There is not much doubt that Oleksandr Dorozhko used inside information when he made a killing trading stock options last fall. Nor is there a dispute that he gained the information illegally. His lawyer, arguing before an appeals court this week, spoke of “a high-tech lock pick.”
But that does not mean that Mr. Dorozhko, a Ukrainian resident, will have to forfeit the $296,456 he earned in one day of trading, beginning just hours before the company in question announced disappointing earnings. The Securities and Exchange Commission blocked him from collecting the profits from his brokerage account, but a federal judge has ordered the S.E.C. to let him have the cash.
The hearing this week, before the United States Court of Appeals for the Second Circuit, in New York, was on the S.E.C.’s request for an emergency order to keep the money frozen. If the commission loses, the case against Mr. Dorozhko will effectively be over. Even if the S.E.C. later won the case, the chances of collecting a judgment in Ukraine would be slim at best.
This situation exists because of a strange anomaly in American securities laws. A person who legally obtains insider information — as a corporate official or an investment banker, for example — will almost certainly break the securities law if he or she trades on the basis of that information before it is made public.
But it is far less clear that someone who illegally gets their hands on such information will have violated the securities laws by trading on it. The securities law used to bring insider trading charges — Section 10(b) of the 1934 Securities Exchange Act — talks of “a deceptive device or contrivance,” and it is not clear that there is any deception involved in simple theft.
“Dorozhko’s alleged ‘stealing and trading’ or ‘hacking and trading’ does not amount to a violation” of securities laws, Judge Naomi Reice Buchwald of United States District Court ruled last month. Although he may have broken laws by stealing the information, the judge concluded, “Dorozhko did not breach any fiduciary or similar duty ‘in connection with’ the purchase or sale of a security.” She ordered the S.E.C. to let him have his profits.
She refused to dismiss the case, saying the S.E.C. could try to prove he got a tip from an insider, but there does not appear to be any evidence of that. Instead, the evidence indicates that on Oct. 17, 2007, someone hacked into a computer system that had information on an earnings announcement to be made by IMS Health a few hours later.
Minutes after the breach of computer security, Mr. Dorozhko invested $41,671 in put options that would expire worthless three days later unless IMS shares plunged before that. The next morning the share price did plunge, and Mr. Dorozhko made his money by selling the puts.
The S.E.C. argues there was deception involved in hacking into the computer system, which was designed to allow access only to authorized people.
That view drew scorn from Charles A. Ross, Mr. Dorozhko’s lawyer, at the appellate hearing Wednesday. “They want you to believe there is a deception of a computer,” he said. “All there is is a high-tech lock pick.”
That argument seemed to draw some sympathy from one of the three judges hearing the appeal. “You deceived a machine,” said Judge Sonia Sotomayor, invoking the image of Big Brother from George Orwell’s novel, “1984.” “We are treating a machine as a person.”
Judge Buchwald’s ruling was the first one to address the S.E.C.’s theory of deception by hacking from overseas. Two previous cases were filed, but one was settled and in the other the defendants chose to forfeit $1.6 million rather than fight the charges. If her opinion stands, it will be very hard for the commission to go after hackers in the future.
The judge appreciated the absurdity of the situation, and expressed disappointment that the Justice Department had not brought criminal charges for computer hacking. The government has offered no explanation for that, but it is possible the department saw no likelihood of ever being able to arrest Mr. Dorozhko, and did not think the case worth the trouble.
The judge also noted that case law could have developed differently, harking back to Justice Harry Blackmun’s dissent to the Supreme Court’s 1980 decision that reversed the insider trading conviction of Vincent Chiarella, a financial printer who learned of takeover targets from his work and traded on the information. The court, Justice Blackmun wrote then, was moving in a direction “that catches relatively little of the misbehavior that all too often makes investment in securities a needlessly risky business for the uninitiated investor.”
Donald Langevoort, a law professor at Georgetown University and the author of a treatise on insider trading law, said in an interview that he thought the S.E.C. should prevail in the case. “Did he commit fraud? Yes,” Mr. Langevoort said. “Was it for the purpose of obtaining a trading advantage? Yes. Why should that not reach the level of the statute?”
The appeals court will decide soon if the asset freeze stands, but a ruling on whether Judge Buchwald correctly interpreted the law, if it comes at all, is many months away. She would first have to dismiss the case.
In the meantime, Congress could clear all this up with a simple amendment to clarify the law. “The European Union revised their insider trading laws to make it clear that any gaining of inside information by criminal activity would be a violation of insider trading laws,” Mr. Langevoort said.
As Chief Justice Warren Burger wrote in his dissent in the Chiarella case, “A person who has misappropriated nonpublic information has an absolute duty to disclose that information or to refrain from trading.” If it is illegal to trade on information acquired legally, why should it be legal to trade on information that was acquired illegally?