Dealbook reports:
The Securities and Exchange Commission is not backing down from its insider trading case against Mark Cuban, the entrepreneur turned professional basketball team owner.
On Wednesday, the S.E.C. filed court papers saying it would appeal a federal judge’s dismissal of the Cuban case, which came in July. The S.E.C. had alleged Mr. Cuban sold his entire 6 percent stake in the Internet search company Mamma.com after being told by senior executives about a secret plan to raise money in a private stock offering.
Stock offerings typically result in a drop in a company’s stock price. By selling his stake before the offering was announced to the public, the S.E.C. alleged that Mr. Cuban avoided about $750,000 in losses.
Mr. Cuban and his lawyers successfully argued that he had never promised not to sell his shares after hearing about the planned stock offering. The judge also said the S.E.C. had no case because it never alleged that Mr. Cuban, who owns the Dallas Mavericks, had made such a promise.
We have covered the Cuban case extensively here at PB.com and your faithful reporter was a signatory on an amicus brief supporting Cuban's position. I was not completely happy with the trial court's decision, however, as I explained:
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.
Wrong, wrong, wrong.
As I explain in my book on insider trading (Securities Law: Insider Trading (Turning Point Series)
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."
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.
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 "apparent reason" why a mere contractual duty cannot suffice thus is simple: The Supreme Court says so. And has done so on three separate occasions. You have to have a fiduciary duty.
Hopefully, the appellate court will recognize this point and hand the SEC an even more crushing defeat.
