The 'Cuban' Case: Lessons for Insider Trading Law
Mark Cuban, the high-profile owner of the Dallas Mavericks, was the subject of a Securities and Exchange Commission insider trading case for almost five years. After many twists and turns, including an initial dismissal that was reversed by the U.S. Court of Appeals for the Fifth Circuit, the case finally went to trial in federal court in Dallas recently. On Oct. 16, a jury returned a defense verdict. The result in the case appears to have turned largely on the jury's view of the facts and witnesses. But the case also included much wrangling over a variety of unsettled legal issues that make for interesting contrasts with other similar cases, including a number in the Southern District of New York.
Mamma and the PIPE
The Cuban insider trading case arose from Cuban's role as a major shareholder of a company then called Mamma.com. In 2004, Mamma.com decided it wanted to do a PIPE (private investment in public equity) transaction, which would involve seeking investors to buy stock in the company in private transactions, at a discount to the market price. The announcement of such a transaction often causes the market price of the company's stock to drop.
As alleged by the SEC, Mamma.com's CEO had a telephone call with Cuban to invite him to participate in the PIPE. The SEC alleged that the CEO prefaced the conversation by informing Cuban that he had confidential information to convey, and Cuban agreed to keep the information confidential. The CEO then told Cuban about the PIPE.
Cuban allegedly became angry because he did not like PIPE transactions, and at the end of the call allegedly said, "Well, now I'm screwed. I can't sell." Cuban allegedly then learned additional information about the PIPE from Mamma.com's investment banker. One minute later, the SEC alleged, Cuban told his broker to sell his entire stake in Mamma.com. After the PIPE was announced, Mamma.com's stock price declined. The SEC alleged that Cuban avoided losses in excess of $750,000 by selling when he did.
The Cuban case is one of a series of cases in which prosecutors and the SEC have attempted to crack down on trading by people who get information about an upcoming PIPE transaction. A number of these cases have been brought in the Southern District of New York.
Duty and the Rule
Perhaps the most significant legal issue involved in the Cuban case was one that was not contested at trial, because it had been resolved at an earlier stage of the case. That issue is: What is required to create a duty to abstain from trading or to disclose the inside information the party has obtained. Wrapped up in that question is the validity of SEC Rule 10b5-2(b)(1). That rule, which was promulgated in 2000, purports to create a duty not to trade on inside information based solely on an agreement to keep the information confidential. (In pertinent part, the rule provides that "a duty of trust or confidence" exists "[w]henever a person agrees to maintain information in confidence"). The SEC promulgated the rule to flesh out an ambiguous part of the law under the so-called "misappropriation theory" of insider trading.
In contrast to the "classical theory" of insider trading, in which a corporate insider trades on (or tips) inside information, the misappropriation theory applies when a non-insider misappropriates information from someone to whom the misappropriator owes a duty. The Supreme Court first accepted this theory in 1997 in United States v. O'Hagan,1 a case in which a lawyer misappropriated information from his law firm, to which he owed a fiduciary duty.
Since O'Hagan, the question of exactly what kind of duty is necessary to make out a violation under the misappropriation theory has bedeviled courts. Is a simple agreement to treat the information confidential enough? Rule 10b5-2(b)(1) says yes, but Cuban argued that the rule goes beyond the SEC's authority as granted by Section 10(b) of the Securities Exchange Act because that statute requires deception. In O'Hagan, the Supreme Court found deception inherent in a fiduciary's failure to abide by his duty not to profit from inside information. When there is no fiduciary relationship, where is the deception?
The district court agreed with Cuban that Rule 10b5-2(b)(1) is invalid and dismissed the complaint against him. But it did not go so far as to hold that only a fiduciary duty can support an insider trading charge. According to the Cuban court, violation of an agreement—even if only implicit—is enough to establish a violation, but only if the agreement goes beyond confidentiality and includes an agreement not to trade.2
The Fifth Circuit subsequently reinstated the SEC's complaint, but not on the basis of Rule 10b5-2(b)(1).3 Rather, the circuit court held that the SEC's complaint sufficiently alleged that Cuban had agreed not to trade as well as to keep the information about the PIPE confidential. It declined to reach the district court's invalidation of Rule 10b5-2(b)(1). Therefore, the invalidation of the rule remained the law of the case, and the SEC was required to prove that Cuban "expressly or implicitly agreed with Mamma.com to keep the material, nonpublic information confidential and not to trade on or otherwise use the information for his own benefit." Ultimately, the jury found there was no such agreement in the Cuban case.4
Would the result have been different in the Southern District of New York? The U.S. Court of Appeals for the Second Circuit has not addressed the validity of Rule 10b5-2(b)(1), but at least one judge in the Southern District has upheld the rule. In United States v. Corbin,5 Judge Victor Marrero rejected a challenge like the one made by Cuban, in part by referring to the pre-rule Second Circuit case United States v. Chestman. In that case, the Second Circuit suggested, at least in dictum, that "explicit acceptance" of an "express agreement of confidentiality" would suffice.6
Based on these decisions, one might conclude that Cuban's argument likely would not have been accepted if the case had been brought in the Southern District. In Corbin and Chestman (both of which involved personal relationships, not business relationships like that between Cuban and Mamma.com), however, the courts did not expressly consider the possible difference between an agreement of confidentiality and an agreement not to trade.7