Don’t Mess With Texas, (Mark) Cubans, or the SEC When It Comes to Insider Trading

As you may have heard, Texan billionaire Mark Cuban was acquitted a couple weeks ago in an insider-trading trial that accused him of selling his stake in a Canadian search-engine company after learning from its CEO that it was planning a stock sale that would dilute his stake. Cuban’s conversation with the CEO took place in 2004, just months after he had purchased his stake, and their conversation was by phone, so there was no recording of it. By selling his shares before the transaction was announced, Cuban avoided $750,000 in losses.

The Securities & Exchange Commission sued Cuban, alleging that his phone conversation included an agreement to keep the information confidential, which meant he was not allowed to trade on it. The SEC sued him for violations of §17(a) of the Securities Act of 1933, §10(b) of the Securities Exchange Act of 1934, and the SEC’s Rule 10b-5. These are some of the government’s most important tools for prosecuting insider trading and other forms of securities fraud. On October 16, after five years of litigation and an eight-day trial, the jury returned a defense verdict on all claims.

But there is some confusion about what insider trading means, or meant, in the Cuban case. The government wasn’t alleging so-called “classical” insider trading, which happens when a corporate insider—say, the CEO himself—trades on juicy information that the public doesn’t know about. There, liability is based on the notion that insiders bear a fiduciary duty to the company’s shareholders, including prospective shareholders looking to buy stock. As a result, the insiders must either not trade on the material, nonpublic information or disclose the information before they do.

In Cuban’s case, the government’s lawsuit was based on a “misappropriation” theory of insider trading, which reaches company outsiders (like shareholders) who come into possession of inside information under circumstances in which they owe a duty of confidentiality to its source. That’s why a company’s lawyers, for example, can’t trade on material, nonpublic information they gain by virtue of their representation. But who else owes such a duty? Well, in 2000, the SEC promulgated Rule 10b5-2, which identifies three, non-exclusive situations that create a duty of trust or confidence that, if breached, can support a misappropriation theory of insider trading:

1. A person agrees to maintain the information in confidence;
2. The person communicating the information has a history, pattern, or practice of sharing confidences with the recipient, such that the recipient knows or reasonably should know that there is an expectation of confidentiality; or
3. The recipient obtains the information from a spouse, parent, child, or sibling, unless the recipient can prove that he or she neither knew nor reasonably should have known that there was an expectation of confidentiality because there was no agreement, understanding, history, pattern, or practice to that effect. (How’s that for a mouthful.)

Cuban’s case involved the first scenario. His defense was that there was no confidentiality agreement between him and the CEO, and absent that, he had no obligation to avoid trading on the information. He also presented evidence that the information was not confidential anyway because it had already been made public through an SEC filing that the company had made before their phone conversation.

Ultimately, the jury found that the government failed even to prove that Cuban received material, nonpublic information in the first place. It probably didn’t help that the government’s star witness—the company’s CEO at the time—testified by videotape rather than in court at trial. It turns out that the SEC couldn’t subpoena him because he lives in Canada, and apparently, he wasn’t willing or able to make the trip down south. His videotaped testimony, moreover, was from a deposition he gave in 2011, seven years after his conversation with Cuban.

The Cuban verdict, however, probably won’t affect the SEC’s priorities going forward. The agency has brought more insider-trading cases in the last three years than in any three-year period in its history, and for the most part, it’s been successful at trial, winning approximately 85% of the time.