On July 17, 2009, the U.S. District Court for the Northern District of Texas found in the case of Securities and Exchange Commission v. Mark Cuban that the Securities and Exchange Commission (SEC) had not adequately alleged all of the information required to establish liability under the misappropriation theory of insider trading. The SEC had alleged that Cuban “agreed to maintain the confidentiality of material, nonpublic information concerning a planned private investment in public equity (PIPE) offering by Mamma.com Inc. [and then] sold his stock in the company without first disclosing to Mamma.com that he intended to trade on this information.” The court found that Cuban’s promise of confidentiality alone did not prevent him from using the information for personal gain. Rather, in order to prove that Cuban’s conduct was a violation of Section 10(b) of the Securities and Exchange Act, the SEC needed to allege that Cuban expressly or implicitly agreed with the CEO of Mamma.com to keep the information confidential and refrain from trading on or otherwise using such information for personal gain.
Background of the Case – SEC Allegations
According to the SEC’s complaint, in March 2004, Cuban purchased 600,000 shares, or a 6.3 percent stake, in Mamma.com. In the spring of 2004, the CEO of Mamma.com called Cuban, the company’s then-largest shareholder, to inform him that the company had decided to raise capital through a PIPE offering. Before divulging this information, the CEO of Mamma.com sought and received Cuban’s promise to keep the information confidential. When the CEO told Cuban about the PIPE offering, Cuban acted angrily, stating that he believed it would dilute his investment as an existing shareholder.
At the end of the conversation, Cuban stated that “Well, now I’m screwed. I can’t sell.” However, despite his comment, Cuban sold all of his holdings in Mamma.com later that evening and on the next trading day, avoiding losses in excess of $750,000.
Court’s Analysis and Decision
Cuban, in his motion to dismiss, alleged that the SEC failed to sufficiently plead the elements of misappropriation liability. First, Cuban contended that “liability under the misappropriation theory depends on the existence of a preexisting or fiduciary-like relationship, as determined exclusively under applicable state law.” The court disagreed, finding that a duty adequate to support insider trading liability can be found in sources other than state law, such as in rules promulgated by the SEC or in an agency regulation promulgated under authority conferred by Congress. Cuban also argued that entering into an agreement could not serve as the basis of a misappropriation action, and that such a claim could result only from a fiduciary or fiduciary-like relationship. The court disagreed, concluding that misappropriation theory liability can arise by agreement, absent a preexisting fiduciary or fiduciary-like relationship. In addition, the court rejected Cuban’s argument that the SEC had to allege that Cuban “[entered] into an agreement that created a relationship bearing all the hallmarks of a traditional fiduciary relationship” in order to establish liability under the misappropriation theory, finding that the SEC only needed to allege that Cuban agreed to keep the information confidential and refrain from using the information for personal gain.
Cuban also argued that the “SEC [had] alleged merely that he entered into a confidentiality agreement, and…that such an agreement is of itself inadequate to establish misappropriation theory liability.” On this point, the court agreed with Cuban, finding that liability under the misappropriation theory arises only when a trader expressly or implicitly agrees to keep the information confidential and refrain from “trading on or otherwise using the information for personal gain.” The court explained that when a trader and an information source are in a fiduciary relationship, the obligation not to disclose information and not to use information for personal gain arises implicitly from the legal duties of the relationship, such as the fiduciary’s duty to act loyally towards the principal. However, where misappropriation theory liability is predicated on an agreement rather than a fiduciary relationship, such as in this case, the trader cannot be held liable unless he expressly or implicitly agrees to nondisclosure and nonuse of the information.
Lastly, the court concluded that Rule 10b5-2(b)(1), which attempts to predicate misappropriation theory liability on an agreement “to maintain information in confidence,” exceeded the SEC’s authority under Section 10(b), because the rule did not also require an agreement not to use the disclosed information, which, as indicated above, the court concluded is a required component of misappropriation liability.
The court granted Cuban’s motion to dismiss on the grounds that the SEC failed to allege that Cuban agreed to refrain from using the confidential information for personal gain. The court granted the SEC 30 days to file an amended complaint.
The court’s decision is surprising in that it more narrowly defines misappropriation theory liability than what the SEC and many practitioners had believed. If the court’s decision is not overturned on appeal and is followed by other courts, a public company that wants to advise shareholders and others of nonpublic developments, or otherwise convey nonpublic information to persons who do not owe a fiduciary obligation to the company, will be advised to seek to obtain not just a confidentiality agreement from the third party, but also an agreement by the third party not to trade in the company's securities until the nonpublic information has been made public by the company, or to refrain from conveying the nonpublic information to such third parties. Public companies should, however, expect to encounter some resistance from sophisticated investors, who will likely balk at this request, or at the very least require that the companies disclose the nonpublic information within a reasonable period of time.
Christopher Lopreste was also a principal author of this On the Subject.