SEC Fifth Circuit Brief in Insider Trading Case Maintains that Agreement to Keep Information in Confidence Includes Agreement Not to Trade
In a brief filed with the Fifth Circuit Court of Appeals in a PIPE-related insider trading case, the SEC argued that the federal district court (ND TX) failed to give proper deference to Commission Rule 10b5-2(b)(1), which provides that an agreement to maintain information in confidence gives rise to a duty that makes trading on the confidential information without disclosure deceptive. Because the text of Exchange Act Section 10(b) allows the interpretation of deception embodied in Rule 10b5-2(b)(1), said the SEC, and because that interpretation of Section 10(b) is reasonable, the Rule is entitled to Chevron deference. More broadly, public policy also supports viewing an agreement to keep inside information confidential as including an agreement not to trade, the SEC emphasized, lest we undermine the purposes of the Exchange Act and Rule 10b-5 to insure honest securities markets. SEC v. Cuban, CA-5, No. 09-10996.
In the SEC enforcement action, the district judge ruled that the agreement required to invoke the misappropriation theory of insider trading liability must include both an obligation to maintain the confidentiality of the inside information and not to trade on or otherwise use the information. Thus, the court held that the SEC did not state a duty arising by agreement since the Commission failed to allege that the defendant, the company’s largest shareholder, undertook a duty to refrain from trading on information about an impending PIPE offering.
The court also ruled that, because SEC Rule 10b5-2(b)(1) attempts to predicate misappropriation theory liability on a mere confidentiality agreement lacking a non-use component, the SEC could not rely on it to establish the shareholder’s liability under the theory.
In this action, the SEC alleged that, after the shareholder agreed to maintain the confidentiality of inside information concerning the offering, he sold his stock in the company without first disclosing to the company that he intended to trade on this information, thereby avoiding substantial losses when the stock price declined after the PIPE was publicly announced. As the PIPE offering progressed toward closing, the company decided to inform the shareholder of the offering and to invite him to participate.
The CEO prefaced the call by informing the shareholder that he had confidential information to convey to him, and the shareholder agreed that he would keep whatever information the CEO intended to share with him confidential. The CEO, in reliance on this agreement, told the shareholder about the PIPE offering. The shareholder reacted angrily to this news, stating that he did not like PIPE offerings because they dilute the existing shareholders.
Several hours after they spoke by telephone, the CEO sent the shareholder a follow-up email in which he provided contact information for the investment bank conducting the offering. The shareholder then contacted the sales representative, who supplied him with additional confidential details about the PIPE. One minute after ending this call, the shareholder telephoned his broker and directed the broker to sell all 600,000 of his shares, thereby avoiding losses in excess of $750,000 by selling prior to the public announcement of the PIPE.
In its brief, the Commission maintained that in adopting Rule 10b5-2(b)(1) it reasonably viewed an agreement to keep information in confidence as giving rise to a duty of trust or confidence, such that undisclosed trading on the information provided in reliance on that agreement involves deception within the meaning of Section 10(b). The district court disagreed, asserting, without citation to any authority, that in the context of information, agreeing not to disclose information and agreeing not to use information are logically distinct.
The court held that an undertaking to maintain information in confidence meant only non-disclosure, and therefore trading without disclosure would not be deceptive. The SEC pointed out that any difference between an agreement not to disclose and an agreement not to trade does not, however, respond to the Commission’s determination, reached after public notice and comment and on the basis of its expertise in regulating the securities markets, that an agreement to maintain information “in confidence” gives rise to a duty of “trust or confidence.”
The Commission said that its determination hews closely to the literal meaning of “confidence, ” which by definition is information entrusted by one person to another in confidence. Thus, the SEC reasoned that fiduciaries using information for personal trading purposes are misappropriating the principal’s property in breach of their duties of loyalty and confidentiality to the principal.
Similarly, a company that entrusts its inside information to another is giving them the use of a corporate asset with value in the securities markets. The promise to maintain the information in confidence is in essence to preserve the economic value of the information, which becomes worth less, or worthless, upon publication. The company entrusts the information to the third party, not to give away trading profits, but to further corporate purposes, said the Commission.
The provider trusts the recipients of the information not to destroy the value of the information by making it public and not to convert the information to their own use by trading upon it. One cannot reconcile an undertaking to keep information confidential and preserve its value, reasoned the SEC, and trading by the recipient that appropriates the value of the information to the trade.
In this case, the company entrusted confidential business information to its shareholder to solicit his interest in participating in its securities offering. That information was corporate property, said the SEC, a business or economic asset to which the company had a right of exclusive use. The company did not disclose the information to give the shareholder a trading advantage over other market participants. Rather, argued the SEC, it disclosed the information for the limited business purpose of inviting the shareholder to participate in the offering only after securing his commitment to maintain the information in confidence. Having secured his agreement to maintain the confidentiality of the information he received for the purpose of considering participating in the offering, company officials were duped by the shareholder’s undisclosed trading.
According to the SEC, numerous insider trading cases support the view that an agreement to maintain information in confidence necessarily includes an agreement not to trade. Because an undertaking of a duty of confidentiality by agreement is typically easily determined, the published cases primarily grapple with the more difficult issue of when, in the absence of an agreement, a sufficient duty can be implied from the relationship between the information provider and recipient.
While this more involved analysis is not necessary where, as here, a duty is undertaken by agreement, the analytical framework employed in these cases shows that a confidentiality agreement establishes a sufficient duty. In addition, various common law doctrines also support the view that agreeing to maintain information in confidence includes agreeing not to trade
More broadly, the SEC noted that public policy supports viewing an agreement to keep inside information confidential as including an agreement not to trade. The district court’s approach would undermine the purposes of the Exchange Act and Rule 10b-5 to insure honest securities markets and thereby promote investor confidence. The shareholder’s informational advantage over other investors was not based on research or skill. Rather, he secretly used corporate property to avoid losses virtually risk-free through securities transactions. His informational advantage stemmed no less from contrivance and deception simply because he undertook a duty of confidence by agreement with the firm rather than one implied from a relationship between the two parties.
Finally, the SEC said that the district court’s approach would cause anomalies with respect to other federal securities law requirements. For example, it would result in the prohibitions on tipping and trading becoming disjointed. Under this approach, one in this shareholder’s situation could not tip another person who then trades because the tip would breach a confidentiality agreement, but would be free to trade himself.
In addition, the district court’s approach would conflict with SEC Regulation FD, which incorporates the principle that a person who agrees to keep information confidential cannot lawfully use that information for trading. Regulation FD was adopted simultaneously with Rule 10b5-2 as part of a broad rulemaking initiative.
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