Brief Fact Summary.
The Securities and Exchange Commission (SEC) (Plaintiff) contended that Cuban (Defendant) undertook a non-use of information duty before selling his 6.3 percent stake in Mamma.com, Inc. on the basis of material, confidential information, and that Defendant was therefore liable of insider trading under the misappropriation theory.Â
Synopsis of Rule of Law.
A shareholder does not undertake a duty of non-use of information sufficient to support a claim of insider trading under the misappropriation theory where the shareholder agrees to keep nonpublic material information confidential, but does not agree he will not trade on that information.
Cuban (Defendant), the largest shareholder of Mamma.com, Inc., with a 6.3 percent interest, was contacted and informed by the CEO of Mamma.com that the company was planning to raise capital through a private investment in public equity (PIPE) offering.Â Prior to revealing this information to Cuban (Defendant), the CEO informed Defendant that the CEO was about to disclose confidential information, and Defendant agreed that he would keep confidential any information the CEO planned to share with him.Â The CEO, in reliance on Defendant’s agreement to keep the information confidential, proceeded to tell Defendant about the PIPE offering.Â At the conclusion of the call Defendant said: â€œWell, now I’m screwed. I can’t sell.â€Â Immediately after receiving more nonpubic information from the investment bank handling the transaction, Defendant sold all of his Mamma.com stock. Â Defendant did not inform Mamma.com of his intention to trade on the information that he had been given.Â The following day, after the markets had closed, Mamma.com public announced the PIPE offering.Â Trading in the company’s stock opened substantially lower the next day and continued to drop in the days that followed.Â Defendant avoided losses surpassing $750,000 by selling his shares prior to the pubic announcement of the PIPE.Â Following the sale, Defendant filed the required disclosure statement with the SEC and â€œpublicly stated that he had sold his Mamma.com shares because the company was conducting a PIPE[.]â€Â Based on these events, the SEC (Plaintiff) brought suit against Defendant under the misappropriation theory of insider trading, claiming violations of Â§ 17(a) of the Securities Act of 1933 (Securities Act), and promulgation of Rule 10b-5.Â Defendant moved to dismiss, asserting that, in order to establish liability for insider trading, the SEC (Plaintiff) had to demonstrate that his conduct was deceptive under Â§ 10(b), which he claimed the SEC (Plaintiff) had not done.Â Specifically, he argued that the Plaintiff had alleged only that he entered into a confidentiality agreement, which is in itself not sufficient to establish misappropriation theory liability because the agreement must arise in the context of a pre-existing fiduciary or fiduciary-like relationship, or create a relationship that bears all the hallmarks of a traditional fiduciary relationship.Â Also, he argued that the existence of a fiduciary or fiduciary-like relationship is governed exclusively by state law, under which the facts pleaded did not demonstrate that he had such a relationship with Mamma.com, and that even under federal common law, the facts pleaded still did not show such a relationship.Â Finally, he argued that the Plaintiff could not rely on Rule 10b5-2(b)(1) to supply the required duty because the Rule applies only in the context of family or personal relationships, and, if the Rule does create liability in the absence of a preexisting fiduciary or fiduciary-like relationship, it surpasses the SEC’s Â§ 10(b) rulemaking authority and could not be applied against him.
Does a shareholder undertake a duty of non-use of information sufficient to support a claim of insider trading under the misappropriation theory where the shareholder agrees to keep nonpublic material information confidential, but does not agree he will not trade on that information?
(Fitzwater, C.J.)Â No.Â A shareholder does not undertake a duty of non-use of information sufficient to support a claim of insider trading under the misappropriation theory where the shareholder agrees to keep nonpublic material information confidential, but does not agree he will not trade on that information.Â The law of insider trading is not based on a federal statute specifically prohibiting the practice, but instead has developed through SEC and judicial interpretations of Â§ 10(b)’s prohibition of â€œdeceptiveâ€ conduct and the antifraud provisions of Rule 10b-5.Â The misappropriation theory of insider trading holds that when a person misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information, the person commits fraud in connection with a securities transaction, and so violates Â§ 10(b) and Rule 10b-5.Â The fraud arises because the undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.Â Therefore, instead of premising liability on a fiduciary relationship of a company insider who, the misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those entrusted him with access to confidential information.Â Under the SEC’s (Plaintiff) Rule 10b5-2, a â€œduty of trust or confidenceâ€ exists whenever a person agrees to maintain information in confidence.Â The SEC (Plaintiff) argues that, under Rule 10b5-2(b)(1) and the facts pleaded in the complaint, it has stated a claim on which relief can be granted.Â According to the SEC (Plaintiff), Cuban (Defendant) is liable under the misappropriation theory based on a duty created by his agreement to keep confidential the information that Mamma.com’s CEO provided him and his breach of that duty when, without informing Mamma.com of his intent to trade in its stock based on the information, he sold his shares in the company.Â Defendant counters that the SEC (Plaintiff) must show that his conduct was deceptive under Â§ 10(b) and that it has not done so.Â Defendant contends that his liability under the misappropriation theory depends on the existence of a preexisting fiduciary or fiduciary-like relationship, which he claims must be determined exclusively under state law.Â While state law can supply the requisite duty, it is not the exclusive source of the duty, and the source of the duty may be located elsewhere without violating the general rule against creating federal common law.Â For example, the Plaintiff can promulgate such a rule, provided the rule conforms to the Plaintiff’s rulemaking authority.Â Additionally, liability under the misappropriation theory does not depend on the existence of a preexisting fiduciary or fiduciary-like relationship.Â This raises the issue of whether beach of a legal duty arising by agreement can be the basis for misappropriation theory liability, and, if so, what the essential elements of the agreement are.Â As noted previously, the misappropriation theory requires deception, where the misappropriator acts deceptively, not only because he uses the source’s material, nonpublic information for personal benefit, in breach of a duty not to do so, but because he does not disclose to the source that he intends to trade on or otherwise use the information.Â Therefore, unless the trader is under a legal duty to abstain from trading on or otherwise using it for personal benefit, it cannot be deceptive to trade on the basis of material, nonpublic information.Â Where the trader and the information source are in a fiduciary relationship, this obligation arises by operation of law upon the creation of the relationship, because based on the fiduciary’s duty of loyalty, the principal has a right to expect that the fiduciary is not trading on or otherwise using the principal’s confidential information.Â There is no reason why such a duty cannot be created contractually, as the duty would arise out of a relationship between specific parties, albeit a contractual relationship, and not the possession of the confidential information only.Â Indeed, the case for misappropriation liability is even stronger where the trader has expressly agreed to refrain from trading on the information.Â The agreement, however, must consist of more than an express or implied promise to keep information confidential.Â The agreement 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.Â That is because regarding confidential information, nondisclosure and non-use are separate concepts.Â A person may use information for his benefit without disclosing the information to others.Â Without a duty not to use the information for personal benefit, there is no deception in doing so.Â In addition, the duty cannot depend on one party’s unilateral expectation that the other party will not use the information where the other party has not specifically agreed to not use it.Â Rather, the duty must rest on the other party’s undertaking of a duty to refrain from doing so.Â Therefore, while Defendant is correct in arguing that an agreement must contain more than a promise of confidentiality, he is incorrect that the agreement must create a fiduciary-like relationship.Â Plus, the enforcement of duties of nondisclosure and non-use that arise by agreement would promote the purpose of the misappropriation theory to protect the integrity of the securities markets and encourage investor confidence.Â The next issue is whether Defendant entered into an agreement, either specific or implied, sufficient to create the duty needed to establish under this theory. One source of law that can provide the answer is state common law.Â Under state common law, Defendant can at best be determined to have agreed to not divulge the confidential information given him by Mamma.com’s CEO.Â In this essential regard, therefore, the Plaintiff’s complaint is not sufficient, as it cannot demonstrate that Defendant agreed to refrain from trading on or otherwise using for his own benefit the information the CEO shared with him.Â Defendant’s statement that he was â€œscrewedâ€ and â€œI can’t sellâ€ seem to express his belief, at least at the time, that it would be illegal for him to trade on the information he had received, but this belief by itself does not make an agreement to refrain from trading on the information.Â It is neither sufficient that the was evidence that the company’s executives or board members unilaterally expected that Defendant would not sell until the PIPE was publicly announced.Â Outside a fiduciary or fiduciary-like relationship, a simple unilateral expectation on the part of the information source cannot create the predicate duty for misappropriation theory liability.Â For these reasons, Plaintiff has failed to plead a duty arising by agreement.Â However, Plaintiff also claims that such a duty may arise from Rule 10b5-2.Â Because the Plaintiff’s rulemaking authority is bounded by the state’s prohibition of conduct that is manipulative or deceptive, Plaintiff cannot by rule establish misappropriation liability on an agreement’s breach of which lacks the necessary manipulation or deception.Â In this case, Defendant’s agreement did not include the necessary component of an obligation not to trade on or otherwise use confidential information for his personal benefit.Â His failure to inform the company that he was doing so, therefore, is not deceptive under Â§ 10(b) and Rule 10b-5.Â By its plain terms, Rule 10b5-2(b)(1) attempts to base misappropriation theory liability on an agreement that lacks an obligation not to trade on or otherwise use confidential information.Â The agreement specified in the Ruleâ€”â€œto maintain information in confidenceâ€â€”relates only to preserving the confidentiality of the information.Â There is nothing in the Rule’s language or purpose that indicates it relates to anything in addition to a confidentiality agreement, as it is concerned with maintaining trust and confidentiality.Â Because Rule 10b5-2(b)(1) attempts to predicate misappropriation theory liability on only a confidentiality agreement lacking a non-use component, the Plaintiff cannot rely on it to establish Defendant’s liability under the misappropriation theory.Â To permit liability based on Rule 10b5-2(b)(1) would exceed the SEC’s Â§ 10(b) authority to prohibit deceptive conduct.Â Therefore, Cuban’s (Defendant) motion to dismiss is granted, but the SEC (Plaintiff) may replead its case.
Memorandum Opinion and Order: Â In the court’s prior ruling, the SEC (Plaintiff) was given 30 days to file an amended complaint that included a well-pleaded claim that Cuban (Defendant) took on a duty, explicitly or indirectly, not to trade on or otherwise use material, nonpublic information about the PIPE offering.Â The Plaintiff has notified the court that it does not intend to file an amended complaint.Â And so, the action against Defendant is dismissed with prejudice.
The Fifth Circuit accepted the SEC’s (Plaintiff) appeal and ruled that the case should not have been dismissed but should have been permitted to proceed.Â Plaintiff argued before the appellate court that a confidentiality agreement creates a duty to disclose or abstain and that, regardless, the confidentiality agreement alleged in the complaint also included an agreement not to trade on the information.Â The court of appeals based its decision exclusively on its interpretation of the complaint, and accordingly, did not reach the issue of whether the Plaintiff overstepped its authority under section 10(b) in issuing Rule 10b5-2(b)(1).Â The court concluded that the allegations, taken as a whole, provided more than a plausible basis to find that the understanding between the CEO and Cuban (Defendant) was that he was not to trade, that it was more than just a confidentiality agreement.Â By contacting the investment bank’s sales representative to obtain the pricing information, Defendant was able to gauge his potential losses or gains from his decision to either participate or abstain from participating in the PIPE offering.Â It was, therefore, plausible that each of the parties understood, if only indirectly, that Mamma.com would only provide the terms and conditions of the offering to Defendant for the purpose of evaluating whether he would participate in the offering, and that Defendant could not use the information for his own personal benefit.Â The court observed that it would require additional fats that had not been put before it to conclude that the parties could not have reasonably reached this shared understanding.Â And so, it vacated and remanded the case to the district court.