A Lesson for Company Insiders in the Use of Confidentiality Agreements
Last month, a federal district court in Texas categorically dismissed a heavily publicized complaint filed by the SEC charging Mark Cuban, a successful entrepreneur and the owner of the Dallas Mavericks, with insider trading. The SEC’s November 2008 claim was based on a misappropriation theory of insider trading, i.e., it alleged that Cuban, a non-insider, violated the federal securities laws by misappropriating confidential information for securities trading purposes in breach of a duty owed to the source of the information. The dismissal in Texas was a highly visible loss for the SEC. In an ironic twist however, at the same time that the court dismissed all claims against Cuban, it also extended the reach of the federal securities laws in the insider trading context. Specifically, contrary to what has historically been the prevailing view, it held that proof of an underlying fiduciary or other such relationship of trust and confidence is not a required element of the misappropriation theory of insider trading. Rather, the court ruled that the duty element can be met by a confidentiality agreement, and then gave specific directives on the terms that the confidentiality requests/agreements had to include to prevent noninsiders from misusing confidential information for their benefit.
The conduct giving rise to the SEC’s lawsuit was Cuban’s sale of his large position in the public company Mamma.com after receiving confidential information from Mamma.com’s CEO that the company planned a PIPE (private investment in public entity) offering. PIPE offerings generally depress a company’s stock price by diluting ownership. The key facts alleged in the complaint were: 1) Mamma.com’s CEO called Cuban, an existing shareholder, to advise him of the upcoming PIPE offering and invite him to participate in it; 2) the CEO told Cuban the offering would be announced the next day, asked Cuban to keep that information confidential, and Cuban agreed to do so; 3) Cuban was upset by the news because he realized it would dilute his ownership and thereby reduce the value of his position; and 4) shortly after the conversation, Cuban called his broker and asked him to sell his entire position in Mamma.com – 519,000 shares. By selling in advance of the publication of the PIPE offering, the SEC alleged Cuban avoided losses of approximately $750,000.
Cuban offered three arguments in his defense. First, he argued that even if the CEO had asked him to keep the information confidential, he had never agreed to do so, and no fiduciary or similar relationship of trust and loyalty existed between him and Mamma.com which would otherwise trigger an obligation of confidentiality. Second, he contended that Rule 10b5-2, which was adopted by the SEC in 2000 and identified certain non-business relationships that could give rise to a fiduciary or fiduciary-like relationship, did not apply to his conduct and thus could not supply the requisite duty of confidentiality because it only applied to family or personal relationships. Finally, he argued that the promulgation of Rule 10b5-2 exceeded the SEC’s rule-making authority.
While the court dismissed the complaint, a clear victory for Cuban, in the process it expanded the reach of the federal laws, at least in the Fifth Circuit and other jurisdictions that follow its precedent. Specifically, the court expressly rejected Cuban’s argument that insider-trading liability based on a misappropriation theory always requires an underlying relationship of trust and confidence. While the court acknowledged that prior Supreme Court cases had clearly held that a fiduciary is bound by a duty of loyalty not to trade or disclose on the basis of nonpublic inside information, the Supreme Court had not ruled that only a fiduciary-like relationship could give rise to such a duty. Instead, the court found that absent a fiduciary or similar relationship of trust and confidence, “an agreement with the proper components can establish the duty necessary to support liability under the misappropriation theory.” Any such agreement, however, had to consist of more than a mere promise to keep the information confidential, which was what Mamma.com’s CEO asked of Cuban. Instead, to be effective, the agreement must also include a prohibition of trading on the information or otherwise using the information for personal benefit. The SEC has not yet indicated whether it will appeal the decision.
Public companies and their employees should not only be aware of the expansion of liability but also how the decision can impact what they communicate to third parties. Under Cuban, it is no longer adequate when disclosing non-public information to third parties to merely tell the recipient that the information is confidential, and ask that its confidentiality be maintained. Instead, to prevent a third party from using the information in a fashion harmful to the company and its shareholders, the third party must also be instructed not to trade on the information or otherwise use it for his/her personal benefit. Adding these conditions in writing where possible, rather than merely orally, is the safest course. Companies should also review their existing written confidentiality/ non-disclosure agreements and make the necessary modifications so they specifically require recipients of such information not only to keep the information confidential, but also not to trade on the basis of information or otherwise use the information for their benefit.