Mark Cuban Wins a Big Round Against SEC Insider Trading Rap

Last year, I flagged the SEC insider trading case against Mark Cuban:

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 SEC today announced that:

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.

In doing so, I opined that:

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 court has now ruled. The opinion is available here.

US District Court Chief Judge Sidney Fitzwater was unwilling to give the SEC the liberal construction it needed:

The dispositive question presented by defendant Mark Cuban’s (“Cuban’s”) motion to dismiss is whether plaintiff Securities and Exchange Commission (“SEC”) has adequately alleged that Cuban undertook a duty of non-use of information required to establish liability under the misappropriation theory of insider trading. Concluding that it has not, the court grants Cuban’s motion to dismiss, but it also allows the SEC to replead.

Let me set up the background. Cuban was charged with insider trading pursuant to Section 10(b) and Rule 10b-5. Specifically, he was charged with misappropriating information from mamma.com. The misappropriation theory of insider trading liability is a recognzed 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--had not been tested until this case. I have long thought the SEC lacked authority to adopt the rule. (See my book Securities Law: Insider Trading (Turning Point Series).

Alternatively, the SEC might have tried 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.

Turning to the Cuban case, 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.

I argued in that old blog post that:

Unfortunately for Cuban, there are some cases that suggest a mere contractual obligation of confidentiality suffices [to establish the requisite duty]. 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 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.

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.

Outstanding. 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.

In contrast, 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.

Because the SEC only pled that Cuban's agreement was one of confidentiality, the complaint had to be dismissed. He allowed them leave to replead, alleging the requisite agreement, but there are no public facts to support a claim that Cuban agreed both to keep the information confidential and to refrain from using it for personal gain.

FYI: I was one of five amici curiae who filed a brief in support of Cuban:

In a brief filed Monday, law professors from Harvard University, Yale University, the University of Chicago, the University of California at Los Angeles and Southern Methodist University argue that the U.S. Securities and Exchange Commission made a legalistic land grab when it sued Cuban for insider trading involving a Canadian company, Mamma.com.

The professors argue that the SEC's case rests on a regulation that is "an invalid exercise of the agency's rule-making authority" and exceeds the scope of case law established by the U.S. Supreme Court. ... 
The law professors who signed Monday's brief are SMU's Alan Bromberg, Harvard's Allen Ferrell, Yale's Jonathan Macey, Chicago's Todd Henderson and UCLA's Stephen Bainbridge. ... 
"In the context of a business relationship, a confidentiality agreement alone is insufficient to create a fiduciary or similar relationship of trust and confidence between the parties," the five professors wrote in their brief, echoing earlier filings by Cuban's team.

The WSJ's Law Blog calls us "five big-wig law professors." Heh.