Implications of Recent Dismissal of SEC Insider Trading Charges Against Mark Cuban

27 July 2009 Publication

Legal News Alert: Transactional & Securities

By: Kenneth B. Winer and Marc B. Dorfman

A district court recently dismissed the highly touted securities enforcement action that the SEC filed against Dallas Mavericks owner Mark Cuban. SEC v. Cuban, 2009 U.S. Dist. LEXIS 61574 (N.D. Tex. July 17, 2009). Four lessons can be drawn from this case:

  • An officer of a public company should consider obtaining a promise not to trade on the basis of material, nonpublic information before providing material, nonpublic information
  • An officer of a public company should consider documenting promises obtained before providing material, nonpublic information to a third party
  • An officer of a public company should consider whether it is prudent to provide material, nonpublic information to a major shareholder who is neither an officer nor a director of the company
  • A third party recipient of material, nonpublic information should hesitate before trading on the basis of the information

SEC Allegations and Dismissal of SEC Complaint
On November 17, 2008, the SEC filed a heavily publicized complaint charging that Mr. Cuban had engaged in unlawful insider trading by selling stock in a company, Mamma.com, Inc. The SEC alleged that in June 2004, the CEO of Mamma.com, Inc. spoke to Mr. Cuban by telephone and invited Mr. Cuban to participate in an offering in which Mamma.com stock would be sold at a discount to the prevailing market price, thereby diluting the shares of existing Mamma.com shareholders. The complaint further alleged that before telling Mr. Cuban information regarding this planned offering, the CEO obtained from Mr. Cuban an oral promise to keep this information confidential. According to the complaint, within hours of receiving this information, Mr. Cuban avoided Mamma.com losses in excess of $750,000 by selling his entire stock position prior to the public announcement of the offering.

On July 17, 2009, Chief Judge Sidney A. Fitzwater, the highly respected Chief Judge of the U.S. District Court for the Northern District of Texas, dismissed the SEC’s complaint. Chief Judge Fitzwater held that the SEC had failed to state a claim against Mr. Cuban because the SEC had alleged neither that Mr. Cuban had a fiduciary relationship with Mamma.com (although Mr. Cuban owned a 6.3-percent stake in Mamma.com, he was not an officer, employer, or director of Mamma.com) nor that Mr. Cuban had agreed not to trade based on the information provided by the CEO.

Chief Judge Fitzwater explained that the essence of the misappropriation theory of insider trading on which the SEC had based its complaint “is the traders 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.” Id. at 19. Chief Judge Fitzwater explained that the duty not to use the information for personal benefit can arise by operation of law from a fiduciary relationship. According to Chief Judge Fitzwater, a duty not to trade based on information also can be based on an express or implied agreement between the source of the information and the trader.

Chief Judge Fitzwater stated that to form the basis for a misappropriation charge, an agreement including a promise to keep the information confidential is insufficient if the agreement does not also include a promise to refrain from trading based on the information:

The agreement ... must consist of more than an express or implied promise merely to keep information confidential. It must also impose on the party who receives the information the legal duty to refrain from trading on or otherwise using the information for personal gain. With respect to confidential information, nondisclosure and non-use are logically distinct. A person who receives material, nonpublic information may in fact preserve the confidentiality of that information while simultaneously using it for his own gain. Indeed, the nature of insider trading is such that one who trades on material, nonpublic information refrains from disclosing that information to the other party to the securities transaction. To do so would compromise his advantageous position.

Id. at 26.

Based on the absence of sufficient allegations giving rise to a duty not to trade, Chief Judge Fitzwater dismissed the SEC’s complaint with leave to file an amended complaint addressing this deficiency.

Four Lessons

  1. Consider Obtaining a Promise Not To Trade On the Basis of Material, Nonpublic Information Before Providing Material, Nonpublic Information
    The reasoning of Chief Judge Fitzwater in dismissing the SEC’s complaint against Mr. Cuban suggests that if a public company decides to provide to a third party nonpublic information that is arguably material, it might be prudent for the company to obtain not only a promise that the recipient will keep the information confidential, but also a promise not to trade on the basis of the information. Indeed, a promise to use the information only for certain enumerated purposes — a type of promise often obtained in connection with the provision of material, nonpublic information to third parties — might have satisfied Chief Judge Fitzwater.
  2. Consider Documenting Promises Obtained Before Providing Material, Nonpublic Information
    In addition, Mr. Cuban’s attorney has publicly denied that the CEO of Mamma.com had obtained from Mr. Cuban a promise to keep the information confidential. See blog maverick: the Mark Cuban Web log at http://blogmaverick.com/?s=Mamma.com. This denial illustrates the danger of relying on an undocumented, oral agreement. Company executives should consider documenting any agreements to keep information confidential and not to trade on the basis of the information.
  3. Consider Whether It Is Prudent to Provide Material Nonpublic Information to a Major Shareholder Who Is Neither an Officer Nor a Director of the Company
    The SEC staff apparently adopted the view that the Mamma.com CEO told Mr. Cuban about the proposed stock offering simply to invite Mr. Cuban to participate in the offering. The SEC might, however, have inferred that the Mamma.com CEO had shared the information with Mr. Cuban in an effort to stay on good terms with a major shareholder. Under this alternative interpretation of the facts, the SEC could have considered charging both the CEO and Mr. Cuban with unlawful insider trading, alleging that the CEO breached the his fiduciary duty to the company by tipping Mr. Cuban in order to improve the CEO’s relationship with a major shareholder.
  4. Recipients of Material, Nonpublic Information Should Hesitate Before Trading on the Basis of the Information
    It would be highly imprudent to conclude, based on the dismissal of the SEC’s complaint, that it is safe for a third party to trade based on material, nonpublic information as long as the third party has not agreed not to trade based on the information. First, there is a danger that the third party could be found to have engaged in unlawful insider trading. Chief Judge Fitzwater’s reasoning might be rejected by other courts. The SEC might proceed on the theory that the company executive providing the information was a tipper and the third party who traded based on the information was a tippee. The company executive might inaccurately claim to have obtained an express promise that the third party would not trade based on the information. The third party might be found to have implicitly promised not to trade on the information.

    Second, the cost of responding to an SEC investigation can be substantial. Most people do not have the financial resources of a Mark Cuban. In addition, an SEC enforcement action, even if ultimately dismissed, can have a severe, adverse impact on a person’s reputation and career.

* This alert is based on an article published by Securities Law 360.

 


Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues.

If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individuals:

Kenneth B. Winer
Washington, D.C.
202.672.5528
kwiner@foley.com

Marc B. Dorfman
Washington, D.C.
202.295.4007
mdorfman@foley.com

Members of our Securities Enforcement & Litigation Practice have many years of experience as government attorneys who investigated and prosecuted a broad range of securities activities. Our vast experience includes defending investigations by the SEC and other securities regulators as well as a wide range of matters involving enforcement actions by the SEC Division of Enforcement, grand juries, state securities regulators, and self-regulatory organizations such as FINRA and the NYSE.

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