Earlier this week, in a significant victory for the Securities and Exchange Commission, the US Fifth Circuit Court of Appeals vacated the judgment of the US District Court for the Northern District of Texas dismissing the SEC’s insider trading case against Mark Cuban, the owner of the Dallas Mavericks, and remanded the case to be relitigated in the District Court. The SEC originally brought civil charges against Mr. Cuban in November 2008, accusing him of avoiding losses of US$750,000 by trading on material nonpublic information which he received from the CEO of Mamma.com Inc. just before news broke that caused the company’s stock price to drop. The Court of Appeal’s decision is significant because it suggests that courts need to engage in a highly fact-specific analysis to determine whether a “duty of trust and confidence” has been breached so as to support an insider trading claim premised on the misappropriation theory. As a result, it may be easier for SEC insider trading claims to survive motions to dismiss, which, in turn, may lead the SEC to assert claims based on a wider range of factual circumstances.
Under the misappropriation theory of insider trading, an individual violates Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder when he “misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of information.”1 The Supreme Court adopted this theory in United States v. O’Hagan, holding that a lawyer who traded on the basis of confidential information obtained from a client “breach[ed] ‘a duty of trust and confidence’ owed to his law firm and client.” This is distinct from the classical theory of insider trading under which liability is premised on breach of a duty owed to the company whose stock is traded. Notably, in O’Hagan, the Supreme Court did not set forth principles for determining which relationships give rise to a duty to disclose material nonpublic information or abstain from trading.
The District Court in Cuban dismissed the case on the basis that Cuban was not subject to any duty not to trade. The Court noted that the complaint failed to assert any facts to reasonably suggest that the CEO intended to obtain any agreement from Cuban to refrain from trading. The Court also held that “a simple confidentiality agreement…[is] insufficient to create a duty to disclose or abstain from trading under the securities laws” (emphasis added).2 The Court further found that the SEC overstepped its authority under Section 10(b) in issuing Rule 10b5-2(b)(1). That rule states that a person has “a duty of trust and confidence” for purposes of the misappropriation theory anytime that person “agrees to maintain information in confidence”—even absent an undertaking to refrain from trading. The SEC appealed to the Fifth Circuit arguing that (1) a confidentiality agreement, without more, creates a duty to disclose or abstain from trading on material, nonpublic information; and (2) regardless, the alleged agreement in this case contained an agreement to abstain from trading and that agreement created such a duty.
In its decision, the Fifth Circuit sidestepped the validity of Rule 10b5-2(b)(1) and largely focused on the facts alleged in the SEC’s complaint. The Court disagreed with the lower court’s finding that these facts did not state a plausible claim, holding that “the allegations, taken in their entirety, provide more than a plausible basis to find that the understanding between the CEO and Cuban was that he was not to trade, that it was more than a simple confidentiality agreement.”3 Interestingly, the Court noted that if there was no obligation on Cuban to refrain from trading, a court may infer that the CEO had deliberately “tipped” information to Cuban, an unlikely conclusion that supported the plausibility of an agreement by Cuban not to trade. Rather than attempt to draw a bright line with regard to “what constitutes a relationship of ‘trust and confidence’,” the Court held that whether or not a duty exists is “inherently fact-bound.”4
The type of relationship necessary to support a violation of Rule 10b-5 remains unclear following Cuban. Critically, investors and companies lack clear guidance as to whether the “duty of trust and confidence” may only arise in the context of a fiduciary-like relationship, or whether a duty only arises from an agreement not to trade or even a basic confidentiality agreement. Cuban highlights that the relevant facts that would be examined in each of these contexts are unique and variable. For example, the finding of a fiduciary-like relationship may well center on a different set of facts (i.e., facts related to the existence of a fiduciary relationship and a breach of that relationship) than an inquiry into the existence of a basic confidentiality agreement.
It remains to be seen if other US circuits will adopt the fact-intensive approach set forth by the Fifth Circuit. Cuban underscores that investors should operate on the assumption that trading while in possession of confidential information could result in insider trading liability even absent an agreement not to trade. Certainly, a claim by the SEC or a third party of the existence of a duty to disclose or refrain from trading is now more likely to survive a motion to dismiss and require extensive discovery and litigation of the facts. In this way, the Cuban decision can be viewed as a significant victory for the SEC beyond its narrow facts since it may provide the SEC with the flexibility to bring insider trading claims under the misappropriation theory based on a wide range of factual circumstances.