High Stakes For the SEC: The Cuban Insider Trading Case Heads to Trial
Dallas Maverick’s owner Mark Cuban lost his bid to end the SEC insider trading case against him when the court rejected his summary judgment motion earlier this month. Now the nearly five year old case is heading for trial. It will present the court and jurors with critical questions regarding deception, duty and confidentiality for insider trading cases. SEC v. Cuban, Civil Action No. 3-08-CV-2050 (N.D. TX Filed Nov. 17, 2008). At the same time the hotly contested, high profile action presents critical issues for SEC Enforcement in wake of the Division’s recent court room loses in Reserve Management Co., the first fund to “break the buck”and Stoker, the companion case to the Citigroup market crisis action pending before the Second Circuit.
The Commission’s complaint centers on a PIPE offering made by Mamma.com Inc., a NASDAQ traded company based in Montreal, Quebec. When the company was planning the offering in 2004 Mr. Cuban was its largest known shareholder. The company contacted him and offered the opportunity to participate in the planned offering. Mr. Cuban was advised by the company at that time, according to the SEC, that the information he was about to be furnished was confidential. Mr. Cuban agreed to maintain its confidentiality, according to the complaint. When the company informed him of the planned PIPE offering Mr. Cuban became very upset. The offering would dilute his holdings.
In subsequent conversations with the company Mr. Cuban learned more details about the planned offering. Mr. Cuban expressed his opposition to the offering in each instance while acknowledging an obligation to keep the information confidential. In one conversation, according to the SEC, Mr. Cuban noted that he could not sell his shares until after the public announcement.
Following his last conversation with a company official about the proposed offering, Mr. Cuban called his broker and directed that his 600,000 share stake in the company be sold. Over a two-day period his shares were sold. The sales were completed the day before the announcement of the PIPE.
Following the public announcement of the offering, the share price of the company fell about 9.3%. That price continued to fall over the next week. According to the complaint, Mr. Cuban avoided losses in excess of $750,000 by selling before the announcement. The complaint alleges violations of Section 10(b) and 17(a).
The district court
The court granted Mr. Cuban’s motion to dismiss the complaint. Critical to the motion, which was supported by five amicus briefs from law professors, was the question of deception under the Supreme Court’s decision in U.S. v. O’Hagan, 521 U.S. 642, 651-52 (1997). There the Court held that a person commits securities fraud in violation of Section 10(b) and Rule 10b-5 when he or she misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information.
Mr. Cuban argued, and the district court concluded, that the critical deception/agreement element was absent. Under O’Hagan, the district court held “the essence of the misappropriation theory is the trader’s undisclosed use of material, nonpublic information that is the property of the source, in breach of a duty owed to the source to keep the information confidential and not to use it for personal benefit . . . Under the misappropriation theory of insider trading, the deception flows from the undisclosed, duplicitous nature of the breach.” The duty between the parties must be to keep the information confidential and, in addition, not to use it for trading purposes the court held. That duty stems from the relationship between the parties.
Here the SEC’s complaint failed to allege an adequate agreement between the parties the Court found. While the complaint states that Mr. Cuban agreed to keep the information confidential, this is not sufficient. Rather, the parties must agree that the information will be kept confidential and that it will not be used for trading purposes. The allegations of the complaint are not adequate to meet this standard. Nor are they bolstered by Rule 10b-5-2 the Court concluded since that Rule is cannot be broader than its predicate, Section 10(b).
The circuit court
Eschewing an opportunity to amend its complaint, the SEC appealed to the Fifth Circuit and prevailed. SEC v. Cuban, No. 09-10996 (5th Cir. Sept. 21, 2010). The Circuit Court essentially disagreed with the district court’s reading of the complaint. Stressing that all reasonable inferences must at the pleading stage be drawn in favor of the SEC, the Court concluded that the “allegations [in the complaint], 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 . . .” It is plausible the Court found that “each of the parties understood, if only implicitly” that Mr. Cuban could not trade.
The inferences drawn by the court in favor of the SEC are predicated on what the opinion describes as a “factually sparse record.” If there were more facts, the outcome might be different. For example, the Court noted that “it would require additional facts that have not been put before us for us to conclude that the parties could not plausibly have reached” an agreement that Mr. Cuban could not trade. The parties also dispute Mamma.com’s motive in providing Mr. Cuban information, the Court stated. The effect of resolving this dispute is unclear. Finally, the Court declined to consider the SEC’s argument based on Rule 10b-5-2(b)(1) which provides for a duty of trust and confidence.
The Court rejected Mr. Cuban’s motion for summary judgment finding, in essence, that the SEC had produced sufficient evidence at this stage of the proceeding to proceed to trial. In seeking a ruling which would halt the proceeding Mr. Cuban raised a series of issues, including:
Lack of an agreement: The motion papers argued that the Commission cannot meet its burden to demonstrate that there was a valid offer, acceptance and meeting of the mind between the parties. This was the critical issue raised at the motion to dismiss stage. Here however the Court rejected the claim, relying on the fact that an agreement can be implied from the surrounding facts and circumstances: “What the SEC must establish at trial is that Cuban agreed, at least implicitly, to maintain the confidentiality of Mamma.com’s material, nonpublic information and not to trade on or otherwise use it. And the existence of such an agreement can be implied from the parties’ conduct and the surrounding circumstances.”
Confidentiality: Mr. Cuban also claimed that there was insufficient evidence from which a reasonable jury could find that he agreed to keep the PIPE confidential. In rejecting this argument the Court declined to detail every fact supporting its conclusion. Rather, the Court found it sufficient to give examples of the type of evidence available which might support a verdict in favor of the Commission. Pointing to Mr. Cuban’s statement “I can’t sell” made at the time the CEO of Mamma.com spoke with him on the phone about the PIPE and told him he was disclosing confidential information, the Court concluded that “the jury could at least reasonably infer that Cuban would not have considered himself foreclosed from trading unless he believed he had agreed to treat the information as confidential.” Similarly, this phrase, viewed in the light most favorable to the SEC as it must on a summary judgment motion, supports the proposition that Mr. Cuban agreed “at least implicitly” to refrain from trading.
Disclosure: The Court also rejected Mr. Cuban’s contention that he was permitted to trade because he had disclosed his intention. Under O’Hagan the duty not to disclose is owed to the information source. If Mr. Cuban fully disclosed his intention to trade to the company, then there is no liability for insider trading based on O’Hagan. Again viewing the evidence in the context of summary judgment standards the Court rejected this claim, holding that “a reasonable jury could find from the evidence in the summary judgment record that Cuban merely disclosed that he ‘was going to sell,’ not that he specified that he would sell before Mamma.com announced the PIPE.” (emphasis original). In reaching this conclusion the Court rejected the SEC’s contention that the disclosure must be made in such a fashion as to give the source of the information sufficient time to take action to prevent the trading.
Materiality: Finally, the Court rejected Mr. Cuban’s claim that the information he received about the PIPE was not material. Although Mr. Cuban offered expert testimony and an event study demonstrating that the deal announcement had no discernable impact on the market, there is other evidence which points to the contrary conclusion including an expert report from the SEC as well as factors regarding the offering itself from which the jury could reasonably determine that the information was material.
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The stage is set for what may be the concluding chapter in this long running saga. The case is proceeding to trial. The stakes could not be higher, particularly for the SEC. The Commission is coming off two high profile trial losses. In addition, the agency lost the first round in this case and got a second chance only because the Fifth Circuit read the complaint differently and more favorably to it than did the district court. While Commission prevailed on summary judgment no doubt it is carefully considering the statement that “the court emphasizes the closeness of this call” made in ruling on the critical deception/agreement issue. Now that close call will be turned over to a jury for consideration.