In July 2009, a federal district court threw out an SEC civil insider trading case against Dallas Mavericks CEO Mark Cuban. (Full disclosure: I co-signed an amicus brief in support of Cuban's position.)
In a long-anticipated brief, the Securities and Exchange Commission argued that a district court failed to give proper deference to one of its rules in dismissing insider trading charges against high profile entrepreneur Mark Cuban (SEC v. Cuban, 5th Cir., No. 09-10996, 1/22/10). ...
In its brief, the agency argued that the district court made three errors, each of which would constitute a sufficient basis to reverse. “First, the district court concluded, without citation to authority, that an agreement to keep information confidential does not encompass any agreement not to trade, and therefore trading securities even after agreeing to keep information confidential does not deceive the source of the information,” the SEC said. “The district court failed to give proper deference to Commission Rule 10b5-2(b)(1), which provides that an agreement to maintain information in confidence gives rise to a duty that makes trading on the confidential information without disclosure deceptive.”
Second, the SEC argued that apart from the rule, trading on material, nonpublic information after agreeing to keep it confidential is deceptive under the more general terms of the antifraud provisions.
Wrong on both counts. You want authority? I'll give you authority:
As I explain in my book on insider trading (Securities Law: Insider Trading (Turning Point Series)), there are two theories on which someone may be held liable for insider trading: (1) The "classical" disclose or abstain rule. In Dirks v. SEC, 463 U.S. 646, 654?55 (1983), the Supreme Court explained the key limit on that theory:
We were explicit in Chiarella in saying that there can be no duty to disclose where the person who has traded on inside information "was not [the corporation's] agent, ... was not a fiduciary, [or] was not a person in whom the sellers [of the securities] had placed their trust and confidence." Not to require such a fiduciary relationship, we recognized, would "depar[t] radically from the established doctrine that duty arises from a specific relationship between two parties" and would amount to "recognizing a general duty between all participants in market transactions to forgo actions based on material, nonpublic information."
Based on the facts as alleged, the most likely scenario is that Cuban will be charged with being a so-called "constructive insider." As Dirks explained:
Under certain circumstances, such as where corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may become fiduciaries of the shareholders. The basis for recognizing this fiduciary duty is not simply that such persons acquired nonpublic corporate information, but rather that they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes.... For such a duty to be imposed, however, the corporation must expect the outsider to keep the disclosed nonpublic information confidential, and the relationship at least must imply such a duty.
Mamma.com clearly expected Cuban to keep the information confidential, but did their relationship "imply such a duty"? Cuban, after all, is not "an underwriter, accountant, lawyer, or consultant working for the corporation." Nor was his stock opwnership enough; at 6.3%, he probably would not be deemed a controlling shareholder.
This is a potential real problem for the SEC. Under Dirks, "the individual must have expressly or impliedly entered into a fiduciary relationship with the issuer." SEC v. Ingram, 694 F.Supp. 1437, 1440 (C.D.Cal.1988).
Unfortunately for Cuban, there are some cases that suggest a mere contractual obligation of confidentiality suffices. See, e.g., SEC v. Talbot, 430 F. Supp.2d 1029 (C.D. Cal. 2006) (holding that absent an express agreement to maintain the confidentiality of information, the mere reposing of confidential information in another does not give rise to the necessary fiduciary duty). I believe these cases were wrongly decided.
Chiarella and Dirks clearly require something more than a mere contract. They require a fiduciary relationship. In turn, a fiduciary relationship requires mre than just an arms-length contract:
A fiduciary relationship involves discretionary authority and dependency: One person depends on another?the fiduciary?to serve his interests. In relying on a fiduciary to act for his benefit, the beneficiary of the relation may entrust the fiduciary with custody over property of one sort or another. Because the fiduciary obtains access to this property to serve the ends of the fiduciary relationship, he becomes duty-bound not to appropriate the property for his own use.
The most relevant precedent here would be Walton v. Morgan Stanley & Co.,623 F.2d 796 (2d Cir.1980). Morgan Stanley represented a company considering acquiring Olinkraft Corporation in a friendly merger. During exploratory negotiations Olinkraft gave Morgan confidential information. Morgan's client ultimately decided not to pursue the merger, but Morgan allegedly later passed the acquired information to another client planning a tender offer for Olinkraft. In addition, Morgan's arbitrage department made purchases of Olinkraft stock for its own account. The Second Circuit held that Morgan was not a fiduciary of Olinkraft: "Put bluntly, although, according to the complaint, Olinkraft's management placed its confidence in Morgan Stanley not to disclose the information, Morgan owed no duty to observe that confidence." Although Walton was decided under state law, it has been cited approvingly in a number of federal insider trading opinions. Hence, I believe the cases finding liability based on a mere contractual duty of confidentiality are wrongly decided.
(2) The misappropriation theory of insider trading liability is an alternative basis for liability, under which the defendant need not owe a fiduciary duty to the investor with whom he trades. Likewise, he need not owe a fiduciary duty to the issuer of the securities that were traded. Instead, the misappropriation theory applies when the inside trader violates a fiduciary duty owed to the source of the information. As eventually refined, the misappropriation theory imposed liability on persons who (1) misappropriated material nonpublic information (2) thereby breaching a fiduciary duty or a duty arising out of a similar relationship of trust and confidence and (3) used that information in securities transaction, regardless of whether they owed any duties to the shareholders of the company in whose stock they traded.
The SEC will claim that the Mamma.com CEO was the source of the information and that Cuban owed him a duty of confidentiality arising not out of a traditional fiduciary relationship but rather out of a similar relationship of trust and confidence. The SEC will then rely on Rule 10b5-2, which provides "a nonexclusive list of three situations in which a person has a duty of trust or confidence for purposes of the 'misappropriation' theory...." Crucially, the Rule purports that such a duty exists whenever someone agrees to maintain information in confidence. Rule 10b5-2?s imposition of liability whenever someone agrees to maintain information in confidence is inconsistent with the emphasis in Chiarella and its progeny on the need for a duty of disclosure that arises out of a relationship of trust and confidence. Whether the SEC has authority to create a rule imposing misappropriation liability on the basis of an arms-length contractual duty of confidentiality--as opposed to a fiduciary duty-based duty of confidentiality--has not been tested. In light of the case law discussed above, however, I think the SEC lacked authority to adopt the rule.
At the district court level, Judge Fitzwater correctly observed that:
Building on Chiarella, the Supreme Court concluded in O’Hagan that, like the classical theory, the misappropriation theory also involves deception within the meaning of § 10(b). O’Hagan teaches that the essence of the misappropriation theory is the trader’s undisclosed use of material, nonpublic information that is the property of the source, in breach of a duty owed to the source to keep the information confidential and not to use it for personal benefit.
As noted above, there are some cases that suggest a mere contractual obligation of confidentiality suffices to establish the requisite duty. As also noted above, however, I believe these cases were wrongly decided. Chiarella and Dirks clearly require something more than a mere contract. They require a fiduciary relationship. In turn, a fiduciary relationship requires more than just an arms-length contract.
Judge Fitzwater did not agree with that view, holding that:
Because under O’Hagan the deception that animates the misappropriation theory involves at its core the undisclosed breach of a duty not to use another’s information for personal benefit, there is no apparent reason why that duty cannot arise by agreement.
In contrast, I have rehearsed the readily apparent reasons above. Yet, even though he got that wrong (IMHO), he got the next bit of the analysis right:
The agreement, however, must consist of more than an express or implied promise merely to keep information confidential. It must also impose on the party who receives the information the legal duty to refrain from trading on or otherwise using the information for personal gain. With respect to confidential information, nondisclosure6 and non-use are logically distinct. A person who receives material, nonpublic information may in fact preserve the confidentiality of that information while simultaneously using it for his own gain. Indeed, the nature of insider trading is such that one who trades on material, nonpublic information refrains from disclosing that information to the other party to the securities transaction. To do so would compromise his advantageous position.
The use/confidentiality distinction is something my insider trading scholarship has long emphasized, but which all too often courts have ignored. As I explained in my book on insider trading:
Although [the leading Supreme Court precedent in Dirks v. SEC] clearly requires that the recipient of the information in some way agree to keep it confidential, courts have sometimes overlooked that requirement. In SEC v. Lund, for example, Lund and another businessman discussed a proposed joint venture between their respective companies. In those discussions, Lund received confidential information about the other's firm. Lund thereafter bought stock in the other's company. The court determined that by virtue of their close personal and professional relationship, and because of the business context of the discussion, Lund was a constructive insider of the issuer. In doing so, however, the court focused almost solely on the issuer's expectation of confidentiality. It failed to inquire into whether Lund had agreed to keep the information confidential.
Lund is usefully contrasted with Walton v. Morgan Stanley & Co. Morgan Stanley represented a company considering acquiring Olinkraft Corporation in a friendly merger. During exploratory negotiations Olinkraft gave Morgan confidential information. Morgan's client ultimately decided not to pursue the merger, but Morgan allegedly later passed the acquired information to another client planning a tender offer for Olinkraft. In addition, Morgan's arbitrage department made purchases of Olinkraft stock for its own account. The Second Circuit held that Morgan was not a fiduciary of Olinkraft: "Put bluntly, although, according to the complaint, Olinkraft's management placed its confidence in Morgan Stanley not to disclose the information, Morgan owed no duty to observe that confidence." Although Walton was decided under state law, it has been cited approvingly in a number of federal insider trading opinions and is generally regarded as a more accurate statement of the law than Lund. Indeed, a subsequent case from the same district court as Lund essentially acknowledged that it had been wrongly decided:What the Court seems to be saying in Lund is that anytime a person is given information by an issuer with an expectation of confidentiality or limited use, he becomes an insider of the issuer. But under Dirks, that is not enough; the individual must have expressly or impliedly entered into a fiduciary relationship with the issuer.Even this statement does not go far enough, however, because it does not acknowledge the additional requirement of an affirmative assumption of the duty of confidentiality.
Judge Fitzwater in the Cuban case correctly observed that an agreement could give rise to misappropriation liability only if it includes both a duty of confidentiality and a duty of non-use. Judge Fitzwater then went on to determine that, to the extent SEC Rule 10b5-2 purports to permit the imposition of liability solely where there was a duty of confidentiality, the SEC lacked authority to adopt it:
Because Rule 10b5-2(b)(1) attempts to predicate misappropriation theory liability on a mere confidentiality agreement lacking a non-use component, the SEC cannot rely on it to establish Cuban’s liability under the misappropriation theory. To permit liability based on Rule 10b5-2(b)(1) would exceed the SEC’s § 10(b) authority to proscribe conduct that is deceptive. This is because, as the court has explained, under the misappropriation theory of liability, it is the undisclosed use of confidential information for personal benefit, in breach of a duty not to do so, that constitutes the deception.
On appeal, the circuit court should affirm Judge Fitzwater's conclusion that an agreement could give rise to misappropriation liability only if it includes both a duty of confidentiality and a duty of non-use. They should, however, disavow his conclusion that a mere contractual duty suffices. Only a duty of confidentiality and a duty of non-use arising out of a fiduciary relationship should suffice.