By: Adam Levy
The Case Against Cuban
The SEC Inspector General recently cleared the SEC of alleged wrongdoing in the insider trading investigation of Mark Cuban, owner of the Dallas Mavericks. (If you happen to have an abundance of time, see the inspector general’s 96-page report). It is an important case testing an 11-year old regulation, SEC Rule 10b5-2(b)(1), used to predicate liability under the misappropriation theory of insider trading. As this is not the first time this case is in the news, it is worth recapping what has happened so far in the courts.
In March 2004, Cuban purchased a 6.3% stake in Mamma.com, a Canadian Internet search engine. Mamma.com then raised additional capital through a PIPE (private investment in public equity) offering. In reliance on Cuban’s oral agreement to keep the information confidential, the CEO told Cuban, then the largest shareholder, about the PIPE offering and invited him to participate. Soon after, Cuban sold all his shares before they dropped, avoiding a $750,000 loss.
In the initial complaint, the SEC argued that Cuban was liable under the misappropriation theory of insider trading based on a duty created by his agreement to keep confidential the information Mamma.com provided him. (SEC Rule 10b5-2(b)(1) states that a duty of trust or confidence exists whenever a person agrees to maintain information in confidence.)
Here is some background on the misappropriation theory: Under the misappropriation theory of insider trading, a person commits fraud in violation of §10(b) of the Exchange Act and SEC Rule 10b-5 by misappropriating material nonpublic information for securities trading purposes, in breach of a duty of loyalty and confidence. U.S. v. O’Hagan, 521 U.S. 642 (1997). Under another theory, called the “classical theory” of insider trading, a corporate insider is liable when he or she trades securities of his or her corporation on the basis of material nonpublic information. O’Hagan, 521 U.S. at 651–52.
The district court held that Cuban was not liable for insider trading under the misappropriation theory, even though Cuban promised to keep material, nonpublic information confidential, as he did not expressly promise to avoid trading on the information. See SEC v. Cuban, 634 F. Supp. 2d 713, 730-31 (N.D. Tex. 2009). The court stated that the SEC could not predicate misappropriation theory liability on a confidentiality agreement without a non-use component. “To permit liability based on Rule 10b5-2(b)(1) would exceed the SEC’s §10(b) authority to proscribe conduct that is deceptive.” Id. at 731. Section 10(b) of the Exchange Act provides the congressional authority for the SEC to promulgate regulations.
On appeal, the SEC argued that the defendant’s agreement to keep the information confidential necessarily included an agreement not to trade on that information. Further, such an agreement gave rise to a duty sufficient to impose liability. See SEC v. Cuban, 620 F.3d 551 (5th Cir. 2010). The SEC argued that the defendant’s undisclosed trading on that information after agreeing to keep it confidential was deceptive, bringing the conduct under §10(b). The Fifth Circuit vacated the district court’s judgment, holding that the defendant had agreed to maintain the confidentiality of the information and to refrain from trading on the information. The Fifth Circuit did not address whether the SEC had overstepped its authority under §10(b) by issuing Rule 10b5-2 (b)(1). Id. at 555.
SEC Rule 10b5-2
In 2000, the SEC promulgated Rule 10b5-2, 17 C.F.R. § 240.10b5-2. According to the SEC’s website, 10b5-2 clarifies how the misappropriation theory applies to certain non-business relationships. This rule provides that a person receiving confidential information under circumstances specified in the rule would owe a duty of trust or confidence and thus could be liable under the misappropriation theory. The rule essentially provides “a non-exclusive list” of three situations in which a person has a duty of trust or confidence for purposes of the “misappropriation” theory of the Exchange Act and Rule 10b-5 thereunder. Notably, the relationship between Cuban and the CEO of Mamma.com can easily be a “business relationship.”
Under 10b5-2, a “duty of trust or confidence” exists in the following circumstances, among others:
- Whenever a person agrees to maintain information in confidence;
- Whenever the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality; or
- Whenever a person receives or obtains material nonpublic information from his or her spouse, parent, child, or sibling; provided, however, that the person receiving or obtaining the information may demonstrate that no duty of trust or confidence existed with respect to the information, by establishing that he or she neither knew nor reasonably should have known that the person who was the source of the information expected that the person would keep the information confidential, because of the parties’ history, pattern, or practice of sharing and maintaining confidences, and because there was no agreement or understanding to maintain the confidentiality of the information.
The SEC’s rationale for enacting Rule 10b5-2 to clarify how the misappropriation theory applies in certain non-business relationships is identical to the traditional rationale behind punishing any insider trading—the SEC is concerned with preserving fairness and confidence in the market place.
Another recent case may illustrate the SEC’s point. In U.S. v. Corbin, 729 F. Supp. 2d 607 (S.D.N.Y. 2010) the District Court refused to dismiss a securities fraud indictment against an outsider who traded on nonpublic information supplied by his co-conspirator’s wife after the co-conspirator agreed not to use or share the confidential information. The defendant argued that the SEC lacked the authority to promulgate 10b5-2. The court rejected the defendant’s argument, holding the SEC based Rule 10b5-2 on a permissible construction of §10(b). Id. at 619. Corbin may illustrate the SEC’s point because the source of the information seems irrelevant from the perspective of fairness. In Corbin, the defendants had an unfair trading advantage achieved not by smarts, research, or skill.
U.S. v. Gansman [cite]provides a look at another function of the rule. In Gansman, a lawyer from Ernst & Young disclosed material, nonpublic information to his mistress he met on Ashleymadison.com. Gansman’s mistress provided that information to other men she met on the website to make trades. The court convicted Gansman under the misappropriation theory. The appeals court acknowledged that Gansman could have had a defense if he showed his mistress owed Gansman a duty of trust or confidence under Rule 10b5-2. The court held that the jury instruction at trial sufficiently conveyed the defense. The jury simply did not buy that Gansman was unaware his mistress was using the information.
The omnipresence of insider trading cases in the news lately has prompted philosophical discussion about why we punish such conduct in the first place. Nevertheless, as Cuban demonstrates, the laws and regulations society uses to punish insider trading are still somewhat in transition. Maybe this is because the moral and public policy arguments against insider trading are not as clear as the moral case against, say, theft or murder. Whatever the cause, it will be interesting to continue to follow Cuban and other insider trading cases where not only the facts are in dispute but the laws are as well.