A Pennsylvania federal court held yesterday that an agreement not to use confidential inside information for trading purposes need not precede the receipt of that information in order to create liability under the misappropriation theory of insider trading. The ruling in SEC v. Cooperman (E.D. Pa.) appears to be the first decision to address the “novel issue” of “[w]hether liability under the misappropriation theory of insider trading may be premised on a post disclosure agreement” not to trade on or otherwise use inside information.

This decision, if followed by other courts, could give the Government greater leeway in pursuing claims against persons who allegedly agreed not to trade on material, nonpublic information received from corporate insiders. The decision allows such claims to proceed even if the Government cannot specify when the alleged agreement was made, as long as the agreement preceded the actual trading.

Factual Background

The Cooperman case was filed against investment advisor Leon Cooperman and his investment advisory firm. Cooperman allegedly had a “close relationship” with “senior executives” of a company in which his funds had invested. In May 2010, that company received a confidential offer for the purchase of one of its significant operating facilities, and the company negotiated the terms of a potential sale between May and July. The transaction was announced to the public on July 27, and the seller’s stock price rose significantly.

Between July 7 and 20, before the deal was announced, Cooperman allegedly had three telephone conversations with an officer and director of the seller, who told Cooperman about the negotiations. The insider allegedly believed that Cooperman had an obligation not to use that information for trading purposes, and, during one of the phone calls, Cooperman allegedly “explicitly agreed that he could not and would not use the confidential information to trade [the target’s] securities.” However, the SEC did not plead during which of the three phone calls that purported agreement was made.

Cooperman bought the seller’s securities after the various conversations, and he realized a profit when the transaction was announced. The SEC then sued him and his firm for insider trading based on the misappropriation theory. Under this theory, a person violates the securities laws when he or she “misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information” (here, the insider).

SEC Rule 10b5-2 states that the requisite duty of trust or confidence exists under the misappropriation theory “[w]henever a person agrees to maintain information in confidence” or “[w]henever the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the nonpublic information expects that the recipient will maintain its confidentiality.” Although Cooperman allegedly had “close relationships with [the seller’s] senior executives,” the SEC did not plead that he had a history, pattern, or practice of sharing confidences with the particular insider who told him about the nonpublic transaction. The SEC proceeded on only the first prong of Rule 10b5-2: the alleged agreement to maintain the information in confidence.

Cooperman argued that the insider-trading claim should be dismissed because the SEC had not pled with particularity “when, exactly, Cooperman agreed not to use the confidential information.” Cooperman maintained that he could not have breached any alleged duty to the insider unless he had agreed not to use the confidential information before the insider disclosed it to him. The SEC, in contrast, argued that the misappropriation theory does not require the agreement to precede disclosure “so long as a duty of trust and confidence exists at the time the recipient trades on the information.” The court agreed with the SEC.

The Court’s Decision

The court held that the SEC’s interpretation “better accords with the language of [Rule 10b5-2], applicable case law, and congressional intent.” Under Rule 10b5-2, “‘a duty of trust or confidence exists . . . [w]henever a person agrees to maintain information in confidence. . . . The creation of the duty is therefore not limited in time,” as long as it precedes the trading. The court also concluded that case law applying the misappropriation theory “does not require an agreement not to trade to precede the disclosure of confidential information.”

In addition, the court observed that insisting on a pre-disclosure agreement “would create a loophole in the SEC’s enforcement scheme for corporations and the outsiders to whom they provide material nonpublic information, legalizing insider trading by means of sequencing.” Under the SEC’s Regulation Fair Disclosure (“FD”), if a corporate insider selectively provides confidential information to an outsider without obtaining an agreement not to trade, the corporation can be held liable. However, the insider may obtain that agreement either before or after disclosing the information. Under Cooperman’s position, “neither the outsider nor the corporation would be held liable” if the corporation obtained the nontrading agreement after disclosing the inside information. The insider’s failure to obtain an agreement not to trade before disclosing the confidential information would insulate the outsider from liability under the misappropriation theory. But the insider’s procurement of such an agreement after the disclosure would insulate the corporation from liability under Regulation FD.”

For all of these reasons, the court concluded that the SEC’s allegations that Cooperman had traded the seller’s securities “following three telephone calls during which [the insider] disclosed material non-public information concerning a $650 million transaction, and Cooperman at some point agreed not to trade on that information, sufficiently plead the ‘who, what, when, where, and how’ concerning Defendants’ insider trading, giving rise to a plausible misappropriation claim.”

Potential Ramifications

The Cooperman decision appears to give the Government greater flexibility in pleading insider-trading claims based on alleged agreements not to use confidential information. As long as the alleged agreement was made before the trading, the Government need not plead that the agreement preceded the disclosure of the information. We will see whether other courts follow this reasoning.

Insider-trading law derives from anti-fraud statutes, so some sort of fraud, deception, or similar breach of duty has always been required for an insider-trading claim. One might ask whether an insider has been deceived if he or she reveals material, nonpublic information before the recipient allegedly promises not to use or disclose it. (Of course, an insider might have an incentive to say that such an agreement existed, to avoid the risk of being charged with tipping confidential information.)

The safer way to avoid this conundrum (at least at the pleading stage) is for the Government to proceed on the broader duty of confidentiality that Rule 10b5-2 also contemplates: the “history, pattern, or practice of sharing confidences.” If the SEC had pled that Cooperman had had such a relationship with the insider, the timing of the alleged agreement not to use the information would likely not have been an issue. But the SEC did not attempt to do so here. We will see whether the SEC tries to develop such evidence as the case proceeds.