ProfessorBainbridge.com

Faith and Treason

Faith and Treason: The Story of the Gunpowder Plot by Lady Antonia Fraser: Few tales better illustrate the old saw, "truth is stranger than fiction," than the story of the Gunpowder Plot. In 1605, Catholic militants disappointed by James I's failure to move towards toleration (allegedly) tried to blow up Parliament by piling gunpowder in a basement. The (purported) plot was discovered in the nick of time. England still celebrates Guy Fawkes' Day to celebrate the failure of the Gunpowder Plot and, among other things, Beefeaters still search the basements of Westminster (in full regalia, no less). The Gunpowder Plot has long been highly controversial. Catholic apologists have claimed that the whole thing was invented by Robert Cecil, Earl of Salisbury, King James' chief minister, and master of a vast intelligence network, with the assistance of Sir Edward Coke as Crown Prosecutor. Protestant apologists claim the Plot was real, the danger was real, and only narrowly averted (by God's special favor).

Antonia Fraser is a leading popular historian of the Tudor and Stuart periods of English history, as well as an accomplished novelist. She writes well, tells stories lucidly, and has a demonstrated command of the period. In "Faith and Treason," she strikes a balanced note. Yes, there was a plot. But the danger was not very real--Salisbury discovered the plot early, the gunpowder was defective, and Salisbury left it in the basement to be dramatically discovered so that the discovery would have maximum political effect. She makes a compelling case.

Fraser is sympathetic to the Catholic plotters, recognizing that they had been pushed too far, but she also doesn't hesitate to call them traitors and terrorists. Contrary to what some reviewers have said, she is not an apologist for either side. Instead, this is a fair and balanced account, written with the verve and style of a novel. Highly recommended.

Time and Me on the Mark Cuban Insider Trading Case

There is an excellent post on Time.com addressing the legal issues in the SEC's insider trading case against Dallas Mavericks owner Mark Cuban. I spoke to the reporter at some length and was really impressed with her concern for getting it right, which is reflected in the care and craftsmanship in the article. Unlike a lot of reporters who just want me to give them a quote that fits their pre-existing story plans, she really wanted to understand what was going on in this case.

Did Mark Cuban have a duty to Mamma.com? That question will take center court as the Securities and Exchange Commission (SEC) sues Cuban, an Internet entrepreneur and owner of the Dallas Mavericks basketball team, for selling his stake in the Web company after the CEO slipped him nonpublic information about an additional stock offering. Cuban, known for his outsize personality, has come out swinging against the SEC and what he calls its "win at any cost ambitions," promising to keep the case ? and the murkiness of insider trading law ? in the public spotlight in a way not seen since Martha Stewart's sale of her ImClone shares.

Ms. Kiviat then goes on to review the relevant legal rules concisely and clearly. She concludes:

Stephen Bainbridge, a law professor at UCLA who has followed insider trading law for two decades and written a book on the topic, points out that the case law around whether or not a contract of confidentiality suffices for illegal insider trading "is not as clear as one would like." Some court findings, he says, suggest that it's not enough for two parties to merely agree to keep information confidential ? they must also have a higher-level relationship, like that of a lawyer and client or a company and employee.

The SEC has brought charges against Cuban under a particular legal theory ? but the legal theories around illegal insider trading have a long history of getting rewritten in the courts. "He's an interesting guy for them to have picked. He's not going to roll over and play dead," says Bainbridge. "If he wants to, he has the resources to take this case all the way up to the Supreme Court." If it comes to that, the case could take on real significance.

FT and me on the Cuban Case

Financial Times:

Litigation experts have exposed weaknesses in the Securities and Exchange Commission?s insider trading case against billionaire investor Mark Cuban, saying current securities laws are ambiguous about whether he would be considered an insider. Whether or not Mr. Cuban gets off, the case shows that private investments in public equity, or PIPEs, are becoming a larger bone of contention for short-term investors. ...

Some, such as UCLA securities law professor Stephen Bainbridge, think the SEC has a good case.

Writing on his blog last week, Mr. Bainbridge said the SEC might try to prove that Mr. Cuban is a ?constructive insider.?

In some cases, he said, accountants, lawyers or other outsiders may become fiduciaries if given inside information for corporate purposes. Although Mr. Cuban was a non-controlling shareholder, previous lawsuits have shown that a simple confidentiality agreement could have made Mr. Cuban an insider.

Yes, but. I also said that the SEC will need to "get a court willing to give the rules a liberal construction on one key point"; namely, whether Cuban is a constructive insider.

Mark Cuban's Defense

In my blog post analyzing the insider trading charges against Mark Cuban, I noted that a key issue will be whether Cuban agreed, as the complaint alleged, to keep the information about Mamma.com's forthcoming PIPE transaction confidential. On his blog, Cuban today quotes a press release from his legal counsel claiming there was no such agreement:

The SEC knows their case centers on one telephone conversation between two individuals- 4 years ago. The SEC claims there was an agreement between these parties to the conversation to keep certain information confidential. We interviewed Guy Faure, the former CEO of Mamma.com Inc., with whom the SEC claims Mr. Cuban made an agreement. We had a court reporter transcribe the interview. There was no agreement to keep information confidential.

Cuban's blog post then goes on to quote from the transcript of the interview.

If there was no confidentiality agreement, Cuban ought to prevail. 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.

So if Cuban's right on the facts, there should be no liability.

But that raises another question: Should Cuban be conducting his defense in public on his blog?

The SEC told the WSJ that:

Scott Friestad, deputy director of the SEC's enforcement division, said: "We're not going to comment on anything Mr. Cuban or his lawyers have to say on Mr. Cuban's blog and we look forward to presenting our case in court."

Any defense lawyers out there with thoughts on whether Cuban should be conducting a public defense via his blog?

The NYT's Floyd Norris Flubs Cuban Story

You'd think that Floyd Norris would know something about securities regulation, since he is the chief financial correspondent for the NY Times and the International Herald Tribune. If his story/blog port today on the Mark Cuban SEC case is anything to go by, however, the guy's a typical MSM idiot. Let's take a look:

Did Mark Cuban, the Internet entrepreneur turned owner of the Dallas Mavericks basketball team, and would-be buyer of the Chicago Cubs, violate insider trading laws in a particularly egregious fashion?

Or is he the victim of a political hit job because he helped finance a movie that was scathingly critical of President Bush?

If Norris knew anything about the SEC, he'd know that the agency has a very clean reputation when it comes to politics. Indeed, the only government agency or official the SEC would be likely to use enforcement activities to benefit is the SEC itself. Back when John Shad was SEC chairman under President Reagan, he adopted a so-called big bang theory of insider trading enforcement. Shad was busy deregulating the securities industry and he wanted to distract Congress. So he launched a series of high profile insider trading cases that made Congress happy to give the SEC bigger budgets and leave Shad to his deregulatory devices. If you want a conspiracy theory, try assuming that the SEC went after Cuban to distract attention from the SEC's misadventures in connection with the financial crisis.

Personally, I don't buy that theory either, but then I'm not a conspiracy theory nut.

Back to Norris:

A person close to Mr. Cuban provided me with a copy of an e-mail message said to have been sent by Jeffrey Norris, an S.E.C. lawyer in the Fort Worth regional office (and no known relation to me.) This e-mail message seems to have been sent after an exchange in which Mr. Norris complained that Mr. Cuban had financed a movie called ?Loose Change? that discusses the president?s actions relating to Sept. 11.

Even if some nut job in the SEC Fort Worth office sent such an email, this sort of enforcement proceeding would have been handled out of the DC office. So it's a red herring. But Norris is happy to pass it along at the behest of a person "close" to Cuban.

Mr. Cuban made a substantial profit from a quick trade in an Internet company that, oh-so-briefly, was a hot stock in 2004. It is not clear from public records just how much money he made, but even if the S.E.C. succeeds in its efforts to take about $750,000 in profits from him, he will still be one of the few public shareholders to rank as having made a lot of money from the company.

Did Norris even read the complaint? The complaint does not allege that Cuban made a profit, it alleges that he avoided a loss. The whole point is that Cuban was "one of the few public shareholders" who avoided a loss and he did so only because he had access to inside information.

As it is, there appears to be no question about when Mr. Cuban sold the stock. The S.E.C. cites phone company records and company memos about the timing and content of the call. If those memos were accurate, it appears that Mr. Cuban knew he had a duty not to sell until the information about the offering was made public.

But even if all that is true, the Norris e-mail, sent from an S.E.C. e-mail address, indicates the commission has a lawyer with, at best, very poor judgment.

An incompetent government employee. There's a shocker. Real news story. And, however bad SEC lawyer Norris' judgment may have been, Cuban's was worse. According to the complaint, he knew he couldn't sell--indeed, he said as much to mamma.com's CEO--and still sold because he had a non atypical temper tantrum.

There's been a lot of stupidity on all sides in this case. Sad to see reporter Norris contributing to it.

The Insider Trading Charges Against Mark Cuban

The SEC today announced that:

The Securities and Exchange Commission today charged Dallas entrepreneur Mark Cuban with insider trading for selling 600,000 shares of the stock of an Internet search engine company on the basis of material, non-public information concerning an impending stock offering.

The Commission's complaint, filed in the U.S. District Court for the Northern District of Texas, alleges that in June 2004, Mamma.com Inc. invited Cuban to participate in the stock offering after he agreed to keep the information confidential. The complaint further alleges that Cuban knew that the offering would be conducted at a discount to the prevailing market price and that it would be dilutive to existing shareholders.

Within hours of receiving this information, according to the complaint, Cuban called his broker and instructed him to sell Cuban's entire position in the company. When the offering was publicly announced, Mamma.com's stock price opened at $11.89, down $1.215 or 9.3 percent from the prior day's closing price of $13.105. According to the complaint, Cuban avoided losses in excess of $750,000 by selling his stock prior to the public announcement of the offering.

You can read the complaint here.

My review of the complaint suggests that the SEC has a pretty weak case, even assuming they can prove out the facts alleged, in large part because they'll need to find a court willing to give the rules a liberal construction on one key point.

The central legal issue in this case likely will be whether Cuban assumed a fiduciary obligation of confidentiality with respect to Mamma.com.

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.

[Update: Cuban is now claiming there was no agreement of confidentiality.]

(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. For the reasons stated above, however, I think the SEC lacked authority to adopt the rule. But my guess is that a court will defer to the agency on its interpretation of the statute.

Alternatively, the SEC may be able to show that the Mamma.com CEO and Cuban had a pattern or practice of sharing confidences such that the recipient of the information knows or reasonably should know that the speaker expects the recipient to maintain the information's confidentiality. This would also satisfy Rule 10b5-2. In addition, the Chestman case suggested that such a pattern could also give rise to fiduciary relationships, at least among family members.

Finally, WTF was he thinking? According to the SEC, Cuban saved a whopping $750,000. According to Wikipedia: "As of 2007, Cuban is #133 on Forbes' "World's Richest People" list, with a net worth of $2.8 billion."

This wouldn't be the first time greed made an iincredibly wealthy person do something stupid over what amounts, from their perspective to chump change. (Remember Martha Stewart, who saved $45,673 by selling her Imclone shares?)

But I really don't understand the psychology in most of these cases. You're rich. You can afford to take a hit.

In Cuban's case, however, I suspect it was not greed but rather his legendary temper that did him in. The PIPE transaction Mamma.com planned would have involved the issuance of new shares at a below market price. It would have diluted the economic value and voting rights of Cuban and the other pre-PIPE investors. The complaint makes clear that Cuban was furious about the planned sale. His anger led him to a rash act, which now could result in serious civil fines. Whether the Justice Department will pursue criminal charges, as well, remains to be seen.

******

On his blog, Cuban quoted a press announcement:

Mark Cuban today responded to a civil complaint filed by the United States Securities and Exchange Commission in the United States District for the Northern District of Texas, Dallas Division. In its complaint, the Commission charges that Mr. Cuban engaged in violations of the federal securities laws in connection with transactions in the securities of Mamma.com Inc.

This matter, which has been pending before the Commission for nearly two years, has no merit and is a product of gross abuse of prosecutorial discretion. Mr. Cuban intends to contest the allegations and to demonstrate that the Commission?s claims are infected by the misconduct of the staff of its Enforcement Division.

Mr. Cuban stated, ?I am disappointed that the Commission chose to bring this case based upon its Enforcement staff?s win-at-any-cost ambitions. The staff?s process was result-oriented, facts be damned. The government?s claims are false and they will be proven to be so.?