 1981, in an effort to capitalize on the salutary effect of the disclosures of the Socal proposal on the price of Amax securities, Reed sold the five-hundred "March 50" call options that he had purchased two days earlier. Reed's profit from this transaction amounted to approximately four hundred thirty-one thousand dollars ($431,000.00).
Subsequently, on March 10, 1981, O'Connor & Associates, an options trading firm, commenced a civil class action against eighteen defendants, including Reed, in the United States District Court for the Southern District of New York, O'Connor & Associates et al. v. Dean Witter Reynolds, Inc., et al., 81 Civ. 1354(MEL). (the "O'Connor litigation"). Plaintiffs in that action had sold Amax call options during the period from February 23, 1981 to March 5, 1981.
In connection with that action, Reed testified in a deposition in San Francisco, California, on April 21-22, 1982.
The transcript of that deposition was thereafter filed with the United States District Court for the Southern District of New York. During this deposition, Reed gave perjurious testimony concerning the circumstances surrounding his transactions involving Amax call options. In the course of discovery proceedings in the O'Connor litigation, Reed also presented and relied upon false and misleading documentation, i.e., handwritten notes that he created in order to disguise the fact that he had engaged in such transactions while in possession of nonpublic, confidential information.
Based on these allegations, the Grand Jury charged Reed with four criminal statutory violations. Count One alleges that Reed's March 4, 1981 purchase of five hundred "March 50" Amax call options operated as a fraud in violation of section 10(b) of the Exchange Act, and Rule 10b-5 thereunder.
Count Two is premised on Reed's telephonic conversation with the Dean Witter Reynolds offices in San Rafael, California and New York City, and charges that Reed's use of the telephone in connection with the disputed Amax options transactions constituted wire fraud in violation of 18 U.S.C. § 1343.
See Letter of Assistant United States Attorney, Paul L. Shechtman, Esq. to Edward M. Shaw, Esq. at 3 (Sept. 27, 1984) (the "Shechtman Letter"), contained as Exhibit B to the Reed Memo.
The latter two counts of the Indictment involve the post-trading aspects of the Government's case, in particular, the discovery phase of the O'Connor litigation. Count Three asserts that Reed committed perjury during his deposition in the O'Connor litigation in violation of 18 U.S.C. § 1623.
The last count accuses Reed of obstruction of justice by his "creating and using false and misleading documentation, to wit, handwritten notes . . . to disguise the fact that he had made such purchases while in possession of unlawfully obtained non-public confidential information," in violation of 18 U.S.C. § 1503.
Indictment at P15.
On October 17, 1984, Reed filed the instant motion to dismiss the Indictment in its entirety. At the outset, Reed expressly denied that he received any nonpublic, confidential information concerning the Socal merger proposal from his father or any other source prior to his March 4, 1981 securities transactions. Moreover, he argues that Counts One and Two should be dismissed because they each fail to allege acts that constitute a criminal violation by Reed. Even if the remaining two counts sufficiently allege criminal offenses, Reed continues, those counts should also be dismissed because venue for prosecutions for the offenses alleged in those counts does not properly lie in this district.
With respect to Counts One and Two, Reed argues that under the instant circumstances and consistent with the express language of the Indictment, the sole theory upon which guilt can rest is that Reed misappropriated "inside" information from his father for the purpose of engaging in highly profitable securities transactions. Reed asserts, and the Government agrees, that he cannot properly be charged as a "tippee" who illegally traded on the basis of nonpublic confidential information received from a corporate insider.
Pursuant to the recent decision of the Supreme Court in Dirks v. SEC, 463 U.S. 646, 103 S. Ct. 3255, 77 L. Ed. 2d 911 (1983), the argument proceeds, an essential element of tippee liability under Rule 10b-5 is proof that the tipping insider disclosed the confidential information with the knowledge or expectation that the tippee would trade on the information, and, thus, with the intent to defraud the securities holders of the insider's company. However, the Indictment does not allege the existence of such a state of mind on the part of Gordon Reed, and the Government has formally acknowledged that it will not endeavor to establish that Reed's father was possessed of such fraudulent intent. See Shechtman Letter at 2.
Reed argues that, given this state of affairs, the survival of counts One and Two rises and falls with an entirely different theory of liability. Specifically, the Indictment alleges that Reed stood in a fiduciary or other relationship of trust and confidence with his father, that in breach of their relationship, Reed misappropriated the information about the Socal merger proposal that he had learned from his father, and that, as a result, Reed's trades on March 4, 1981 constituted securities and wire fraud. See Indictment at P7. In his motion papers, Reed asserts that this "misappropriation" theory must fail for two independent reasons. First, he urges, the Indictment lacks the factual allegations necessary to establish the existence of a fiduciary relationship between Reed and his father. The mere assertion in paragraph 4 of the Indictment that "Gordon W. Reed and Thomas C. Reed had a special relationship of trust and confidence and frequently discussed business affairs in the expectation that Thomas C. Reed would keep his father's confidences" is insufficient, Reed contends, to sustain the Government's allegation that Reed was the confidant of his father. A second deficiency in Counts One and Two, Reed maintains, is that those counts do not allege and would not support a claim that defendant's conduct resulted in some legally cognizable injury or potential injury to Gordon Reed.
Turning to the remaining counts of the Indictment, Reed denies that he had testified falsely under oath or that he submitted fraudulent and misleading documents during the course of discovery proceedings in the O'Connor litigation. However, Reed continues, even if the charges contained in Counts Three and Four are accurate, he may not be prosecuted in the Southern District of New York for the crimes alleged. According to Reed, there exists binding Second Circuit authority to the effect that the proper venue for prosecutions for perjury and obstruction of justice is not the district in which the underlying judicial proceeding (the "target proceeding") is pending. Instead, Reed maintains, precedent has established that venue for such prosecutions lies only in the district in which the alleged criminal acts took place. Since both the deposition testimony and submission of documents at issue in the instant case occurred beyond the confines of this district, Reed concludes, there is no basis for venue in the Southern District of New York for prosecution under Counts Three and Four.
D. The Government's Position
In response to Reed's motion, the Government argues that the Indictment should not be dismissed and that Reed's motion should be denied because Counts One and Two properly allege acts constituting securities fraud and wire fraud and because venue properly lies in this district for a prosecution under Counts Three and Four. With respect to the first two counts of the Indictment, the Government, joined by the SEC,
asserts that Reed engaged in criminally fraudulent conduct by misappropriating nonpublic, confidential information from his father, in breach of the Reed's relationship of trust and confidence. Such conduct, the Government charges, violates the federal securities and wire fraud statutes, and is not protected from prosecution by the Supreme Court's decision in Dirks v. SEC, supra, 103 S. Ct. 3225. "Of course, none of these charges have been established by evidence, but at this stage of the proceedings the indictment must be tested by its sufficiency to charge an offense." United States v. Sampson, 371 U.S. 75, 78-79, 9 L. Ed. 2d 136, 83 S. Ct. 173 (1962). Moreover, it is fundamental that an indictment must set forth the elements of the offense sought to be charged, and that an indictment that does not state a crime cannot be sustained. See e.g., Walker v. United States, 342 F.2d 22, 26 (5th Cir.), cert. denied, 382 U.S. 859, 15 L. Ed. 2d 97, 86 S. Ct. 117 (1965); Johnson v. United States, 206 F.2d 806, 808 (9th Cir. 1953).
In connection with Count Three, the Government contends that under the express terms of the federal perjury statute venue may lie in the Southern District of New York inasmuch as Reed's alleged prevarications occurred during a proceeding "ancillary to" a civil action in this district. See 18 U.S.C. § 1623(a). Similarly, the Government insists, the crime of obstruction of justice, with which Reed is charged in Count Four, may be prosecuted in this district because the relevant case law, legislative history, and public policy considerations permit such prosecutions in the district in which the administration of justice was intended to be impeded.
The instant case presents an issue of first impression, this Court's resolution of which the Government contends significantly may affect future litigation under the securities laws.
Against this background, and at the risk of belaboring what may by now have become doctrinally obvious, the Court embarks upon a brief review of the recent additions to the relevant legal landscape in order to more carefully set the juridical context of the instant case. With the guidance of such precedent, the Court turns to address the various contentions of the parties and to assess the legal sufficiency of the allegations and charges presented by the Indictment.
A. Recent Precedent - The Necessity for a Fiduciary or Confidential Relationship
The parties correctly perceive that the sufficiency vel non of Counts one and Two depends upon this Court's assessment of the legal consequences of the relationship between Reed and his father as alleged in the indictment. Both sides acknowledge that, as the Supreme Court held in Chiarella v. United States, 445 U.S. 222, 63 L. Ed. 2d 348, 100 S. Ct. 1108 (1980), the mere possession of nonpublic, confidential market information does not bring with it a corresponding duty to publicly disclose that information or to abstain from trading on the basis of such select knowledge.
See id. at 234. Rather, the duty to "disclose or abstain" arises only from a relationship of trust and confidence either between the parties to a market transaction or between the trading party and the source of that information.
The defendant in Chiarella was a "markup man" employed by a financial printer. On the basis of information contained in various announcements of corporate takeover bids that his employer was hired to print, the defendant was able to deduce the names of the target companies of several bids before the final printing and dissemination of the announcements. Without disclosing this knowledge, he purchased stock in the target companies and sold the shares immediately after the takeover attempts were disclosed publicly. For his efforts, the defendant found himself with substantial - albeit short lived - trading gains, as well as a seventeen count conviction for violations of section 10(b) and Rule 10b-5. Neither was to survive - the defendant was forced to disgorge his profits to the sellers of the shares, and the Supreme Court reversed his conviction. The court explained that when an allegation of fraud is based upon nondisclosure, there can be no conviction absent a duty on the part of the defendant to speak. "And the duty to disclose arises when one party has information 'that the other [party] is entitled to know because of a fiduciary or other similar relation of trust and confidence between them.'" Id. at 228 (quoting Restatement (Second) of Torts § 551(2)(a)(1976)) (brackets in original).
Applying these principles to the case confronting it, the Chiarella court held that the defendant had been under no duty to disclose the information concerning the takeover plans of the acquiring companies. He was not a corporate insider, and had received no confidential information from the target companies. Moreover, the Court explained, no such duty arose from the defendant's relationship with the sellers of the target companies' securities because the defendant had had no prior dealings with them, was not their agent or fiduciary, and was not a person in whom those sellers had placed their trust and confidence. the Court concluded:
We cannot affirm petitioner's conviction without recognizing a general duty between all participants in market transactions to forgo [forego] actions based on material, nonpublic information. Formulation of such a broad duty, which departs radically from the established doctrine that duty arises from a specific relationship between two parties, see n.9, supra, should not be undertaken absent some explicit evidence of congressional intent. . . .
. . . Section 10(b) is aptly described as a catchall provision, but what it catches must be fraud. When an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak. We hold that a duty to disclose under § 10(b) does not arise from the mere possession of nopublic [nonpublic] market information.
More recently, in Dirks v. SEC, supra, 103 S. Ct. 3255, the Supreme Court had further occasion to address and refine the source and scope of tippee liability under the section 10(b) and Rule 10b-5.
In Dirks, the Court again rejected the notion that a general duty attaches to anyone who knowingly receives nonpublic material information from an insider to disclose that information before trading. Instead, Justice Powell reaffirmed his holding for the Court in Chiarella that the mere possession of nonpublic, confidential information does not give rise to a duty to disclose or abstain; only a specific relationship of trust and confidence between the parties creates such a duty.
See Dirks v. SEC, supra, 103 S. Ct. at 3262 n.15; Moss v. Morgan Stanley Inc., 719 F.2d 5, 12 (2d Cir. 1983), cert. denied, 465 U.S. 1025, 104 S. Ct. 1280, 79 L. Ed. 2d 684 (1984); Walton v. Morgan Stanley & Co., Inc., 623 F.2d 796, 799 (2d Cir. 1980).
Because this requirement of a specific relationship between the shareholders and the individual trading on inside information has created analytical difficulties for the SEC and the courts in policing tippees who trade on inside information, the Court expressly delineated the circumstances under which a ban on tippee trading attaches. The Court acknowledged that there must be some limits on tippee trading, else insiders might escape the constraints of their fiduciary duty not to exploit corporate information for personal gain by passing nonpublic, confidential information on to outsiders for the same improper purpose. Consistent with the precept that a relationship of trust and confidence is at the fulcrum of liability under section 10(b), the Court concluded that the tippee's duty to disclose or abstain from trading is derivative of the insider's duty. Justice Powell explained:
Thus, some tippees must assume an insider's duty to the shareholders not because they receive inside information, but rather because it has been made available to them improperly. And for Rule 10b-5 purposes, the insider's disclosure is improper only where it would violate his Cady, Roberts duty. Thus a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.
Id. at 3264 (footnote omitted).
As a result of the secondary nature of tippee liability, a tippee may be under a duty to disclose or abstain only when the information on which he relied was tipped to him by an insider in breach of the insider's fiduciary duty. Whether a particular disclosure constitutes such a breach, the Court concluded, depends in large part on the purpose of the disclosure. In the words of Justice Powell:
the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach. . . .
. . . [T]o determine whether the disclosure itself "deceive[s], manipulate[s], or defraud[s]" shareholders, Aaron v. SEC, 446 U.S. 680, 686 100 S. Ct. 1945, 1950, 64 L. Ed. 2d 611 (1980), the initial inquiry is whether there has been a breach of duty by the insider. This requires courts to focus on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or reputational benefit that will translate into future earnings.
Id. at 3265-66 (footnote omitted) (brackets in original).
In the instant case, the Indictment does not allege and the Government does not maintain that Gordon Reed disclosed any information concerning the Socal offer wtih an eye towards receiving a direct or indirect personal benefit from such disclosure. In particular, it is nowhere charged that Gordon Reed revealed to defendant nonpublic, confidential information concerning the Socal offer out of a desire for "pecuniary gain or a reputational benefit that will translate into future earnings." Dirks v. SEC, supra, 103 S. Ct. at 3266. On the contrary, the Government has continually depicted Gordon Reed as the victim of his son's connivance, having mistakenly relied on defendant's confidence and on the expectation that the son would not trade on the basis of the father's disclosures. See, e.g., Oral Argument Transcript at 24. Thus, the Government had not charged and does not here contend that Gordon Reed breached his Cady, Roberts duty to Amax and its shareholders not to use inside information for personal advantage. See Cady, Roberts & Co., supra, 40 S.E.C. at 912 n.15. In the absence of such a breach by the insider, defendant's father, the Government concedes that there can be no derivative "tippee" liability by Reed, and defendant is not so accused.
B. The Misappropriation Theory
From the perspective of public policy, the constellation of principles ennunciated in Chiarella and Dirks present this Court with a troubling anomaly. As applied, those principles indicate that an individual who receives from a corporate insider nonpublic, confidential information that is likely to affect the value of a corporation's securities will be liable if the insider made the disclosure out of a desire for personal material gain but not if the insider acted with a more benign purpose.
This conclusion, however, hardly ends the present inquiry. After the Supreme Court's decisions in Chiarella and Dirks, it is no longer open for the Government to pursue Reed for fraudulent nondisclosure on a theory of tippee liability. However, those cases raise no obstacle to the theory of liability propounded in the indictment. Specifically, the Indictment alleges that Reed misappropriated from his father nonpublic, confidential information concerning the Socal merger proposal. Relying on the holding in United States v. Newman, 664 F.2d 12 (2d Cir. 1981), cert. denied, 464 U.S. 863, 104 S. Ct. 193, 78 L. Ed. 2d 170 (1983), and its reaffirmation in SEC v. Materia, 745 F.2d 197 (2d Cir. 1984), the Government argues that Reed committed securities and wire fraud when he "misappropriated nonpublic information in breach of a fiduciary duty and traded on that information to his own advantage." SEC v. Materia, supra, at 203.
This theory of liability attempts to impose criminal culpability for improper trading on "outsiders," i.e., persons who lack a direct fiduciary relationship with a corporation or its shareholders. See generally Note, Outsider Trading After Dirks v. SEC, 18 Ga. L. Rev. 593 (1984); Langevoort, Insider Trading and the Fiduciary Principle: A Post-Chiarella Restatement ("The Fiduciary Principle "), 70 Cal. L. Rev. 1, 44-53 (1982). Under this theory it is not argued that defendant breached some obligation to disclose material nonpublic information to those with whom he trades, or to the public-at-large. Rather, the focus of analysis under this approach is on the source of the information. See Langevoort, The Fiduciary Principle, supra, 70 Cal.L.Rev. at 46. Stripped to its essentials, outsider trading liability is premised on the common law principle that when a fiduciary profits from confidential information that he had received because of his fiduciary status, he breaches a legal duty to the person or entity that entrusted him with the information. The misappropriation of secret information for personal aggrandizement in breach of such a relationship constitutes fraud. See e.g., United States v. Newman, supra, 664 F.2d at 18. The origins of this approach can be traced to the law of restitution. A person who receives confidential information from another and misappropriates it for personal benefit is deemed to hold the proceeds of the misappropriation in a constructive trust for the benefit of the entrusting party. The misappropriator thus becomes the trustee ex maleficio, or quasi-fiduciary, of the entrustor. See Langevoort, The Fiduciary Principle, supra, 70 Cal.L.Rev. at 30-31 & n.121. In the context of the securities laws, it does not matter for purposes of assessing liability whether the recipient of the information is actually trading in the securities issued by the source of the information. Rather, the duty is breached by the misappropriation and resulting profit, and a constructive trust attaches.
In United States v. Newman, supra, 664 F.2d 12, the Second Circuit decided in the affirmative the issue left open in Chiarella as to whether criminal liability for securities fraud can be premised upon the fiduciary duty owed to an acquiring corporation by virtue of one's position as an employee of a firm retained by that corporation. The defendant in Newman was a securities trader and manager of the over-the-counter trading department of a New York brokerage firm. He had obtained confidential information concerning proposed corporate mergers and acquisitions from the employees of certain investment banking firms. The employees had misappropriated this information, which had been entrusted to their employers by corporate clients, and surreptitiously conveyed it to Newman. Newman, in turn, passed the information along to two foreign confederates. The three conspirators then constructed and executed an elaborate scheme for purchasing the stock of companies that were merger and takeover targets of the subject investment banking firms. By making such purchases prior to the announcement of the various corporate acquisitions and the accompanying rise in the market price of the target companys' securities, the conspirators were able subsequently to sell the stock at prices well higher than the prices they had paid for the same securities. As a result, Newman and his co-conspirators reaped substantial profits, which they shared with the employees of the investment banking firms. All five men were indicted for securities and mail fraud. In upholding the legal sufficiency of this indictment, a divided panel of the Second Circuit held that the defendants' misappropriation of confidential information entrusted to the investment bankers constituted the requisite element of fraud under Rule 10b-5 as well as a breach of duty to both the investment banking firms and those firms' clients. The court explained that "[b]y sullying the reputations of the [investment banking firms] as safe repositories of client confidences, [Newman] and his cohorts defrauded those employers as surely as if they took their money." Id. at 17 (citations omitted). Moreover, the court continued, the defendants also wronged the clients of the investment banking firms, "whose takeover plans were keyed to target company stock prices fixed by market forces, not artificially inflated through purchases by purloiners of confidential information." Id.26
In Materia, the Second Circuit reaffirmed its holding in Newman "that one who misappropriates nonpublic information in breach of a fiduciary duty and trades on that information to his own advantage violates Section 10(b) and Rule 10b-5." SEC v. Materia, supra, at 203 (footnote omitted). The court rejected as contrary to its holding in Newman the defendant's argument that, inasmuch as he had no duty of disclosure to those with whom he had traded, he could not be held to have violated section 10(b) and Rule 10b-5. The court instructed that ancillary issues such as standing and whether the defendant had breached a duty to a particular plaintiff arise only in private civil actions for securities fraud. They are not germane in enforcement actions brought by the SEC. Rather, as the court had previously held in Newman, section 10(b) and Rule 10b-5 do not require the perpetration of a fraud on a particular buyer or seller of securities. It is sufficient that the defendant's conduct "operat[ed] . . . as a fraud or deceit upon any person, in connection with the purchase or sale of any security." Rule 10b-5. See also SEC v. Materia, supra, slip op. at 36-41; United States v. Newman, supra, 664 F.2d at 18-19.
The defendant in Materia was employed as a "copyholder" by a financial printer. Despite extensive efforts by the employer and its clients to keep confidential certain information concerning proposed tender offers,
the defendant was able to derive the identities and purchase the securities of several tender offer targets. Soon after the public announcemnt of the planned corporate acquisitions and the concomitant rise in the market price of the securities, the defendant sold his holdings at substantial gains. Shortly thereafter, the SEC filed an enforcement action, charging that the defendant had violated and was about to violate section 10(b) and 14(e) of the Exchange Act and Rule 10b-5 and 14e-3 thereunder. The complaint was premised upon the SEC's allegations that the defendant had traded in securities of the tender offer targets on the basis of material nonpublic information that he had misappropriated from his employer and its clients. Following a nonjury trial, the district court held that the defendant's conduct violated the antifraud provisions of the federal securities laws as charged. On appeal, the defendant did not contest the district court's finding that he had misappropriated confidential information from his employer and traded on that information to his advantage. Instead he argued that such activity does not violate the securities laws, an argument that the court held directly controverted its holding in Newman. See SEC v. Materia, supra, slip op. at 36. The court explained:
Materia "misappropriated - stole to put it bluntly - valuable nonpublic information entrusted to him in the utmost confidence." United States v. Chiarella, 445 U.S. 222, 245, 63 L. Ed. 2d 348, 100 S. Ct. 1108 (1980) (Burger, C.J., dissenting). We hold that such activity falls squarely within the "fraud or deceit" language of the Rule. Legislative history to the Securities Exchange Act of 1934 makes clear that the antifraud provision was intended to be broad in scope, encompassing all "manipulative and deceptive practices which have been demonstrated to fulfill no useful function." S. Rep. No. 792, 73d Cong., 2d Sess., 6 (1934). This language negates the suggestion that the provision was aimed solely at the eradication of fraudulent trading by corporate insiders. Against this expansive construction of "fraud or deceit," Materia's theft of information was indeed as fraudulent as if he had converted corporate funds for his personal benefit.
The Court similarly rejected the defendant's argument that his employer had not been injured by the defendant's misappropriation of client confidences. The court opined that
among a financial printer's most valuable assets is its reputation as a safe repository for client secrets. By purloining and trading on confidences entrusted to Bowne, it cannot be gainsaid that Materia undermined his employer's integrity. See Newman, supra, at 17. Accordingly, we are driven to the conclusion that, by his misappropriation of material nonpublic information, Materia perpetrated a fraud upon Bowne.
Id. at 37-38 (footnote omitted).
In expanding upon the conception of outsider-misappropriation liability under the securities laws that was marginally addressed in Chiarella and Dirks, the Second Circuit in Newman and Materia established a binary principle of analysis. On the one hand, the cases reveal that those who misappropriate nonpublic, confidential information that they then use to engage in securities trades may be liable under section 10(b) and Rule 10b-5 even if they owed no duty of disclosure to the sellers of the securities involved.
On the other hand, however, the cases have conditioned such liability on the existence of, at least, a duty of fidelity and confidentiality to some person or persons, which duty is rooted in a fiduciary or other relationship of trust or confidence between the misappropriator and the person or entity to whom the duty is owed.
C. The "Confidential Relationship" Principle
As the foregoing cases require, and the parties readily concede, the focus of this Court's inquiry must settle upon the question of whether Reed and his father enjoyed a relationship of trust and confidence. According to the Government, this relationship both inspired the alleged disclosure by Gordon Reed and governed the uses that defendant legally might have made of such information. Absent proof of the existence of such a relationship and corresponding duty, Reed may not be held criminally liable under the "misappropriation" theory advanced in the Indictment. Similarly, inasmuch as Reed's alleged violation of the wire fraud act also requires proof of a fraudulent breach of fiduciary duty, failure by the Government to establish the special relationship alleged will prove fatal to both Counts One and Two. See, e.g., United States v. Weiss, 752 F.2d 777, slip. op. at 7102 (2d Cir. 1985); United States v. Siegel, 717 F.2d 9 (2d Cir. 1983) (mail fraud statute is violated when fiduciary fails to disclose material information that he is under a duty to disclose to another under circumstances in which the non-disclosure could or does result in harm to another); United States v. Newman, ...