As regular readers know, I've been following this case with interest, including having contributed to amicus brief in support of Cuban's position. As I recently reminded readers, in the original post back in 2008, I wrote:
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." AlthoughWalton 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, theChestman 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."
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?
I still think Cuban's right on the law, but the federal courts have proven to be essentially ineducable on this point.
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