Confidentiality Agreement on Inside Information Also Includes Duty Not to Trade Says SEC Brief

A shareholder who agreed to keep confidential the inside information given to him by the company also accepted the duty not to trade on the information and his trading without advance disclosure to the company constituted deception, argued the SEC in a reply brief filed with the Fifth Circuit. No company providing inside information in reliance upon an agreement to keep the information confidential would believe that it was authorizing the recipient to trade on the information, said the SEC, nor could any recipient of such information reasonably believe that he was authorized to trade. These common-sense notions are incorporated into SEC Rule 10b5-2(b)(1), which sets forth a duty to disclose before trading on a person who agrees to maintain the information in confidence. SEC v. Cuban, CA-5, No. 09-10996.

The case is on appeal from a district court ruling in an SEC enforcement action 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.

Refuting the shareholder’s argument that a sufficient duty of disclosure only arises from a full-fledged, traditional fiduciary relationship, the SEC pointed out that the Supreme Court in United States v. O’Hagan, 521 U.S. 642 (1997), recognized that a fiduciary or similar obligation is sufficient. Although O’Hagan involved a traditional fiduciary relationship (attorney-client), conceded the SEC, that does not mean such a relationship is required. In the SEC’s view, all that is needed for potential liability under the misappropriation theory is a duty to the provider not to use the information for personal benefit, such that a duty of disclosure arises and makes undisclosed trading deceptive.

The Commission also noted the Supreme Court’s declaration in Carpenter v. United States, 484 U.S. 19 (1987) that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that information for their own personal benefit.

The SEC similarly refuted the argument that the legal basis for determining what facts and circumstances give rise to the requisite duty of disclosure must come exclusively from state law. Rather, Rule10b5-2(b)(1) validly sets forth a sufficient duty binding on the shareholder, said the Commission, and therefore controls based on the Supremacy Clause of the U.S. Constitution. Moreover, Section 10(b) is not coextensive with common law doctrines of fraud given the antifraud statute’s important purpose to rectify perceived deficiencies in the available common law protections. The SEC emphasized that the meaning of deception under the antifraud provisions of the federal securities laws is a federal question extending beyond the common law.

The SEC also noted that the Supreme Court’s concern in dicta in the 1977 Santa Fe Industries case that to allow a Rule 10b-5 action sans allegations of manipulation or deception would create a federal fiduciary principle absent an indication of congressional intent was inapposite. The Court did not suggest that conduct that does involve deception, as in this case, should not be measured against federal standards under Section 10(b), a statute which clearly indicates congressional intent to create federal standards for deceptive conduct in connection with securities transactions. Indeed, because the misappropriation theory requires deception, the Court concluded in O’Hagan that the theory is consistent with Santa Fe.

Finally, the SEC turned to an amicus brief filed by a group of law professors that the Commission said was based on a fundamental disagreement with the controlling Supreme Court decisions adopting the misappropriation theory and reflected a misunderstanding of how that theory applies to facts alleged in the SEC’s complaint.

Amici asserted that the misappropriation theory of insider trading relied on by the SEC is tangential to the primary purpose of the antifraud provisions of the Exchange Act to prevent the deception of investors and to facilitate disclosure of information to the market. To the contrary, said the SEC, the Supreme Court has stated that the misappropriation theory is well tuned to an animating purpose of the Exchange Act to insure honest securities markets and thereby promote investor confidence. Amici further incorrectly asserted, continued the SEC, that under the misappropriation theory, theft rather than fraud or deceit, seems the gravamen of the prohibition. The Supreme Court has made clear, countered the SEC, that deception through nondisclosure is central to the misappropriation theory.

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