On July 17, the U.S. District Court for the Northern District of Texas (the Court) dismissed insider trading charges brought against Mark Cuban by the U.S. Securities and Exchange Commission (SEC).1 The SEC alleged that Mr. Cuban was liable under the "misappropriation theory" of liability for securities trading in breach of a duty created by his oral agreement to keep confidential certain information provided by the CEO of Mamma.com Inc. (the Company), a publicly-traded company in which Mr. Cuban was a shareholder. In a case of first impression, the Court rejected the SEC's long-held view, embedded in Rule 10b5-2 and Regulation FD2, that such a duty exists whenever a person agrees to maintain information in confidence. Instead, the Court ruled that a breach of a legal duty arising by agreement can only be the basis for misappropriation theory liability if it is predicated on a person's agreement, either expressed or implied, to maintain the confidentiality of the information and to refrain from trading on or otherwise using the information for personal benefit.
According to the SEC complaint, on June 28, 2004 the CEO of the Company contacted Mr. Cuban, the Company's largest stockholder, to inform him of an impending private investment in public equity (PIPE) offering, and to ask Mr. Cuban if he would like to participate. The CEO prefaced the phone call by informing Mr. Cuban that he had confidential information to convey, and Mr. Cuban agreed that he would keep the information confidential.
Mr. Cuban was displeased with the planned offering, expressing concerns that it would dilute existing shareholders. Without informing the Company that he intended to trade on the information that he had agreed to keep confidential, Mr. Cuban sold his entire 6.3% stake in the Company on June 29, 2004. After the markets closed on June 29, 2004 the Company publicly announced the PIPE offering and, as a result of that news, the share price declined over the next several days. By selling his shares prior to the public announcement of the offering, Mr. Cuban was able to avoid losses in excess of US$750,000.
The Court's Decision
Under the "misappropriation theory" of insider trading liability, a person commits fraud "in connection with" a securities transaction, and therefore violates Section 10(b) of the Exchange Act and Exchange Act Rule 10b-5, when that person misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information.3
In dismissing the insider trading charges against Mr. Cuban, the Court held that such a duty (under the misappropriation theory) can arise by agreement where a pre-existing fiduciary or fiduciary-like relationship is absent. The agreement, however, must consist of more than an express or implied promise merely to keep the information confidential. It must also impose on the party who receives the information a legal duty to refrain from trading on (or otherwise using) the information for personal gain. In the opinion of the Court, without both requisite elements, misappropriation theory liability cannot attach. The Court also held that it was beyond the SEC's rulemaking authority to impose liability where both such elements were absent. Specifically, the Court held that the SEC could not rely on Rule 10b5-2(b)(1) to establish misappropriation theory liability because the express terms of the Rule refer only to an undertaking to maintain confidentiality, and do not require an undertaking not to trade on or otherwise use the information for personal benefit. Rule 10b5-2(b)(1) states that the applicable duty arises "[w]henever a person agrees to maintain information in confidence."
In sum, because the SEC failed to allege that Mr. Cuban undertook a duty, either expressly or implicitly, to refrain from trading on the information, the Court held that he could not be liable under the misappropriation theory of insider trading.
In considering the implications of this decision, it should be noted that the decision is not binding outside the Northern District of Texas, and that the decision may ultimately be subject to review by the U.S. Court of Appeals. Nevertheless, the following practice points are worthy of consideration:
- Publicly-traded companies engaged in confidential discussions with third parties should obtain agreements, preferably in writing, that address both of the requisite elements of the misappropriation theory of insider trading liability articulated by the Court: an agreement (i) not to disclose the confidential information and (ii) to refrain from trading in the company's securities.
- Existing agreements governing the provision of confidential information may need to be revised to include an express undertaking not to trade on or otherwise use such information for personal benefit.
- Customary practices among participants in PIPE offerings and other private placements of securities by publicly-traded companies governing the provision of confidential information may need to be revised. In the past, issuers have often relied on statements in offering materials that such information is being provided for the "sole purpose" of evaluating a possible investment in the securities offered for sale. Under the Court's ruling, however, a mere unilateral expectation on the part of the information source cannot create the predicate duty for misappropriation theory liability outside a fiduciary or fiduciary-like relationship.
To address this concern, absent a formal written agreement with the information recipient, issuers may wish to modify their offering materials to state in bold type that the recipient and its representatives shall be deemed to have represented that they will maintain the confidentiality of the information and will refrain from trading in the company's securities on the basis of any information contained in the offering materials.
Until it becomes clear that the views expressed by the Court have been accepted by the U.S. appellate courts and the SEC, we recommend that recipients of material, nonpublic information continue to refrain from trading on the basis of such information where one has agreed to keep the information confidential or otherwise has a duty to do so.
1. The court's decision can be found at https://ecf.txnd.uscourts.gov/cgi-bin/show_public_doc?2008cv2050-33.
2. See SEC Regulation FD Compliance and Disclosure Interpretations, Question 10 which states:
Q: If an issuer gets an agreement to maintain material
nonpublic information in confidence, must it also get the
additional statement that the recipient agrees not to trade on the
information in order to rely on the exclusion in Rule 100(b)(2)(ii)
of Regulation FD?
A: No. An express agreement to maintain the information in confidence is sufficient. If a recipient of material nonpublic information subject to such a confidentiality agreement trades or advises other to trade, he or she could face insider trading liability.
3. See United States v. O'Hagan, 521 U.S. 642 (1997). This theory of insider trading is distinct from the "traditional" or "classical" theory of insider trading liability which is premised on a relationship of trust and confidence between shareholders of a corporation and those insiders – directors, officers and controlling shareholders – who obtain confidential information by reason of their position with the corporation. The classical theory of insider trading liability was adopted by the U.S. Supreme Court in Chiarella v. United States, 445 U.S. 222 (1980).
Kevin Cramer is a partner in the Business Law Department of the firm's New York office where he practices U.S. M&A and securities law. James Lurie is a partner in the Business Law Department of the firm's New York office. Marc Kushner is a partner in the Corporate Practice Group of the firm's New York office.
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