One of the most vexing questions in any insider trading case is whether trading on confidential information has truly violated any recognized duty under the federal securities laws. Under either of the theories, the classical theory or the misappropriation theory, commonly used to support a violation in these cases, courts have long recognized the need to show breach of duty, but they have not always agreed on the nature and scope of that duty – what one commentator went so far as to suggest was a “failure to meaningfully define the scope and content of the fiduciary duty” required to establish insider trading.1 As Justice Frankfurter observed long ago in SEC v. Chenery Corp.2, “to say that a man is a fiduciary only begins the analysis; it gives direction to further inquiry. To whom is he a fiduciary? What obligations does he owe as a fiduciary? In what respect has he failed to discharge these obligations? And what are the consequences of his deviation from duty?” In late September, two federal courts addressed this very issue with quite different results that may nonetheless give some guidance on the issue.
SEC v. Cuban
Mark Cuban is making headlines for more than just his appearance on the HBO hit show “Entourage.” He is also involved in litigation with the SEC. Although his case was pronounced dead in July 2009, it was recently revived by the U.S. Court of Appeals for the Fifth Circuit.
In SEC v. Cuban3, the Commission accused entrepreneur and Dallas Mavericks owner Cuban (backed by an eight-lawyer-deep rotation at the district court level, it may be noted) of insider trading when he dumped substantial holdings of a company just prior to the company’s PIPE offering. According to the SEC’s complaint, as of March 2004, Cuban, a large minority stakeholder in Mamma.com, a Canadian search engine company, was invited to participate in an effort to raise capital through a private investment in public equity (PIPE). Mamma’s CEO contacted Cuban directly, informed Cuban that he was about to share with him confidential information and told Cuban about the PIPE offering. Cuban immediately became upset because he believed that PIPEs dilute the interests of existing shareholders. Presented with that harsh financial dilemma, Cuban is alleged to have responded at the end of the conversation, “Well, now I’m screwed. I can’t sell,” after which he contacted Mamma’s investment bank to obtain additional confidential details about the PIPE and the discounts available to current investors. Within a minute of the call to the investment bank, however, Cuban sold 10,000 shares of his Mamma stock. He sold the remaining 590,000 shares the next day. In doing so, Cuban avoided more than $750,000 in losses as a result of these stock sales.
When the SEC came knocking with an action for disgorgement, Cuban moved to dismiss on the ground that while he had agreed to keep the knowledge of the PIPE confidential, he had never agreed to refrain from trading his stock. Thus, he argued, the confidentiality agreement by itself did not prevent him from doing so and, as a result, he had not breached any actionable duty to Mamma. In the words of Section 10(b), he had not done anything “deceptive.”
The U.S. District Court for the Northern District of Texas agreed and granted Cuban’s motion, finding that the confidentiality agreement alone was not enough to prevent him from trading his Mamma stock. Now, the Fifth Circuit has reversed under the misappropriation theory of insider trading.
Unlike the classical theory of insider trading, which generally applies to corporate insiders (which Cuban was not) and the information they obtain as a result of their position at the corporation, the misappropriation theory “holds that a person violates section 10(b) ‘when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.’”4 Thus, the question in Cuban was, in the words of U.S. vs O’Hagan5 whether Cuban had “feigned fidelity to the source of the information.” The Fifth Circuit concluded that at least at this stage of the proceedings, the complaint plausibly stated that he had.
According to the Fifth Circuit, “the allegations, taken in their entirety, provide more than a plausible basis to find that the understanding between the CEO and Cuban was that he was not to trade, that it was more than a simple confidentiality agreement.” Although Cuban’s statement “Well, now I’m screwed, I can’t sell” alone may not have been enough to find an understanding not to trade, the statement in combination with his subsequent conversation with Mamma’s investment bank, in which he asked for additional confidential details of the PIPE plausibly suggested otherwise. According to the court, “It is at least plausible that each of the parties understood, if only implicitly, that Mamma.com would only provide the terms and conditions of the offering to Cuban for the purpose of evaluating whether he would participate in the offering, and that Cuban could not use the information for his own personal benefit.”
Notably, the Fifth Circuit once again declined to further define what constitutes a relationship of “trust and confidence.” Nor would the court say whether such a duty existed under the instant facts. But because the appellate court had a different reading of the complaint from that of the district court, it vacated the district court’s judgment and remanded the matter for discovery, summary judgment motions and trial, “if reached.”
SEC v. Obus
In another case decided in late September, the U.S. District Court for the Southern District of New York was more willing to define what constitutes a relationship of trust and confidence, this time on a fully developed record, and it found against the SEC.
In SEC v. Obus6, the Commission alleged an insider trading case against a tipper, who was an employee of a potential funder of a proposed acquisition; his tippee, who was an employee of an investment firm; and the tippee’s superior, whose investment firm purchased the target company’s shares in advance of the public announcement of the transaction. As was the case in Cuban, before making the challenged purchase, the purchaser spoke directly to a principal of the target company about the anticipated transaction, which conversation the SEC claimed created a duty not to trade. According to the complaint, the trade, performed while in possession of material nonpublic information, violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.
The SEC asserted claims under both the classical and misappropriation theories of insider trading. In response to the classical theory of insider trading, the individual defendants maintained that the tipper was not a corporate insider and therefore did not owe a duty to the target company. And in response to the misappropriation theory, they argued that although the tipper owed a duty to his employer (the potential funder), the tippee did not breach any duty owed to the target because the conversation between the two did not include an agreement not to trade. Finally, all three individuals maintained that the SEC had not established the required element of scienter.
As it turned out, the potential funder’s own internal investigation gave substantial support to each of the defendants’ arguments. Following that internal investigation (which began around the same time as the SEC’s investigation), the tipper received a letter of reprimand based on his employer’s internal policy, which urged employees to consult with company counsel to determine whether communications are being undertaken in an appropriate manner. The reprimand went on to state that at the time the tipper was working on the potential matter, he was aware that the tippee’s investment firm was a significant shareholder of the target company, but that while he asked the tippee for his views on the company, the tipper did not discuss the nature of the specific transaction being contemplated, other than to tell the tippee that the tipper’s company was considering doing business with the target.
The district court would later agree with each of these assessments and grant summary judgment in favor of defendants.
In concluding that the tipper owed no duty to the acquired company under the classical theory, the court agreed he was not a temporary insider simply because he was in possession of material nonpublic information. Under the law of the state of New York, no general fiduciary relationship exists between financial institutions and their borrowers or other parties to an arm’s-length commercial contract. That was especially true here, where the discussions never included a confidentiality undertaking and the acquirer ultimately declined the financing. The court held that a fiduciary relationship exists only when a defendant enters into a “special relationship” and explicitly accepts the duty of confidentiality, or where such acceptance is implied from a similar relationship of trust and confidence. In the absence of any such “special relationship” here, and in light of the additional fact that the potential funder had not expressly entered into a confidentiality agreement with the target, the court concluded that the SEC’s attempt to assert the classical theory of insider trading must fail.
Turning to the misappropriation theory, the court first noted that liability, if any, must stem from a “fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information.” Here, the trader owed no fiduciary duty to the target, and nothing in the discussion between him and the principal of the target suggested to the court that a reasonable jury could conclude otherwise. And as for the tipper’s breach of duty, if any, the letter of reprimand concluded that though the tipper had made a “mistake,” he had not acted with malice or intent. As a result, according to the court, the SEC failed to present sufficient evidence from which a reasonable jury could conclude that any of the three defendants acted with the requisite degree of deception. Therefore, the court granted summary judgment in favor of the individual defendants and dismissed the claims brought against them.
Are the Cuban and Obus decisions inconsistent in their treatment of the duty of confidentiality? Perhaps not. The Cuban decision was based on the SEC’s complaint alone, where statement of a plausible claim was the standard. The Obus decision, on the other hand, was based on a fully developed record and decided on summary judgment, after all available facts relating to duty and confidentiality had been placed before the court. Had there been a written confidentiality agreement between the target company and the potential funder, or had the potential funder expressly agreed to become a fiduciary of the target company, the outcome of Obus would surely have been different under the classical theory. And as for the misappropriation theory, which requires proof of a breach by the tippee, while the Cuban complaint may have survived the pleading stage, the result may not be the same if and when the case reaches summary judgment or trial. If the facts as developed in Cuban do not suggest more than a plausible agreement by the tippee to guard Mamma’s confidences, the SEC should not expect to fare better in Cuban than it did in Obus.
1 Bainbridge, Stephen M. “Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition,” 52 Wash & Lee L. Rev. 1189, 1198.
2 SEC v. Chenery Corp., 318 U.S. 80, 85-86 (U.S. 1943).
3 SEC v. Cuban, No. 09-10996, 2010 WL 3633059 (5th Cir. Sept. 21, 2010).
4 Cuban, 2010 WL 3633059, at *2 (emphasis added).
5 U.S. v. O’Hagan, 521 U.S. 642, 652 (1997).
6 SEC v. Obus, No. 06-cv-3150 (S.D.N.Y., filed Apr. 25, 2006).
Stradley Ronon At Work
Stradley Ronon partners David C. Franceski Jr. and Lawrence Stadulis will speak at the 2010 National Society of Compliance Professionals (NSCP) national meeting on Nov. 2 in Baltimore. Franceski will moderate a workshop, “Political Contributions, Procurement, Placement Agents & Lobbying: State & Federal Rulemaking Updates: Pay to Play Rules.” Stadulis will present, “Advertising: Beyond the Definitions,” in which he will provide a hands-on review of Financial Industry Regulatory Authority marketing materials and discuss creative conflict resolutions and negotiations. The NSCP’s annual meeting serves as an educational forum to update its members on the most recent developments in regulatory compliance.
Stradley Ronon partner Gregory DiMeglio will serve as a panelist on, "Inside Insider Trading: A Look at Galleon and Other Recent Cases," at the American Bar Association’s Fifth Annual National Institute on Securities Fraud in New Orleans on Oct. 7, 2010. The panel will discuss the use of wiretaps and surveillance in the recent Galleon indictment, as well as effective defenses against insider trading allegations.
Stradley Ronon attorney Heather Fritts served as moderator for the Pennsylvania Bar Association (PBA) panel discussion, “Straight Talk About the Risks Facing Directors & Officers,” at the Pennsylvania Bar Institute CLE Conference Center. The panel discussed risks facing directors and officers of public companies, including securities-fraud class-action lawsuits and Securities and Exchange Commission investigations.
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