THE CUBAN DECISION: LESSONS FOR SEC ENFORCEMENT AND ISSUERS
Mark Cuban won dismissal of his highly publicized insider trading case. While the court offered the SEC the opportunity to replead its complaint, it may not be able to in view of the ruling. The ruling is significant in terms of its impact on an already battered SEC enforcement program and, at the same time, should be carefully considered by issuers when evaluating their procedures regarding material non-public information. SEC v. Cuban, Civil Action No. 3:09-CV-2050 (N.D. Tex. Decision Filed July 17, 2009).
The facts to Cuban are straightforward. Mamma.com Inc. was planning a private investment in public equity or PIPE offering. At the time, Mr. Cuban was a large shareholder in the company with a 6.3% stake. As the PIPE offering progressed toward closing, the company contacted Mr. Cuban and asked if he would like to participate. According to the SEC, before extending the invitation however, the CEO of Mamma.com told Mr. Cuban that he would have to keep the information confidential. Mr. Cuban agreed. As the company expected, Mr. Cuban reacted angrily to the news, stating that he did not like PIPE offerings because they dilute the holdings of existing shareholder. At the conclusion of the conversation Mr. Cuban stated “Well, no I’m screwed. I can’t sell.” Two internal e-mails at the company note that Mr. Cuban recognized he could not sell his shares until after the announcement of the offering.
Subsequently, the company provided Mr. Cuban with contact information for the investment bank conducting the offering. Mr. Cuban contacted the sales representative and obtained additional details about the offering. At the conclusion of that telephone call on June 28, 2004, Mr. Cuban contacted his broker and directed him to sell the 600,000 shares of Mamma.com he owned. A small portion of the shares were sold that day and the remainder the next. At the conclusion of trading on June 29, 2004, the company announced the PIPE. Mr. Cuban did not inform the company that he was selling his shares just prior to the announcement.
The court granted Mr. Cuban’s motion to dismiss the SEC’s insider trading complaint which alleged violations of Sections 10(b) and 17(a) based on the misappropriation theory under U.S. v. O’Hagan, 521 U.S. 642, 651-52 (1997). Under that decision, a person commits securities fraud in violation of Section 10(b) and Rule 10b-5 when he misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information. The key to that decision, and the central point of Mr. Cuban’s motion which was supported by five law professors who filed amicus briefs, is the question of deception, an element required by the plain text of Section 10(b).
Under O’Hagan, the 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.
The duty stems from the relationship between the parties. It may be derived from a fiduciary relationship. That type of relationship is not required, however. The duty can also be supplied by an express agreement between the parties. As the court held: “[i]ndeed, the duty that arises by agreement can be seen as conferring a stronger footing for imposing liability for deceptive conduct than does the existence, without more, of a fiduciary or similar relationship of trust and confidence. In the context of an agreement, the misappropriator has committed to refrain from trading on material, nonpublic information. The duty is thus created by conduct that captures the person’s obligation with greater acuity than does a duty that flows fore generally from the nature of the parties’ relationship.”
Here the SEC’s complaint fails to allege an adequate agreement between the parties. 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. It is the duty from this express agreement in situations like this one which becomes the predicate for the breach and the deception which flows from that breach. The fact that Mr. Cuban commented that he was “screwed,” while possibly indicating his belief at the time, does not reflect such an agreement.
The court also rejected the SEC’s reliance on Rule 10b5-2. That rule provides a non-exclusive definition of circumstances in which a person has a duty of trust and confidence for purposes of the misappropriation theory. In part, it provides that such a relationship exists “[w]henever a person agrees to maintain information in confidence.” Since this Rule is based on Section 10(b), it cannot be broader than the section, according to the court. By its plain terms the Rule provides only for a relationship of trust and confidence without mentioning an obligation not to trade or use the information for a personal benefit. Thus, the court concluded that “[b]ecause Rule 10b5-2(b)(1) attempts to predicate misappropriation theory liability on a mere confidentiality agreement lacking a non-use component, the SEC cannot rely on it to establish Cuban’s liability under the misappropriation theory.” Likewise, since the complaint fails to plead facts which support such an obligation between Mr. Cuban and the company, the complaint is dismissed without prejudice. The SEC is permitted to replead its complaint.
Cuban is another high profile loss for the SEC’s Enforcement Division at a time when the program clearly needs to move forward in a positive and aggressive manner. Just last week, SEC Chairman Mary Schapiro was on Capital Hill reassuring law makers that the program is being revitalized and moving forward in a positive fashion as discussed here. While the Administration’s regulatory reform proposals have not called for the merger of the SEC with other agencies, others are repeatedly pressing for such action by Congress.
Losing high profile cases will not help the agency’s cause. This is particularly true here. The court’s opinion concludes that the reason for the loss is a lack of factual support — the complaint does not allege the kind of facts necessary to support the claim. This may be viewed as flimsy factual analysis by Enforcement investigators who should be expert at such an undertaking. To the extent this is the cause for the loss rather than an unexpected ruling on the nature of the confidentiality agreement required, it reflects the over bloated supervisory ranks of the Division where supervisors rely on summaries of evidence rather than a first hand knowledge of key facts as discussed here. Perhaps more importantly, the loss may reflect the need for a more robust Wells process where there is a true give and take about the facts and the legal theory of the case before any enforcement decision is made.
Cuban also raises a note of caution for all issuers. The decision makes it clear that issuers should take care to ensure that they have secured an agreement which will adequately protect confidential information prior to providing it to others. This is particularly true in view of cases such as the “Merrill Lynch squawk” box case where the action was premised on inadequate procedures regarding inside information. In the Matter of Merrill Lynch, Pierce, Fenner, & Smith Inc., Admin. Proc. File No. 3-13407 (Mar. 11, 2009), available at: http://www.sec.gov/litigation/admin/2009/34-59555.pdf. See also Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The Retirement Systems of Alabama, Exchange Act Release No. 57446 (March 6, 2008), available at http://www.sec.gov/litigation/investreport/34-57446.htm (insider trading investigation settled with adoption of procedures and a Section 21(a) report).