On July 17, 2009, in a significant defeat for the Securities and Exchange Commission, Northern District of Texas Chief District Judge Sidney Fitzwater dismissed the high-profile insider-trading charges that the SEC had brought against well-known entrepreneur Mark Cuban.1 In a 35-page opinion, Judge Fitzwater set forth a comprehensive analysis of the so-called “misappropriation theory” of insider trading, a theory first recognized by the Supreme Court in United States v. O’Hagan2 as a basis for liability under the anti-fraud provisions of Section 10(b) of the Securities Exchange Act. Judge Fitzwater’s decision, which gave the SEC thirty days to file an amended complaint consistent with his ruling, marks a setback for the SEC in a case that has attracted substantial media coverage.
More broadly, the ruling in Cuban, if adopted by other courts, would limit the reach of the misappropriation theory by requiring the SEC to prove that an individual who has traded on non-public, material information had an independent, pre-existing duty to the source of the information not to trade on that information. Under the decision, it is not enough that the trading party simply agreed to keep the information confidential. This view may cause issuers, prior to disclosing material, non-public information to potential, non-fiduciary investors or similarly situated parties, to seek an agreement not to trade on or otherwise use the information, in addition to the standard confidentiality agreement, if they wish to preclude pre-announcement transactions in their shares by the recipients of the information.
Mark Cuban owned a 6.3% stake in Mamma.com, a Canadian search-engine firm traded on the NASDAQ. In spring 2004, Mamma.com decided to raise capital through a Private Investment in Public Equity (“PIPE”) offering. Prior to public disclosure of the PIPE deal (which, as a dilutive transaction, was expected to exert downward pressure on the company’s share price), Mamma.com’s CEO contacted Mr. Cuban to ask if he wanted to participate in the offering. As alleged, the CEO first told Cuban that he had confidential information to convey to him and that Cuban would have to keep that information confidential.Mr. Cuban agreed to do so; the CEO then told him about the proposed PIPE offering. Cuban was displeased because he believed that the PIPE offering would dilute existing shareholders. At the end of the call, he purportedly told the CEO, “Well, now I’m screwed. I can’t sell.”3
A few hours after the call, the CEO sent Mr. Cuban an email providing contact information for the investment bank assisting in the offering. Cuban spoke with a sales representative from the investment bank, who provided him with additional confidential information about the transaction. One minute after ending that call, Mr. Cuban telephoned his broker and directed him to sell all of his Mamma.com shares. According to the complaint, by selling his shares prior to the public announcement of the PIPE deal, Mr. Cuban avoided losses of over $750,000.4
The Court’s Analysis
The SEC sued Cuban for violating various federal anti-fraud laws, including section 10(b) of the Exchange Act and Rule 10b-5. Section 10(b), which is the core anti-fraud provision of the Exchange Act, makes it unlawful for any person to use a “manipulative or deceptive device or contrivance” in connection with the purchase or sale of a security in contravention of SEC rules. Under the “misappropriation theory,” a person violates section 10(b) and Rule 10b-5 when he “misappropriates confidential information for securities trading purposes, in a breach of duty owed to the source of the information.”5 The key issue inMr. Cuban’s case, as framed by the Court, was whether Cuban, by trading on the information he received from Mamma.com’s CEO despite his agreement to keep it confidential, had undertaken and then violated, the kind of duty that is contemplated by the misappropriation theory.
The SEC argued that Rule 10b5-2, which the SEC adopted following O’Hagan in an effort to define certain circumstances under which a duty will be found, captured Cuban’s agreement to maintain the confidentiality of the PIPE deal. And indeed, subsection (b)(1) of the rule provides that “a ‘duty of trust or confidence’ exists [for purposes of the misappropriation theory] . . . [w]henever a person agrees to maintain information in confidence.”6 The SEC claimed that Cuban had undertaken the requisite duty of trust imposed by the subsection by agreeing to maintain the confidentiality of the PIPE offering, and then breached that duty when he used the information by selling his own Mamma.com shares prior to public disclosure.
While agreeing with the SEC that a duty of trust or confidence in this context can be created by operation of SEC rule and a contractual agreement between the parties (Cuban had disputed both propositions), the Court held that there could be no liability under 10(b) (or any rule promulgated pursuant to the statute) where a non-fiduciary (like Cuban) had not also agreed to refrain from trading on or otherwise using confidential information for personal gain. A misappropriation claim under 10(b), the Court explained, must involve some form of deception, and there can be no liability under the theory where the recipient of information has not deceived its source.7 Mr. Cuban had promisedMamma.com’s CEO that he would not disclose information about the PIPE deal; but he had not promised to refrain from trading on it. Thus, Cuban had committed no act of deception, had not breached his agreement with the CEO, and had not violated 10(b). The Court further held that imposing insider trading liability as a result of the duty defined by Rule 10b5-2(b)(1) – which purports to permit liability solely on the basis of a pre-existing agreement to hold information confidential — would “exceed the SEC’s § 10(b) authority to proscribe conduct that is deceptive.”8 In this regard, the Court seemed to cast doubt on the legitimacy of the rule as applied to future insider-trading actions brought by the SEC.9
The Court’s ruling is subject to appeal and its findings with respect to the misappropriation theory are not binding on other federal courts. But by drawing a conceptual distinction in this context between holding information confidential, on the one hand, and using that information to profit in the financialmarkets, on the other, Judge Fitzwater has created a degree of uncertainty in the law thatmay impact the terms on which issuers agree to disclose information to potential investors and other third parties. Prudent issuers will consider adding language that explicitly protects not just the confidentiality of material, non-public information, but also its use.
Moreover, the Cuban decision may have implications in any area of the law where a commitment to maintain the confidentiality of information has heretofore been understood to be co-extensive with an agreement not to trade on it. Regulation FD, for example, which is designed to prevent selective disclosure of material, non-public information by an issuer to certain market participants, does not apply to any disclosure to “a person who expressly agrees to maintain the disclosed information in confidence.”10 A finding in this context that an agreement to “maintain information in confidence” does not encompass an agreement not to trade on the information, would seem to run against the spirit and purpose of Regulation FD (if not its letter), given that the regulation does apply, by its own terms, to any disclosure to a holder of the issuer’s securities, “under circumstances in which it is reasonably foreseeable that the person will purchase or sell the issuer’s securities on the basis of the information.”11 In this sense, Cuban may have a ripple effect through the securities laws, the scope of which is not yet clear.