Federal District Court in Dallas Dismisses SEC Complaint Attempting to Broaden Insider Trading Liability Under Misappropriation Theory
On July 17, 2009, a federal district court in Texas dismissed an insider trading suit brought by the Securities and Exchange Commission (SEC) against Mark Cuban, the high-profile owner of the NBA's Dallas Mavericks. The court held that insider trading liability under federal law could not be premised solely on an agreement to keep information confidential in the absence of a commitment not to trade on the information. The decision is of interest to defense counsel and to corporate counsel drafting agreements and policies designed to protect companies from the misuse of material nonpublic information.
The SEC's complaint alleged that Cuban was an investor in internet search company Mamma.com when, in 2004, the company decided to proceed with a private investment in public equity (PIPE) offering and invited him to participate. The company's CEO prefaced the invitation by informing Cuban that he had confidential information to share, and Cuban agreed to maintain the confidentiality of the information. In response to the invitation, Cuban became upset, informed the CEO that the upcoming PIPE offering would dilute his shares, and concluded by telling the CEO "[w]ell, now I'm screwed. I can't sell." A short time later, and before the public announcement of the PIPE offering, Cuban sold his entire stake in the company. The SEC alleged that Cuban avoided losses in excess of $750,000 by selling when he did.
The Court's Decision
The central question considered by the court was whether the SEC adequately alleged that Cuban assumed a duty not to trade on the confidential information disclosed to him by the CEO. The SEC's complaint clearly alleged that Cuban agreed not to disclose the information but did not allege that he agreed not to trade on the information.
The law of insider trading is not based on a federal statute expressly prohibiting the practice and has instead developed through SEC and judicial interpretations of Securities Exchange Act Section 10(b)'s prohibition of "deceptive" conduct and the antifraud provisions of SEC Rule 10b-5. The courts have generally recognized two theories of insider trading liability. Under the "traditional" or "classic" theory of liability, a corporate insider who trades in his corporation's securities on the basis of material nonpublic information breaches the duty to publicly disclose confidential information before trading. This duty arises from the fiduciary relationship of trust and confidence that exists between the corporation's shareholders and its insiders. Under the "misappropriation" theory, a noninsider commits fraud when he misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information. The source of the information is defrauded when the noninsider purchases or sells securities based on that information in breach of a duty to the insider. The noninsider's deception of the party who entrusted him with the confidential information forms the actionable "deception" under the securities laws and the basis for liability under the misappropriation theory.
The SEC took an expansive view of the misappropriation theory and argued that Cuban should be held liable for insider trading based on his breach of an oral agreement to maintain the confidentiality of nonpublic information that he subsequently used as the basis for securities trading. The court rejected this argument, holding that, although an agreement between two parties may give rise to insider trading liability under the misappropriation theory, such an agreement must (a) include an express or implied promise to maintain the confidentiality of the information and (b) impose upon the party receiving the information a legal duty to refrain from trading on or otherwise using the information for personal gain. Because the SEC alleged only that Cuban had agreed to maintain the confidentiality of the information in question – and not that he had agreed not to use the information to trade – the court concluded that his breach of the agreement was insufficient to establish insider trading liability.
The court also considered the language of SEC Rule 10b5-2(b)(1), which provides that a duty of trust or confidence for purposes of the misappropriation theory of insider trading exists whenever a person agrees to maintain information in confidence. The court concluded that, because Rule 10b5-2(b)(1) purports to premise liability under the misappropriation theory on an agreement that lacks any affirmative obligation not to trade on or otherwise use the confidential information for personal benefit, the SEC could not rely on it to establish Cuban's liability under the misappropriation theory.
What the Decision Means
This trial court decision may well be reviewed by a court of appeals and may not be the last word on the subject. Regardless of how the decision fares on appeal or in other courts, it reflects the challenges of applying the misappropriation theory of insider trading. In addition, while the decision represents a setback for the SEC, it underscores the SEC's aggressive commitment to pursuing insider trading and suggests that individuals should use extreme caution when trading while in possession of material nonpublic information.
For companies, this decision is consistent with current best practices for nondisclosure agreements, which should contain separate provisions that the recipient of information will maintain the confidentiality of the information and will not use the information for trading purposes or other personal benefit.
Read full complaint.
Read full opinion.