The U.S. District Court for the Northern District of Texas and the U.S. Court of Appeals for the Second Circuit issued separate opinions in July 2009, with alternative views on what constitutes deception for the purposes of insider trading liability. In SEC v. Cuban, the Northern District Court of Texas dismissed a complaint for failure to state a claim under the misappropriation theory of insider trading, holding that deception for the purposes of establishing a claim under this theory requires the defendant to have had an affirmative duty to the source of the information not to trade on material, nonpublic information. In SEC v. Dorozhko, the Second Circuit vacated a district court’s order and held that based on the ordinary meaning of deception, a claim for insider trading does not require that the defendant have a fiduciary duty to the company in all cases where the claim is based on an affirmative misrepresentation. As these cases illustrate, insider trading laws are far from certain.
Section 10(b) of the Securities Exchange Act of 1934 prohibits any person from using or employing any manipulative or deceptive device in connection with the purchase or sale of any security. Rule 10b-5 of the Exchange Act generally prohibits fraud or deceit in connection with the purchase or sale of a security.
Developed through SEC and judicial interpretations, there are two theories under which a person may be found liable for insider trading under Section 10(b) and Rule 10b-5. The first is the “traditional” or “classical” theory, in which a corporate insider trades on the basis of material, nonpublic information. The foundation for this theory is that the insider acquires material, nonpublic information because of his or her relationship with the company, which gives rise to a duty to disclose before trading on the material, nonpublic information. The second theory is the “misappropriation theory,” in which a corporate outsider trades on the basis of material, nonpublic information in breach of a duty owed to the source of the information. In addition to these theories, the SEC has adopted Regulation FD to prevent selective disclosure of material, nonpublic information and has adopted Rule 10b5-2 to impose a duty of trust or confidence in misappropriation insider trading cases when, among other things, a person agrees to maintain information in confidence.
SEC v. Cuban
In the Cuban case, the SEC alleged that Mark Cuban, the owner of the NBA’s Dallas Mavericks and the largest shareholder in Mamma.com, was liable under the misappropriation theory for trading on material, nonpublic information that Cuban had agreed to keep confidential. In early 2004, the CEO of Mamma.com informed Cuban of a proposed PIPE offering and asked Cuban whether he wanted to participate. Before receiving this information, Cuban had agreed that he would keep any information the CEO revealed to him confidential. After reacting angrily to the news of the PIPE offering, Cuban said: “Well, now I’m screwed. I can’t sell.” A few hours later, Cuban allegedly talked with the investment bank conducting the offering who gave him additional confidential details about the PIPE offering. Cuban then sold all of his shares in Mamma.com without informing the company of his intention to trade on the confidential information. The next day, the company publicly announced the PIPE offering and the stock price dropped over 10 percent. As a result of selling before the announcement, Cuban avoided losses of $750,000 on the sale of his stock.
In its opinion, the district court stressed that showing deception is the key to a successful claim under the misappropriation theory. According to the court, a person is not deceptive if he or she discloses to the source of the information the intent to trade on the information. Rather, the court stated that, under the misappropriation theory, trading on the basis of material, nonpublic information cannot be deceptive unless the stockholder has a legal duty to refrain from trading on or otherwise using the information for personal benefit. The court opined that this duty does not need to be a fiduciary duty owed to the company, but can arise by agreement.
The court dismissed the SEC’s complaint because it only alleged that Cuban agreed to keep the information confidential but did not allege that he agreed to refrain from trading on the confidential information. Although the court held that an agreement alone, even without a fiduciary duty, can be the basis for a duty giving rise to liability under the misappropriation theory, the court also held that such an agreement must undertake both an obligation to maintain the confidentiality of the information and an obligation not to trade on or otherwise use the information. The court further held if there is no duty not to use the information for personal benefit, there is no deception in doing so. The court interpreted Cuban’s remark that he could not sell as an observation rather than an agreement to refrain from trading. The court also noted that Cuban’s stock sales did not breach his agreement with the CEO because the sales did not involve or result in the disclosure of the confidential information. The court found that, as a result, Cuban did not engage in a deceptive act. Although the court allowed the SEC to amend its complaint, on August 12, 2009, the SEC asked the court to enter final judgment, which would allow the SEC to appeal the decision. The SEC has stated that it is considering whether to appeal the decision.
In the Cuban case, the SEC also argued that Rule 10b5-2(b)(1) provides the requisite duty under which Cuban could be held liable as the rule provides that a duty of trust or confidence exists whenever a person agrees to maintain information in confidence. The court, however, rejected this argument and held that the duty cannot be premised on Rule 10b5-2(b)(1) because this rule does not include an obligation not to trade on the confidential information. According to the court, to allow liability on the basis of Rule 10b5-2(b)(1) would exceed the SEC’s rulemaking authority to proscribe deceptive conduct under Section 10(b).
SEC v. Dorozhko
Similar to Cuban, the Dorozhko case involved a corporate outsider. In anticipation of releasing its third-quarter earnings, IMS Health, Inc. engaged Thompson Financial, Inc. to manage the online release of its earnings report, which was scheduled to occur after the close of trading on October 17, 2007. Before the release, an anonymous hacker, which the SEC claimed was Oleskandr Dorozhko, accessed Thompson’s computer database and obtained the earnings report for IMS Health. Later that afternoon, Dorozhko purchased put options in IMS Health set to expire in the same month. After the close of the market, the company released its earnings, reporting that its earnings per share were 28 percent below expectations. The next morning, the stock price dropped and Dorozhko was able to sell his put options for a profit of more than $286,000.
In Dorozhko, the SEC did not allege liability under either the traditional or misappropriation theories of insider trading. As a true outsider of IMS Health, Dorozhko did not owe a duty to the company regarding its earnings information. Rather, the SEC premised its case on a claim of fraud under Section 10(b) alleging that the hacking itself involved various misrepresentations by Dorozhko.
The key issue in this case was whether computer hacking constitutes a deceptive device under Section 10(b). The district court held that while Dorozhko’s conduct may be criminally actionable, under Supreme Court jurisprudence, deception under Section 10(b) requires a breach of a fiduciary duty. The Second Circuit vacated the district court’s decision and instead opined that nothing in the Supreme Court’s jurisprudence expressly imposes a fiduciary-duty requirement on the ordinary meaning of “deceptive” where the alleged fraud is an affirmative misrepresentation rather than nondisclosure. According to the Second Circuit, while nondisclosure in breach of a fiduciary duty satisfies deception under Section 10(b), nothing precludes the SEC from alleging a straightforward claim of fraud based on affirmative misrepresentations. The Second Circuit remanded the case to the district court to determine whether Dorozhko’s computer hacking was “deceptive” under Section 10(b). Specifically, the Second Circuit asked the district court to consider whether Dorozhko affirmatively misrepresented himself to gain access to the system, which the Second Circuit said would be “deceptive” under Section 10(b), or whether he merely exploited a weakness in the system, which the Second Circuit said may be more like theft rather than an affirmative misrepresentation.
Both the Cuban and Dorozhko cases highlight the uncertainty and ambiguity surrounding insider trading laws, specifically how courts interpret the deceptive requirement under Section 10(b) and Rule 10b-5. While Cuban stands for the proposition that a breach of a duty not to trade on material, nonpublic information is required to maintain a claim under the misappropriation theory of insider trading, Dorozhko shows that a duty may not be necessary in all cases. Neither of these decisions is likely to be the final word on the issue. As the SEC declined to file an amended complaint in Cuban, it may decide to appeal that decision to the Fifth Circuit, where it would likely challenge, among other things, the court’s interpretation of Rule 10b5-2. As a result of the uncertainty surrounding these cases, the scope of what constitutes a deceptive act ultimately may be an issue for the Supreme Court or Congress to decide.
As the Dorozhko case involves more unusual facts, the Cuban case is more likely to have a practical impact on issuers, particularly if the decision is appealed and affirmed by the Fifth Circuit or followed by other courts. As Cuban highlights, providing information selectively in compliance with Regulation FD, which permits disclosure of material nonpublic information to a person who expressly agrees to keep that information confidential, may not protect an issuer that wants the recipient to refrain from trading on the information. The SEC likely expected Rule 10b5-2 to protect issuers from the recipients trading on the confidential information, but the Cuban court disagreed with this interpretation. Also, companies often use confidentiality agreements when they provide confidential information to others, such as in connection with possible M&A or investment transactions. Following Cuban, a company should be especially cautious when disclosing confidential information and should seek assurance in a written confidentiality agreement that the recipient will not use the information (1) for the purpose of trading in the company’s securities, (2) for any reason other than to evaluate the transaction for which the agreement is entered, or (3) to violate the federal securities laws.
We would not expect the SEC to alter its enforcement procedures in light of the Cuban decision, particularly because the decision is subject to appeal and is not binding on other courts. As a result, investors should be cautioned in relying on the Cuban decision to trade on the basis on material, nonpublic information. It would be inadvisable for a person who only agrees to hold information confidential to assume that he or she may trade in the company’s securities while in possession of the confidential information.