Billionaire Mark Cuban beats the SEC’s full court press

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$2.5 billion.  That’s how much Mark Cuban is worth.  So, why was Mark Cuban in court over a mere $750,000?

The story begins in 1995, when Mark Cuban and Todd Wagner started Audionet, which later became Broadcast.com, an internet radio company.  In 1999, four years after its founding, Broadcast.com was acquired by Yahoo! for $5.9 billion and Cuban became a multi-billionaire overnight.

The money must have been burning a hole in his wallet because in 2000, Cuban acquired the NBA’s Dallas Mavericks.  In 2003, he purchased Landmark Theatres.  In 2004, he produced a short-lived reality TV series.  In 2005, he invested in Brondell, Inc. And in what turned out to be his most ironic business venture, in 2006, Cuban financed Sharesleuth.com, a website “aimed at exposing securities fraud and corporate chicanery.”

In 2004, in the midst of his many other transactions, Cuban sold his shares of a Canadian internet company in order to avoid a $750,000 loss.  The details surrounding this transaction are the reason Cuban found himself in court.

Cuban was aware that Mamma.com’s newest stock offering would dilute the value of his shares.

The Canadian internet company, in which Cuban owned 600,000 shares, was Mamma.com. Cuban’s 600,000 shares were worth $7.9 million.  In June 2004, Cuban allegedly had an eight-minute phone conversation with the then-CEO of Mamma.com, Guy Faure.  Faure allegedly informed Cuban that the company “was planning a stock offering called a private investment public equity, or PIPE.”  Cuban immediately knew the offering would dilute the value of his shares.  According to Faure, Cuban responded to this news saying, “Now I’m screwed. I can’t sell.”

On November 17, 2008, the Securities and Exchange Commission (“SEC”) filed a complaint against Mark Cuban alleging that he engaged in insider trading in securities issued by Mamma.com in violation of Section 17(a)(pdf) of the Securities Act of 1933 and section 10(b) of the Securities Exchange Act of 1934.  Cuban, however, later testified in his own defense that he could not recall the details of that eight-minute conversation with Faure and was planning to sell without knowledge of the new stock offering.

It meets the statutory requirement that there be “deceptive” conduct “in connection with” a securities transaction.

Insider trading is commonly misperceived as uniformly illegal conduct.  However, not all insider trading is illegal.  Legal insider trading occurs when corporate insiders buy or sell stock in their own companies.  This activity must be reported to the SEC.  On the other hand, “illegal insider trading” refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.  This activity will spur the SEC to open an investigation.

Section 10(b) of the Securities Exchange Act of 1934 states, in pertinent part, that it shall be unlawful for any person to “use or employ, in connection with the purchase or sale of any security . . ., any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate . . ..”  Thus, this statute forbids , as discussed in the 1997 Supreme Court case of U.S. v. O’Hagan, “using any deceptive device in connection with the purchase or sale of securities, in contravention of rules prescribed by the Commission.”

There are two theories of liability concerning insider trading.  The first is the classical theory, which is what most people think of when they hear “insider trading.”  The classical theory occurs when a corporate employee uses his position with the company in order to gather material, confidential information and then use that information to trade his corporation’s securities.  The second is the misappropriation theory, which is the “proper subject of a section 10(b) charge because it meets the statutory requirement that there be ‘deceptive’ conduct ‘in connection with’ a securities transaction.”

The Supreme Court in O’Hagan recognized the misappropriation theory as establishing liability for a corporate “outsider.”  As opposed to the classical theory, the misappropriation theory reaches outside of the corporation’s walls in order to hold non-employees liable for taking advantage of their association with a company and their proximity to certain information.

In the more recent case involving Mark Cuban, he was specifically alleged to have violated Rule 10b5-2(b)(1) of the Securities and Exchange Act of 1934.  This particular rule establishes a duty on the part of the “outsider” whenever that person “agrees to maintain information in confidence.”  Prior to this regulation, the SEC was required to establish a fiduciary relationship between the parties.  This change, however, reduced the SEC’s burden in misappropriation cases because it only requires a showing of confidentiality. Yet, a showing of confidentiality is often difficult to establish.

Mr. Cuban’s legal team convinced the jury that the information provided to Mr. Cuban had become public knowledge by the time Mr. Cuban sold his shares.

Cuban moved to dismiss the case on the grounds that he owed no duty to the company, but the court denied Cuban’s motion for summary judgment; the charges were a classic example of the misappropriation theory of insider trading.  In denying Cuban’s motion, the court examined whether the SEC had shown facts sufficient to support the existence of a confidentiality agreement.  The Court also evaluated whether the SEC had sufficiently established the possibility of an agreement not to trade.

After making its initial determinations, the court’s charge to the jury required that the SEC prove the following elements:

1) that Mr. Cuban received material, nonpublic information;
2) that Mr. Cuban expressly or implicitly agreed to keep the information confidential and not to trade on or otherwise use the information for his own benefit;
3) that Mr. Cuban traded on that information;
4) that Mr. Cuban did not first disclose that he planned to trade on the information;
5) that Mr. Cuban acted knowingly or with severe recklessness;
6) that Mr. Cuban’s conduct was in connection with the sale of a security; and
7) that Mr. Cuban used interstate commerce in connection with the sale of a security.

After an eight-day trial, the jury found that the SEC had failed to prove the first five elements and returned a verdict for Mr. Cuban.

Mr. Cuban’s legal team was able to convince the jury that the information provided to Mr. Cuban had become public knowledge by the time Mr. Cuban sold his shares.  This was accomplished by showing evidence of an increase in trading volume over a short period of time.  Cuban’s attorneys claimed that this spike in trading was a result of the pending PIPE transaction, which meant the transaction was already public knowledge and not confidential.  Additionally, Mr. Cuban’s last witness stated that the information was public knowledge prior to Mr. Cuban selling his 600,000 shares.

 Almost a decade after Mr. Cuban sold his 600,000 shares of Mamma.com, he finally has the outcome he wanted.

Almost a decade after Mr. Cuban sold his 600,000 shares of Mamma.com, he finally has the outcome he wanted.  As a corporate “outsider,” Mr. Cuban was able to take the information given to him by the corporation’s CEO and use that to save $750,000.

But what does this mean for the SEC and corporate officers?  Well, officers, now more than ever, must watch every statement, message, and conveyance they make.  And if any statement is made, the officer must ensure that the information becomes public knowledge so that the misappropriation theory of insider trading becomes inapplicable.

As for the SEC, in order to crack down on insider trading it must find a way to establish whether the information being conveyed by insiders to “outsiders” is confidential.  If the commission is unable to make this showing, then the misappropriation theory loses its bite and insider trading by corporate “outsiders” will continue to sully an already tainted business.