In SEC Enforcement Action: Federal Court Rules that Agreement Supporting Misappropriation Theory Must Have a Non-Use Component

In an SEC enforcement action, a federal 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 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. However, the court gave the SEC 30 days to replead if the Commission can allege that the shareholder undertook a duty, expressly or implicitly, not to trade on or otherwise use inside information about the 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. SEC v. Cuban, USDC, ND Texas.

As part of its opinion, and after examining US Supreme Court precedent, the court concluded that an agreement with the proper components can establish the duty necessary to support liability under the misappropriation theory.

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.

The nature of the duty required to support misappropriation theory liability is at the heart of the present case. Citing the Supreme Court’s O’Hagan ruling, the district judge said that the misappropriation theory holds that a person commits fraud in connection with a securities transaction, and thereby violates Rule 10b-5, when he or she misappropriates confidential
information for securities trading purposes in breach of a duty owed to the source of the information.

The district judge rejected the shareholder’s contention that liability under the misappropriation theory depends on the existence of a preexisting fiduciary or fiduciary-like relationship. The court determined that, under Supreme Court’s precedents, breach of a legal duty arising by agreement can also be the basis for misappropriation theory liability.

For example, the Court’s O’Hagan ruling teaches that the essence of the misappropriation theory is the trader’s undisclosed use of inside 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. O’Hagan states unmistakably that deception through nondisclosure is central to this theory. And by providing that a person can avoid misappropriation theory liability by disclosing his intention to use confidential information, noted the court, it confirms that the deception inheres in the undisclosed use of information, in breach of a duty not to do so.

In simple terms, the misappropriator acts deceptively, not merely because he or she uses the source’s inside information for personal benefit, in breach of a duty not to do so, but because he or she does not disclose to the source the intent to trade on or otherwise use the information.

In the context of the misappropriation theory, therefore, said the court, trading on the basis of inside information cannot be deceptive unless the trader is under a legal duty to refrain from trading on or otherwise using it for personal benefit. 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 under O’Hagan the deception that animates the misappropriation theory involves at its core the undisclosed breach of a duty not to use another’s information for personal benefit, reasoned the court, there is no apparent reason why that duty cannot arise by agreement.

There is no indication in O’Hagan that such a fiduciary or fiduciary-like relationship is necessary to impose the requisite duty, or is otherwise an essential element of the misappropriation theory.

That a duty analogous to a fiduciary’s duty of loyalty and confidentiality can be created by agreement also fully comports with the Supreme Court’s Chiarella’s teaching that the duty must arise out of a relationship between specific parties and not the mere possession of confidential information.

The court therefore concluded that a duty sufficient to support liability under the misappropriation theory can arise by agreement absent a preexisting fiduciary or fiduciary-like relationship. Indeed, the court went further and said that the duty arising by agreement can confer a stronger footing for imposing liability for deceptive conduct than does the existence, without more, of a fiduciary or similar relationship of trust and confidence.

In the context of an agreement, the misappropriator has committed to refrain from trading on inside information. The duty is thus created by conduct that captures the person’s obligation with greater acuity than does a duty that flows more generally from the nature of the parties’ relationship. The misappropriator is held to terms created by his own agreement rather than to a duty triggered merely by operation of law due to his relationship with the source of the inside information

The agreement, however, 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.

Where misappropriation theory liability is predicated on an agreement, a person must undertake, either expressly or implicitly, both obligations. He or she must agree to maintain the confidentiality of the information and not to trade on or otherwise use it. Absent a duty not to use the information for personal benefit, there is no deception in doing so.

Although the court therefore agrees with the shareholder that an agreement must contain more than a promise of confidentiality, the court disagrees with his contention that, for a person to be held liable under the misappropriation theory, he must enter into an agreement that creates a relationship bearing all the hallmarks of a traditional fiduciary relationship.

Thus while the SEC adequately pleads that the shareholder entered into a confidentiality agreement, it did not allege that he agreed, expressly or implicitly, to refrain from trading on or otherwise using for his own benefit the information the CEO was about to share.

Having determined that the SEC’s complaint was insufficient to plead a duty arising by agreement, the court turned to the issue of whether the SEC could rely on Rule 10b5-2(b)(1) to impose the required duty. In 2000 the SEC adopted Rule 10b5-2, which delineates certain circumstances that will give rise to a duty of trust or confidence for purposes of the misappropriation theory. Rule 10b5-2(b)(1) provides that a duty of trust or confidence exists whenever a person agrees to maintain information in confidence.

The court concluded that, by its 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. The agreement specified in the Rule, to maintain information in confidence, relates merely to preserving the confidentiality of the information.

Nothing in Rule 10b5-2(b)(1) requires that the agreement encompass an obligation not to trade on or otherwise use the information. Because Rule 10b5-2(b)(1) attempts to predicate
misappropriation theory liability on a mere confidentiality agreement lacking a non-use component, the SEC cannot rely on it to establish the shareholder’s liability under the misappropriation theory.

To permit liability based on Rule 10b5-2(b)(1) would exceed the SEC’s § 10(b) authority to proscribe conduct that is deceptive. This is because, explained the court, under the misappropriation theory of liability it is the undisclosed use of confidential information for personal benefit, in breach of a duty not to do so, that constitutes the deception.

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