The recent decision of the Court of Appeals for the Second Circuit in SEC v. Dorozhko
further illustrates the uncertain state of the limits of insider trading. Reversing an earlier District Court decision, the Court held that while a breach of a fiduciary duty is required where the fraud is premised on silence, no such breach is required where there has been an affirmative misrepresentation. A memo by Davis Polk & Wardwell LLP, available here
, discusses the decision.)
Editor’s Note: This post is by Annette Nazareth’s colleagues William M. Kelly, Joseph A. Hall, Michael Kaplan, William J. Fenrich, and Janice Brunner.
On Friday, a federal district court in the Northern District of Texas dismissed the SEC’s insider trading case against Dallas Mavericks owner Mark Cuban. While the celebrity of the defendant has undoubtedly contributed to the widespread publicity of the dismissal, the real news is that the SEC has, for the moment at least, lost a case on what might seem to have been slam-dunk facts:
• Company shares material nonpublic information with its largest shareholder, who agrees to keep the information confidential.
• The shareholder, upon learning the information, says “Well, now I’m screwed. I can’t sell”.
• Shareholder nonetheless turns around and dumps all of his shares, sparing himself a $750,000 loss when the material nonpublic information is later disclosed.
What’s missing here? Mr. Cuban, abetted by a group of law professor amici, argued that Rule 10b-5 liability requires a fiduciary or fiduciary-like relationship with the provider of the information, and that a mere agreement cannot provide a basis for liability. The court rejected this view, but it also rejected the SEC’s long-held view, reflected in its adoption of Regulation FD and Rule 10b5-2, that third parties who accept material nonpublic information from a company on a confidential basis are precluded from trading on the information. The court held that Mr. Cuban’s oral agreement to maintain confidentiality, without an agreement not to trade, was not enough.
What does this decision mean for potential providers and recipients of material nonpublic information?
For providers—for example, companies interested in sharing information with potential investors or acquirers—the case says that if you want the recipient not to trade, you had better be specific. The safest approach, of course, is to seek a written contractual standstill from recipients. But agreements of this sort are often difficult to get parties to agree to, especially where, as in this case, the recipient would be asked to sign the agreement “blind”, without knowing the nature of the information. As a practical matter, providers may have to content themselves with a “sole use” provision, along the lines of “recipient agrees to use the information solely for the purpose of considering an investment”. Had such a provision been in place, the result in this case might well have been different.
For recipients of material nonpublic information, our advice is not to rely on this decision. The case was decided at the trial court level, is not binding on other courts, and the SEC has been given the right to file an amended complaint. Whether or not the SEC chooses to replead the case or to appeal the decision, we are certain that it will not accept the case as the final word and will continue to seek enforcement action on facts like these. Thus, while the decision will provide comfort to parties who have to defend themselves for what they have done, we would not use it as a basis for deciding what you should do. The prudent judgment continues to be that if you have agreed to keep information confidential, you should not use it as a basis for trading.
Lastly, the case highlights the curious fact that, 75 years after the enactment of the Securities Exchange Act and the creation of the SEC, and after decades of judicial exegesis of the Delphic text of Section 10(b), we still don’t quite know when insider trading is illegal.
See S.E.C. v. Cuban, No. 3:08-CV-2050-D (N.D. Tex. July 17, 2009)