From Chiarella to Cuban: The Continuing Evolution of the Law of Insider Trading

From Chiarella to Cuban:

The Continuing Evolution of the Law of Insider Trading

Anthony Michael Sabino* & Michael A. Sabino**

Fordham Journal of Corporate & Financial Law, Vol. XVI (2011), pp. 673–741

* Partner, Sabino & Sabino, P.C. Professor of Law, St. John’s University, Tobin College of Business. Former Judicial Law Clerk to the Hon. D. Joseph DeVito, United States Bankruptcy Court, District of New Jersey.

** Brooklyn Law School (J.D. anticipated 2012). Intern, the Hon. Leonard B. Austin, Appellate Division, Second Department, State of New York. The authors dedicate this Article to the memory of Mary Jane Catherine Sabino: attorney, professor, author, and most importantly, beloved spouse of Anthony and mother of Michael and James. All we do, we do with her foremost in our thoughts and forever in our hearts.

Table of Contents

  1. Preface
  2. Introduction
  • The Fundamentals of Section 10(b)
    1. The Statute and the Rule
    2. Section 10(b) and Insider Trading
  1. Chiarella: The Beginning
  2. Dirks: A Tale of Vindication
  3. O’Hagan: The Misappropriation Theory at Last
  • Cuban: Victory, Then Defeat, and Now Uncertainty
    1. A Cuban Victory
    2. A Reversal of Fortune: Cuban in the Fifth Circuit
    3. Reflections on Cuban
  • Analysis & Commentary
    1. The Axioms of the Law of Insider Trading
    2. “Well, Now I’m Screwed, I Can’t “
    3. The Law as It Must Be
  1. Conclusion

I.  Preface

What does an old-school financial printer (one from the bygone era of ink and printing presses) have in common with a present-day Internet billionaire (one more often seen on ESPN than CNBC)? Both were accused by the government of “insider trading.” While the former defeated the charges brought against him in a case which began the Supreme Court’s modern interpretation of federal insider trading laws, the latter recently suffered a setback at the appellate level in the form of a remand to the district court.

By now, legal professionals have likely discerned that the first scenario refers to the seminal 1980 United States Supreme Court case Chiarella v. United States.1 Sports fans and legal scholars alike probably recognize the second scenario as describing SEC v. Cuban,2 a case brought against the flamboyant owner of the Dallas Mavericks professional basketball team, which was first dismissed by the U.S. District Court for the Northern District of Texas and subsequently reinstated by the Fifth Circuit Court of Appeals. The disparate outcomes reached in Chiarella and Cuban clearly reflect the difficulty the federal courts have encountered in formulating a consistent method of interpreting federal insider trading laws.

Federal securities laws broadly proscribe the employment of fraudulent or deceptive devices in connection with the purchase or sale of securities in the public markets.3 “Insider trading” is a species of such malfeasance and occurs when one uses material, nonpublic information to profit in the trading of stock.4 The titular “evolution” of the law of insider trading has been spawned by a series of contrasting legal decisions and an abundance of interesting twists and turns.

Parts II and III of this Article provide an exposition of the statutory underpinnings of insider trading and a description of the fundamentals of federal securities laws. Parts IV through VII then trace the development of modern insider trading jurisprudence, starting with the Supreme Court’s inaugural holding in Chiarella and then moving across three decades of evolving precedent to the recent Cuban decision. Part VIII provides the authors’ analysis and commentary on the current state of insider trading laws. The Article concludes in Part IX with some observations as to what the future holds for the law of insider trading.

II.  Introduction

Insider trading has always captured the public’s attention (not to mention the watchful eye of the Department of Justice and the Securities and Exchange Commission (“SEC”)). In recent decades, we have witnessed such episodes as the Ivan Boesky/Michael Milken scandal5 and the “Yuppie Five” prosecutions.6 These occurrences were so engrossing that they gave rise to a myriad of exposés, cinematic epics7, and other fictional works depicting stories of Wall Street gone wrong. Even when insider trading was not the actual charge alleged, such as in the Martha Stewart prosecution,8 the mere hint of subterfuge involving confidential corporate secrets had the effect of setting the world on its ear.

Recent episodes lend credence to the adage that, “the more things change, the more they stay the same.” Current events detail charges of insider trading at well-known hedge funds,9 illegal tips obtained from an employee inside the behemoth Microsoft Corporation,10 and even a secretary at the Walt Disney Company being arrested for allegedly leaking confidential tips about the House of Mouse’s stock.11 Therefore, it came as no surprise when notoriety immediately attached to the SEC’s filing of charges against Mark Cuban, a well-known business mogul and sportsman, for allegedly trading on material, nonpublic information regarding a technology company in which he held a major investment stake.12

III.  The Fundamentals of Section 10(b)

Having established the high profile of insider trading cases, we now turn to the first crucial step in our analysis of modern insider trading jurisprudence – an exposition of the well-established foundation for bringing such cases under our federal securities laws. We will begin with an examination of Section 10(b) of the Securities Exchange Act of 1934.13

A.  The Statute and the Rule

The birth of federal securities laws in this country traces its roots to the Great Depression and the reforms passed in reaction thereto. The federal statutes were intentionally designed to rectify shortcomings in common law protections against fraud by establishing higher standards of conduct in the securities industry,14 although they were not intended to replicate common law maxims, such as the law of fiduciaries.15 The Supreme Court has long held that the overarching purpose of the federal securities laws is to remedy the proven inadequacies of common law protections in order to ensure the fair and honest functioning of an impersonal stock market.16

The Securities Exchange Act of 193417 (“Exchange Act”) and its predecessor, the Securities Act of 1933,18 are the twin pillars of the same comprehensive federal scheme of regulating the stock markets. The Exchange Act established the Securities and Exchange Commission to administer the federal securities laws.19 The SEC is empowered to investigate any violations of the federal securities laws, rules or regulations, as well as to seek monetary penalties for such transgressions.20 Of all the antifraud provisions found in the federal securities laws and the Exchange Act in particular, Section 10(b)21 is “[t]he quintessential statute     “22 Section 10(b)

provides in relevant part:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails,…… [t]o 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 in the public interest or for the protection of investors.

It is axiomatic that the preservation of the integrity of the stock market has been an animating purpose of Section 10(b) since its passage over seventy years ago.24

As previously indicated, Section 10(b) authorizes the Securities and Exchange Commission to promulgate rules and regulations to enforce the statute. The relevant rule promulgated under Section 10(b), universally known as Rule 10b-5,25 “is an extended version of the prohibitions enacted in title 15, and is used both in conjunction and interchangeably with the statutory provision.”26

Rule 10b-5 makes it unlawful:

(a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact . . . , or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Because Rule 10b-5 was promulgated under Section 10(b), it “does not extend beyond conduct encompassed by Section 10(b)’s prohibition.”28 Thus, “[t]he scope of Rule 10b-5 is coextensive with the coverage of Section 10(b).”29 To be certain, “Section 10(b) does not incorporate common-law fraud into federal law.”30

By enacting Section 10(b), “Congress meant to prohibit the full range of ingenious devices that might be used to manipulate securities prices.”31 Rule 10b-5 was likewise designed to protect investors from manipulative devices and frauds foisted upon the stock exchanges by unscrupulous parties.32 It should be noted that both the statute and its accompanying rule have been acknowledged as having deep roots in common law notions of fraud and deceit.33 Thus, in reviewing adjudications under Section 10(b), the Supreme Court has explicitly “retained familiar legal principles as [its] guideposts.”34 Paramount among those is the principle that a purported violation must contain an element of scienter, an intent to deceive, manipulate, or defraud.35

In sum, “[S]ection 10(b) was designed with the intent to cut a wide swath through all manner of insidious devices that might be used to perpetrate fraud upon the securities marketplace.

Ground[ed] in timeless principles of fraud and deceit, the antifraud statute has kept those common law traditions as guideposts, while still ranging far beyond their historical boundaries.”36

In the realm of securities litigation, Rule 10b-5 and its parent Section 10(b) are paramount.37 This explains the Court’s demonstrated desire to define the boundaries of Section 10(b) liability with great care. The Supreme Court has consistently emphasized adherence to the statutory language in defining the scope of conduct prohibited by the statute.38 The Court has made it abundantly clear that “conduct not prohibited by the text of the statute” cannot be challenged under Section 10(b) or Rule 10b-5.42 As stated by Justice Scalia in the recent landmark case Morrison v. National Australia Bank Ltd.: “[T]o ask what conduct § 10(b) reaches is to ask what conduct § 10(b)

prohibits……. “43

In sharp contrast, we note Justice Scalia’s admonition that “Section 10(b)…… punishes not all acts

of deception……. Not deception alone, but deception with respect to certain purchases or sales is

necessary for a violation of the statute.”48 Section 10(b) punishes only deceptive conduct “in connection with the purchase or sale of any security………………………….. “46 The Court has held that the phrase “in

connection with” found in Section 10(b) means “to coincide” with the purchase or sale of a security.47

Moreover, the Court in Ernst & Ernst v. Hochfelder rejected the notion that Section 10(b) encompasses mere negligence, since to do so would “add a gloss to the operative language of the statute quite different from its commonly accepted meaning.”53 Significantly, the Court in Central Bank reiterated its “refus[al] to allow 10b-5 challenges to conduct not prohibited by the text of the statute.”54

Thus, we have the foundation of our federal securities laws. Nearly eighty years ago, the cornerstones of this foundation, the Securities Act of 1933 and the Securities Exchange Act of 1934, were set in place. Since then, many other principles have been incorporated into this body of law and regulation. Viewed as one great edifice, our federal securities laws have proven to be a durable and effective means of assuring the sanctity of the American capital markets by imposing a discipline of transparency, disclosure, and honesty.

B.  Section 10(b) and Insider Trading

In its modern popular usage, “[i]nsider trading is a catchphrase used to describe a particular type of securities fraud – that which involves trading on material information that is unavailable to the marketplace.”55 It is a great irony that “[n]o statute defines illegal insider trading.”56 To the contrary, even experts have characterized insider trading as “the amalgamation of judicial opinions that have developed in both the civil and criminal context.”57

We begin by introducing what has been known for decades as the “classical” theory of insider trading. In United States v. Cusimano,58 the Second Circuit distinguished the “classical” or “traditional” theory of insider trading as a wrong perpetrated by a corporate insider who exploits confidential information for individual profit.59 United States v. Nacchio60 presents a modern example of “classical” insider trading by a high level corporate insider. In that case, the former CEO of telecommunications giant Qwest Communications was convicted of insider trading for transacting in the corporation’s stock on the basis of material, nonpublic information.61

“Classical” insider trading is not always defined by a single act of malfeasance. In certain instances, the insider repeatedly shares knowledge of corporate secrets and profits with an individual outside the corporation, known as the “tippee.” A “tippee” is one who receives confidential information from a corporate insider.62 A prime example of such conspiratorial

behavior is found in United States v. McDermott,63 where a prominent Wall Street investment banker tipped off his paramour and was subsequently convicted for insider trading.64

Not every “inside” relationship or tip constitutes a violation of Section 10(b). Consider, for example, the case of United States v. Chestman.65 Chestman was the stockbroker for the husband of the granddaughter of the owners of Walbaum, Inc., a publicly traded company that owned a large supermarket chain.66 The granddaughter’s husband tipped off Chestman that Walbaum was going to be taken over at a premium price by rival supermarket chain A&P. Chestman purchased Walbaum stock prior to the takeover and saw his investment double after A&P announced the buyout.67 After Chestman was tried and convicted of insider trading under Rule 10b-5 at the district court level,68 the Second Circuit reversed, holding that Chestman could not have breached a fiduciary duty because the husband from whom he received the tip did not owe a fiduciary duty to Walbaum.69 Chestman is intriguing because it demonstrates that even a familial relationship, though normally perceived to be confidential in nature, may not be enough to create a fiduciary duty as contemplated by Section 10(b).

For instance, in charging business magnate Martha Stewart with obstruction of justice and lying to investigators about her trading in the stock of ImClone Systems, Inc., the government deliberately chose not to take the risk of alleging that Stewart had engaged in trading on material, nonpublic information.70 Yet, the non-accusation brought about a firestorm of controversy at trial, where each side sought to take advantage of the glaring omission of a Rule 10b-5 charge of insider trading.71

The emerging counterpoint to the “classical” theory of insider trading is the theory of insider trading by means of “misappropriation.” At this point it is sufficient to broadly define the misappropriation theory as the wrongful taking and exploitation of confidential information in order to profit in the buying and selling of stock.73

A noteworthy case involving the misappropriation theory is SEC v. Cherif.74 After losing his job at a Chicago bank, Cherif forged credentials to obtain access to his ex-employer’s confidential investment banking files and subsequently traded on the stolen information.75 Castigating the defendant as more than a “mere thief,” the Seventh Circuit classified Cherif’s wrongdoing as fraudulent because he deprived his former employer of something of value by his chicanery.76 Cherif is generally regarded as marking the Seventh Circuit’s adoption of the misappropriation theory of insider trading.

In United States v. Falcone,77 the so-called “Business Week” case, the defendant’s stockbroker acquaintance acquired the contents of an issue of Business Week magazine from an employee of the publication prior to its public release.78 The conspirators then utilized information in the popular “Inside Wall Street” column to purchase stocks before the magazine’s official release date in violation of the policy of strict confidentiality that Business Week imposed on its vendors.79 The case is best known for the Second Circuit’s reliance on the “in connection with” requirement of

Section 10(b).80

In SEC v. Dorozhko,81 the defendant fraudulently obtained material, nonpublic information by hacking into a corporate computer system and reaped profits by trading on that information.82 The Second Circuit held that a breach of fiduciary duty was not required for computer hacking to be “deceptive” within the meaning of Section 10(b).83 In so holding, the Second Circuit declared that “deceit” equals “fraud” within the context of Rule 10b-5 cases.84

What punishments has Congress established for violations of Section 10(b)? Specifically, the SEC is authorized to impose civil penalties for insider trading by bringing an action in a federal district court.85 To prevent the “unfair use of [inside] information,” corporate directors, officers, and certain shareholders must disgorge any short term profits made by transacting in the company’s stock to the corporation, “irrespective of any intention.”86 Congress occasionally enlarges the sanctions for insider trading, but has essentially left the operative law (Section 10(b) and Rule 10b-5) untouched.87

The sweeping reforms instituted by the Sarbanes-Oxley Act of 200289 added some significant weapons to the prosecutor’s arsenal to combat insider trading. Principally, Section 807 of the Sarbanes-Oxley Act,90 codified at Section 1348 of Title 18, imposes criminal liability on anyone who “knowingly executes, or attempts to execute . . . [a fraud upon] any person in connection with

. . . any security” or employs fraudulent means to obtain “any money or property in connection with the purchase or sale of . . . any security………………………. “91 The statute imposes a harsh sentence of up to

twenty-five years of imprisonment for anyone convicted of committing such a fraud.95

IV.  Chiarella: The Beginning

Every legal epic begins somewhere. It cannot be disputed that, in the realm of insider trading, the beginning is found in Chiarella v. United States.96 In that case, defendant Vincent Chiarella handled documents for Pandick Press, a Wall Street financial printer. In the era prior to PDFs and e-mail attachments, firms such as Pandick literally printed copies of prospectuses and other offering documents for stock deals and corporate takeovers.97 In the mid-1970s, Chiarella’s job was to “mark up” such documents in preparation for the final printing and dissemination of materials when the offers became public.98

The secrecy of the identities of the corporations involved in any transaction was an important issue, handled in a most rudimentary way – blank spaces were left or fictitious names were substituted for the real names of the acquiring and target companies.99 The true corporate names were inserted only on the night of the final printing when the New York exchanges were closed.100 Yet, such rudimentary precautions did not deter the intrepid Mr. Chiarella. He carefully compared the unique financial data in each of the documents to information already publicly available, and thereby deduced the identity of several acquiring and target entities. He purchased stock in the

target companies and sold it once the takeover was announced and after the share price naturally increased. In a little more than a year, he made over $30,000 in profits.101

The SEC investigated Mr. Chiarella’s activities.102 Chiarella entered into a consent decree with the Commission in which he agreed to return his profits to the sellers of the shares, was discharged from his job by Pandick Press, and was indicted on seventeen counts of violating Section 10(b) and Rule 10b-5.103 Chiarella was subsequently tried and convicted, and his conviction was affirmed by the Second Circuit Court of Appeals.104 But the story did not end there, for the Supreme Court made what some still consider a startling reversal.105

Writing for the Court, Justice Lewis Powell framed the central question as “whether a person who learns from the confidential documents of one corporation that it is planning an attempt to secure control of a second corporation violates § 10(b) of the Securities Exchange Act of 1934 if he fails to disclose the impending takeover before trading in the target company’s securities.”106 Justice Powell wrote that Section 10(b) does not state whether silence in itself may constitute a prohibited manipulative or deceptive device.108 Section 10(b) was designed to broadly ban all fraudulent practices, but neither its text nor its legislative history affords genuine guidance on this issue.109

The Chiarella Court acknowledged that SEC administrative decisions do play an important role in the development of Section 10(b) jurisprudence.110 In Cady, Roberts & Co.,111 the Commission “held that a broker-dealer and his firm violated [Section 10(b)] by selling securities on the basis of undisclosed information obtained from a director of the issuer corporation who was also a registered representative of the brokerage firm.”112 The Commission’s decision was an early enunciation of its “disclose-or-abstain” rule, under which “a corporate insider must abstain from trading in the shares of his corporation unless he has first disclosed all material information known to him.”113

The Chiarella Court further added that a failure to disclose material information is fraudulent only when there is a duty to do so, and that “the duty to disclose arises when one party has information that the other [party] is entitled to know because of a fiduciary or other similar relation of trust and confidence between them.”115

Applying these standards, the Court in Chiarella concluded that the defendant was not a corporate insider because “he received no confidential information from the target company.”119 Therefore, Chiarella’s use of that financial data “was not a fraud under § 10(b) unless he was subject to an affirmative duty to disclose it before trading.”121 The Court noted that the jury charge failed to make that distinction. Quite to the contrary, the trial judge’s instructions effectively imposed upon Chiarella a duty to disclose to all sellers.122

Writing for the Court, Justice Powell identified two paramount defects in the reasoning of the courts. First, the lower courts failed to recognize that “not every instance of financial unfairness constitutes fraudulent activity under § 10(b).”123 Second, the lower courts erroneously determined

that “the element required to make silence fraudulent [, namely,] a duty to disclose [,]”124 was present under the facts of the case. Here, no such duty could have arisen from Chiarella’s relationship with the sellers because he “had no prior dealings with them” and he was neither their agent nor fiduciary.125 In the Court’s view, Chiarella was merely a “complete stranger who dealt with the sellers only through impersonal market transactions.”126

The Court expressed the heart of its analysis as follows:

“Section 10(b) is aptly described as a catchall provision, but what it catches must be fraud. When an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak. We hold that a duty to disclose under § 10(b) does not arise from the mere possession of nonpublic market information. The contrary result is without support in the legislative history of § 10(b) and would be inconsistent with the careful plan that Congress has enacted for regulation of the securities markets.”132

With that, Vincent Chiarella was a free man, the federal government suffered a stunning reversal of fortune, and a great cornerstone of the law of insider trading was set in place.133

A few additional words about Chief Justice Burger’s dissent are in order.134 Chief Justice Burger acknowledged the general rule that “neither party to an arm’s-length business transaction has an obligation to disclose information to the other unless the parties stand in some confidential or fiduciary relation.”135 He argued in dissent, however, that the rule should be limited when an informational advantage is obtained by wrongful or unlawful means.136 In particular, he insisted that both Section 10(b) and Rule 10b-5 should be read “to encompass and build on th[e] principle .

. . that anyone who has misappropriated nonpublic information has an absolute duty to disclose that information or to refrain from trading.”137 In an abrupt closing, the Chief Justice strongly condemned Chiarella, declaring that by his actions he, “stole to put it bluntly” and was guilty “beyond all doubt” of violating Section 10(b) and Rule 10b-5.141

V.  Dirks: A Tale of Vindication

The central points of Chiarella were reiterated and tested in Dirks v. Securities and Exchange Commission.143 In 1973, Raymond Dirks was an officer of a New York broker-dealer firm that specialized in providing investment analysis of insurance company securities to institutional investors.144 In early 1973, Dirks was contacted by Ronald Secrist, a former officer of Equity Funding of America, a diversified insurance and financial services company. Secrist informed Dirks that the assets of Equity Funding were vastly overstated as a result of fraudulent corporate practices.145 Secrist urged Dirks to verify the fraud and disclose it to the public.146

On his own initiative, Dirks investigated the allegations, going so far as to travel to Los Angeles to interview several officers and employees of the corporation.147 During the course of his two week

investigation, Dirks informed a number of clients and investors of the burgeoning evidence of fraud at Equity Funding.149 Although neither Dirks nor his firm owned or traded in Equity Funding shares, some of the persons to whom Dirks provided information sold their holdings of Equity Funding securities, including five investment advisers whose liquidated holdings totaled more than $16 million.150

While the Wall Street Journal initially refused to print Dirks’ story for fear of subjecting itself to a libel claim, word of Dirks’ investigation spread like wildfire, and the price of Equity Funding’s stock soon cratered from $26 per share to less than $15 per share.151 This implosion of the share price led the New York Stock Exchange to halt trading in Equity Funding stock.152 California insurance regulators subsequently impounded Equity Funding’s records and uncovered evidence of the fraud.153 The SEC filed charges against the firm and Equity Funding was immediately placed into receivership.154

After administrative court proceedings, the SEC found that Dirks “had aided and abetted violations of § 17(a) of the Securities Act of 1933, § 10(b) of the Securities Exchange Act of 1934, and SEC Rule 10b-5, by repeating the allegations of fraud to members of the investment community who later sold their Equity Funding Stock.”155 In a surprising act of leniency, the SEC, in recognition of his key role in exposing the fraud, only censured Dirks.156

Unmoved by the SEC’s beneficence, Dirks sought judicial review.157 Unfortunately for him, the District of Columbia Circuit entered judgment against Dirks.158 The Supreme Court recognized the importance of the issue to the SEC and the securities industry and granted certiorari.159 In a stunning reversal of fortune for the SEC, the Court overturned the lower court and found for Dirks.160

Writing for a 6-3 majority, Justice Lewis Powell (who, significantly, was also the author of Chiarella) first succinctly set forth the basis for Dirks’ conviction. Specifically, Dirks had received material, nonpublic information from insiders at Equity Funding with whom he had no prior relationship and shared that information with certain investors who, in reliance upon these revelations, sold their Equity Funding shares.161 According to the Court, “[t]he question [was] whether Dirks violated the antifraud provisions of the federal securities laws by this disclosure.”162

The Dirks Court took the opportunity to reaffirm the crux of what it held in Chiarella – that Section 10(b) and Rule 10b-5 are violated when access to confidential information is misused and covertly exploited for private gain.165 However, Dirks reinvigorated Chiarella‘s maxim that “there is no general duty to disclose” and such an obligation cannot arise from the mere possession of material, nonpublic information.166 The Dirks Court confirmed that “[s]uch a duty arises rather from the existence of a fiduciary relation.”167

In clarifying the import of its holding, the Dirks Court declared that “some tippees must assume an insider’s duty to the shareholders not because they receive inside information, but rather because

it has been made available to them improperly.”185 Hence, the assumption of a fiduciary duty to disclose or abstain can take place only when the inside source of the confidential information has first breached his fiduciary duty to his constituency “and the tippee knows or should know that there has been a breach.”186

A highly influential factor in this analysis is the tipper’s reason for disclosing confidential information. The key test is whether the disclosing insider benefited, either directly or indirectly, from revealing the information. Justice Powell stated that “[a]bsent some personal gain, there [can be] no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.”190 Dirks clearly establishes that regulators and courts alike must base their allegations and decisions on “objective facts and circumstances            “192

Under its established insider trading and tipping rules, the Supreme Court found no actionable wrongdoing by Dirks. The Court classified Dirks as “a stranger to Equity Funding, with no

pre-existing fiduciary duty to its shareholders.”195 “[N]or did Dirks misappropriate or illegally obtain the information about Equity Funding.”196 Ray Dirks prevailed, and the SEC went down in a bitter defeat.198

VI.  O’Hagan: The Misappropriation Theory at Last

Lawyers have long had the solemn duty of upholding the law. Only in rare instances are members of the profession accused of actually breaking the law themselves. Unfortunately, however, the landmark case of United States v. O’Hagan200 presents such a scenario.

James Herman O’Hagan was a partner at the eminent law firm of Dorsey & Whitney, then based in Minneapolis, Minnesota. In July of 1988, Dorsey was retained as local counsel by Grand Metropolitan PLC (“Grand Met”), a U.K. food conglomerate, as part of its takeover bid for the Pillsbury Company, also headquartered in Minneapolis. Although, “O’Hagan did no work on the Grand Met representation,”201 he nevertheless took a strong financial interest in the Grand Met acquisition.

In mid-August of 1988, while Dorsey & Whitney was still actively representing Grand Met, O’Hagan purchased “call options” on Pillsbury stock.202 By the end of that time, O’Hagan had amassed some 2,500 Pillsbury options, “apparently more than any other individual investor,”203 in addition to buying some 5,000 shares of Pillsbury common stock.204 When on October 4, 1988, Grand Met publicly announced its bid to acquire Pillsbury, O’Hagan sold off his investments and made a net profit of well over $4 million.205

O’Hagan’s newfound riches soon caught the eye of the SEC, prompting an investigation culminating in a fifty-seven count indictment. The SEC’s principal allegations were that O’Hagan had defrauded both his own law firm and its client, Grand Met, by diverting material, nonpublic information about the planned Pillsbury acquisition for his own gain.206 Ultimately, O’Hagan was

convicted on fifty-seven counts and sentenced to nearly three and a half years in prison.207 Somewhat surprisingly, a divided panel of the Eighth Circuit Court of Appeals reversed all of O’Hagan’s convictions.208 Acknowledging that the “[d]ecisions of the Courts of Appeals are in conflict on the propriety of the misappropriation theory under § 10(b) and Rule 10b-5,” the Supreme Court granted certiorari.209

Writing for the Court, Justice Ginsburg set out the paramount questions before the Justices, first addressing the misappropriation theory of insider trading liability. Justice Ginsburg asked whether a person, trading in stock for personal profit, violates Section 10(b) and Rule 10b-5 when he utilizes confidential information misappropriated in a breach of a fiduciary duty owed to the source of that nonpublic data.210 The O’Hagan Court replied in the affirmative211 and ultimately held that criminal liability for violating Section 10(b) “may be predicated on the misappropriation theory.”212

Justice Ginsburg first exposited the “traditional” or “classical” theory, which is, in brief, when a corporate insider trades in the stock of his own corporation on the basis of material, nonpublic information. Such conduct is wrongful because the employment of inside information qualifies as the “deceptive device” outlawed by Section 10(b) and Rule 10b-5.215

In contrast, the “misappropriation” theory holds accountable those who misappropriate confidential data and trade with that special knowledge, in breach of a duty owed to the source of the information, and it is the violator’s “undisclosed, self serving use” of the information so gained which defrauds the source of its lawful exclusivity in possessing that knowledge.216 The misappropriation theory is “[i]n lieu” of premising liability upon a corporate insider pursuant to the classical theory, and instead, liability flows from the “trader’s deception of those who entrusted him with access to confidential information.”217

Reaching the gravamen of the O’Hagan Court’s reasoning, Justice Ginsburg next declared that “[t]he two theories are complementary, each addressing affects to capitalize on nonpublic information” in buying or selling stock.218 While the classical theory zeroes in on a corporate insider’s breach of trust owed to shareholders, conversely, the misappropriation postulation “outlaws trading on the basis of nonpublic information by a corporate ‘outsider'” breaching a duty of confidentiality owed to the source of the information.219

Turning to the case at bar, the Justices expressed agreement with the government’s contention that trading upon misappropriated information fell within the conduct prohibited by Section 10(b). Those proven to misappropriate “deal in deception” and pretend loyalty to their source “while secretly converting” its information for personal gain.221 The pivot of the instant case was deception by nondisclosure, that is, the cover-up of the act of misappropriation.224 Furthermore, the Court noted that full disclosure to the source, that the person in possession of the privileged information does intend to trade upon it, negates the deception, and thus forecloses Section 10(b) liability.226

In concluding, the O’Hagan Court held that “the misappropriation theory . . . is both consistent with the statute and with our precedent.” Setting forth some of the requisite elements of criminal liability under Rule 10b-5, O’Hagan declared that the prosecution must first prove a willful violation of the proviso, and next that the alleged violator knew of the prohibition.240 Thus, O’Hagan’s original convictions on the Section 10(b) violations were restored.242

O’Hagan marked the first time the Supreme Court recognized and expounded upon the misappropriation theory of insider trading. The Court carefully and explicitly delineated what it is about misappropriation that makes it a violation of the law – the wrongfulness of taking the confidential data of another and utilizing it for personal gain in the transacting of securities.

VII.  Cuban: Victory, Then Defeat, and Now Uncertainty

A.  A Cuban Victory

The Fifth Circuit Court of Appeals’ decision in Securities and Exchange Commission v. Cuban lays the latest foundation in insider trading jurisprudence.244 Mark Cuban, the putative defendant, enjoyed a meteoric rise in the high-tech industry after founding Broadcast.com, a company he sold to Yahoo! Inc. in 1999 for an astonishing $4.7 billion. Notwithstanding his obvious business acumen, he is better known in professional sports circles as the outspoken team owner of the National Basketball Association’s Dallas Mavericks.

The essence of the courtroom drama was simple – charged with insider trading, Cuban was first able to win a dismissal, without prejudice to refiling, of the government’s case.245 As of March 2004, Cuban was an investor in Mamma.com, a Canadian company that operated an internet search engine. Cuban personally owned 600,000 shares, or a 6.3% stake, in the NASDAQ-traded company. At about that time, the company’s management decided to raise capital via a PIPE offering.246 “PIPE” stands for “Private Investment in a Public Entity.”

Given that Cuban was Mamma.com’s largest then-known shareholder, the firm’s CEO contacted him by telephone.247 According to the allegations, the CEO prefaced the call by telling Cuban he was about to share confidential information, and Cuban supposedly agreed to maintain its confidential nature.249 The corporate chief proceeded to tell Cuban about the PIPE offering.250 Cuban’s responded without favor. “Well, now I’m screwed,” was the alleged retort.251 Cuban angrily expressed his disdain for PIPE offerings.252 At the end of the conversation with the CEO, Cuban allegedly declared “[Now] I can’t sell.”253

According to the SEC, “[o]ne minute after ending this call, Cuban telephoned his broker and directed the broker to sell all 600,000 of his Mamma.com shares.”256 After first selling but a handful of shares in after-hours trading, the broker was able to sell the vast bulk of Cuban’s holdings in Mamma.com during the next trading day. Cuban did not inform the management of Mamma.com either of his intentions to sell or the eventual liquidation of his stake.257 All told, Cuban avoided in

excess of $750,000 in losses by dumping his stake ahead of the news about the PIPE.258

The Securities and Exchange Commission pounced on these largely undisputed facts.259 The Commission alleged that Cuban violated the federal securities laws, specifically Rule 10b-5, under the “misappropriation” theory of insider trading.260 Cuban quickly moved to dismiss the regulators’ case.261

Chief District Judge Sidney A. Fitzwater succinctly posited the question before the court as to whether the SEC “adequately alleged that Cuban undertook a duty of non-use of information required to establish liability under the misappropriation theory.” Concluding that the agency had failed in that regard, the court granted Cuban’s motion to dismiss, but expressly authorized the government to replead.262

The district court drew from the foregoing the following conclusion of law: “trading on the basis of material, nonpublic information cannot be deceptive unless the trader is under a legal duty to refrain from trading on or otherwise using it for personal benefit.”306 However, and of great import, the court ruled that “a duty analogous” to a fiduciary duty can arise by agreement. The court was explicit in finding that such an agreement “must consist of more than an express or implied promise merely to keep information confidential.”310 The Cuban opinion declared that the agreement must impose a legal duty to refrain from trading or otherwise acting for personal gain upon the recipient of the nonpublic information.311

Ultimately, the district court concluded that the government’s complaint failed in that task.321 Chief Judge Fitzwater took note of the precise words that the SEC alleged Cuban spoke in his crucial conversation with Mamma.com’s CEO.322 Cuban agreed to keep the information confidential, but he did not agree, overtly or implicitly, to refrain from trading or otherwise employing the information for personal gain.323 With that, the district court granted Cuban’s motion to dismiss.341

B.  A Reversal of Fortune: Cuban in the Fifth Circuit

Mark Cuban’s victory in the Northern District of Texas was short-lived. A panel of the U.S. Court of Appeals for the Fifth Circuit, sitting in New Orleans, summarily reversed the court below, reinstated the SEC’s action, and most importantly, insisted upon the commencement of discovery.342 Writing for the panel, Circuit Judge Patrick E. Higginbotham343 declared that the Fifth Circuit was “[t]aking a different view from our able district court brother,” overturning the dismissal and directing that the reinstated case “must proceed to discovery.”344

The Fifth Circuit emphasized that the Supreme Court “did not set the contours of a relationship of trust and confidence” central to finding misappropriation liability.354 Nonetheless, the tribunal found itself tasked with determining whether or not Cuban was in such a relationship here.

The panel honed in on Cuban’s subsequent telephone conversation with the corporation’s investment banker, where, in a supposed eight minute call, Cuban was given more detail on the anticipated PIPE offering.357 The Fifth Circuit then declared that “[i]t is a plausible inference that Cuban learned the off-market prices available to him and other PIPE participants.”358 The call to sell his shares came a single minute after Cuban ended his call with the corporation’s banker.359

Judge Higginbotham then wrote that, “taken in their entirety,” the combined weight of these allegations “provide[s] more than a plausible basis to find” that Cuban had knowingly and willingly entered into “more than a simple confidentiality agreement.”363 It was “at least plausible . . . if only implicitly,” that all concerned understood that Cuban could not act upon the more detailed information newly gained.364

In conclusion, the Fifth Circuit returned to one of the fundamental propositions behind its reversal of the district court – that there is a “paucity” of jurisprudence on what constitutes a relationship of trust and confidence that must first exist for there to be liability pursuant to the misappropriation theory.370 The circuit court vacated the lower court’s judgment of dismissal, and remanded to the district court for further proceedings – with the explicit command that discovery must proceed on those precise issues.372

C.  Reflections on Cuban

For now, Mark Cuban has been dealt a setback. While the district court’s dismissal of the government’s charges awarded him the initial victory, the Fifth Circuit’s reversal reinstates the complaint, and allows the prosecutors to proceed. Still, this most recent development is by no means the last word.

At this stage, the appellate court has explicitly demanded discovery. What that discovery shall yield is, as of yet, uncertain. It is hard to imagine what subset of allegations is still discoverable, and which allegations the agency did not incorporate into its pleading the first time. This might explain why the regulators were so dead set on appealing the lower court’s dismissal, rather than taking the easier road that was so explicitly offered by the district judge, that of filing a revised complaint.

Supreme Court review could be the ultimate result for the parties, and at the same time potentially establish the 21st Century’s first precedent on the law of insider trading. From the outset, Chief District Judge Fitzwater’s decision can be viewed as far more consonant with the holdings of Chiarella, Dirks, and O’Hagan, in taking a more principled and cautious view of the scope of Section 10(b) and Rule 10b-5. In sharp counterpoise, we see the Fifth Circuit’s holding to be more expansive in its application of the last three decades of precedents.

VIII.  Analysis & Commentary

A.  The Axioms of the Law of Insider Trading

We now arrive at our analysis of all that has come before. The Supreme Court’s jurisprudence on the matter of insider trading holds clear and consistent threads of reasoning that has produced certain themes over the years.

First, for decades the Justices have consistently struck a theme of focusing on the limitations of Section 10(b) liability, while concurrently delimiting the statute’s offspring, Rule 10(b)-5. The pronouncements of the Court are legion, declaring time and again that the courts are bound to apply the text of the relevant provision only, and adamantly refusing to venture beyond its plain wording.

Second, the essence of the Chiarella holding, which remains as strong today as when it was decided thirty years ago, is that there must be a true fiduciary duty, and it must truly be breached, in order to incur Section 10(b) liability. Chiarella’s precept that fiduciary duty arises from a specific relationship between the parties continues to be reaffirmed in the present day.

Third, it was the advent of O’Hagan that provided the timely and substantive next step in the natural growth of the law of insider trading. Just as Chiarella and Dirks had cemented the bonds of breach of fiduciary duty in the context of Section 10(b) liability, O’Hagan was the next and equally solid brick in the infrastructure, adding the final leg to the trilogy.

Fourth, we now impose this evolution of Section 10(b) liability upon the instant case of Cuban, where we find the district court’s opinion better reasoned and more in line with Supreme Court precedent. Indeed, Chief Judge Fitzwater exhibited sharp awareness of the Supreme Court precedents that bound him.

B.  “Well, Now I’m Screwed. I Can’t Sell.”

These seven words are the pivot upon which two federal courts turned, but in polar opposite directions. Chief District Judge Fitzwater interpreted them as a declarative that, at most, committed Mr. Cuban to an agreement to keep confidential what he had just learned about Mamma.com’s PIPE offering. The learned district judge did not find that this excited utterance bound Mr. Cuban to any further obligation to the company, its shareholders or the market at large.

In sharp contrast, the Fifth Circuit assigned the terse expletive a wholly different interpretation, or at the very least implied as much. Writing for the panel, Circuit Judge Higginbotham subscribed to the SEC’s notion that, by these few words, Mr. Cuban did in fact commit not to trade on what he had learned, and thereafter bound himself not to trade his shares evermore (or at least until the PIPE deal was made public).

We are most troubled by the Fifth Circuit’s additional gloss on the putative defendant’s words. Taken at face value, it is beyond cavil that Mr. Cuban’s declaration, obviously made in an agitated

state, certainly does not contain the words like ‘promise,’ ‘agree,’ or the like. Nor can any such words of commitment be sensibly implied from his excited retort.

We respectfully differ with the Fifth Circuit in the following additional aspects of its decision. While the panel unhesitatingly acknowledges the Supreme Court’s remonstration that there is no generalized duty between all market participants to abstain from trading, we sense that it draws an erroneous conclusion from that principle. In Cuban, the opinion as cast by Judge Higginbotham utilizes the rule of ‘no generalized duty’ as a launching point for a larger imposition of liability, without specific guidelines.

We are troubled that the Fifth Circuit made a far more permissive holding as to the government’s burden. The appeals court read more into those seven words, a great deal more, and, we respectfully contend, without just cause. In doing so, not only did the tribunal authorize the government to reinstitute this proceeding, but its expansive view of the requirements to sustain a Section 10(b) case flies in the face of the far more constrained view of insider trading prosecutions that the Supreme Court has long imposed.

C.  The Law as It Must Be

First, examining the seminal decision of Chiarella, it is our opinion that the Fifth Circuit did not take heed of the Supreme Court’s admonition that not everyone is a fiduciary who is thus prohibited from trading when knowledgeable about a certain corporate stock. Mere possession of material, nonpublic information is not egregious, and, depending upon the actor, acting upon that knowledge is not necessarily violative of the law.

Second, we apply the lessons of Dirks to the instant case of Cuban. Dirks rightfully avoided sanction because, in part, there was nothing improper as to how he was provided with the material, nonpublic information that he later disseminated. We respectfully contend that the tribunal failed to give credit in Cuban for that same circumstance.

Third, and conceivably of tremendous import for today and the days to come, why did the Fifth Circuit in Cuban apparently not heed the robust warning of the dangers of unbridled prosecutorial power enunciated in Dirks? The Dirks Court decried the hazard of loosely applied statutory prohibitions, and the damage they could wreak in the hands of an overzealous government.

Fourth, the Justices in Dirks heavily emphasized that Section 10(b) liability can only be rightfully judged on ‘objective criteria.’ We find the SEC’s case in Cuban to be fatally flawed, precisely because it cannot meet this absolute prerequisite. The regulators bet everything on the perception of Mr. Cuban’s memorable telephonic utterances.

The paramount lesson of Chiarella and Dirks, the early and seminal cases in the field, is that the government cannot proscribe conduct at its whim. The regulators are tasked with finding violations

by means of clear evidence, and pursuant to rational, principled interpretations of the controlling statute and rule made within their textual proscriptions, but not beyond. By ascribing a more

far-ranging perspective to Mr. Cuban’s excited utterances, the Fifth Circuit has given the SEC dangerously broad latitude to prosecute on evidence that is flimsy at best.

IX.  Conclusion

Insider trading is the stuff of high drama, both in real life and in fiction. It captures our attention with its high profile participants, accusations of stock market skullduggery, calls for justice by outraged prosecutors and regulators, and attention grabbing headlines when these cases reach court.

History has proven that Section 10(b) and Rule 10(b)-5 are truly the primary weapons in the continuing fight against wrongdoing in the stock market. Nonetheless, even the most well intended weapon, if wielded unwisely, will do more harm than good. Therefore, the Supreme Court has wisely delimited the reach of these two deterrents to their strict statutory texts.

Concomitantly, the Court has fashioned a set of further protections, centered mainly around the Chiarella, Dirks, and O’Hagan triumvirate of clarifying and enabling just decision-making. The first two properly confine Section 10(b) to actual breaches of true fiduciary duty, while the last necessarily encompasses the wrong of misappropriation and metes out well-deserved punishment.

As we now look at today’s Cuban case, we find ourselves in agreement with the position espoused by the district court, and concerned for the future with what the Fifth Circuit’s reversal portends.

Looking to the future, we wonder if Cuban is the rightful heir to the logic and reasoning of Chiarella, Dirks, and O’Hagan. Will it be the extension of that trilogy or merely a misguided diversion from the law’s true course? Nothing less than the future of the law of insider trading liability pursuant to Section 10(b) and Rule 10(b)-5 hangs in the balance.380

Footnotes & References

  1. Chiarella v. United States, 445 U.S. 222 (1980). Full text — Justia
  2. SEC v. Cuban, 634 F. Supp. 2d 713 (N.D. Tex. 2009), vacated, 621 F.3d 551 (5th Cir. 2010). District court: Justia —

N.D. Tex.. Fifth Circuit: Justia — 5th Cir.

  1. See generally 15 U.S.C. § 78j(b) (2006). Cornell LII — 15 U.S.C. § 78j
  2. United States v. O’Hagan, 521 U.S. 642, 651-52 (1997). Justia — O’Hagan
  3. See JAMES STEWART, DEN OF THIEVES (1992). Stewart chronicles the insider trading investigation that brought about the demise of “Junk Bond King” Michael Milken and Drexel Burnham Lambert.
  4. See Kurt Eichenwald, Two Firms Charged As Insiders, N.Y. TIMES, Nov. 3, 1986, at
  5. See, e.g., WALL STREET (20th Century Fox 1987).
  6. United States v. Stewart, 433 F.3d 273 (2d Cir. 2006). Justia — Stewart
  7. Raj Rajaratnam / Galleon Group insider trading charges. See SEC Press Release — Galleon Group
  8. Pequot Capital / Samberg insider trading probe. See SEC Press Release — Pequot/Samberg
  9. Disney assistant insider trading arrest, Bloomberg (May 27, 2010).
  10. Press Release, SEC, SEC Files Insider Trading Charges Against Mark Cuban (Nov. 17, 2008). SEC Press Release

— Cuban. Complaint: SEC Complaint PDF

  1. 15 U.S.C. § 78j(b). Cornell LII
  2. Herman & MacLean v. Huddleston, 459 U.S. 375, 389 (1983). Justia
  3. Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 474-76 (1977). Justia
  4. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 170-71 (1994). Justia
  5. 15 U.S.C. § 78a et seq. (2006) [the “Exchange Act” or the “1934 Act”]. Cornell LII
  6. 15 U.S.C. § 77a et seq. (2006) [the “Securities Act” or the “1933 Act”]. Cornell LII
  7. 15 U.S.C. § 78d. Cornell LII
  8. 15 U.S.C. § 78u. Cornell LII
  9. 15 U.S.C. § 78j(b). Cornell LII
  10. Anthony Sabino, The New Uniform Statute of Limitations for Federal Securities Fraud Actions, 19 L. REV. 485, 487 (1992).
  11. SEC v. Zandford, 535 U.S. 813, 821 (2002). Justia
  12. 17 C.F.R. § 240.10b-5 (2010). Cornell LII — Rule 10b-5
  13. Morrison v. Nat’l Austl. Bank Ltd., 130 S. Ct. 2869, 2881 (2010). Justia — Morrison
  14. Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 477 (1977). Justia
  15. Basic, Inc. v. Levinson, 485 U.S. 224, 230-31 (1988). Justia
  16. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.7 (1976). Justia. Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551

U.S. 308, 319 (2007). Justia

  1. Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 173 (1994). Justia
  2. United States v. Cusimano, 123 F.3d 83 (2d Cir. 1997). Justia
  3. United States v. Nacchio, 573 F.3d 1062 (10th Cir. 2009). Justia
  4. United States v. McDermott, 245 F.3d 133 (2d Cir. 2001). Justia
  5. United States v. Chestman, 947 F.2d 551 (2d Cir. 1991) (en banc). Justia
  6. SEC v. Cherif, 933 F.2d 403 (7th Cir. 1991). Justia
  7. United States v. Falcone, 257 F.3d 226 (2d Cir. 2001). Justia
  8. SEC v. Dorozhko, 574 F.3d 42 (2d Cir. 2009). Justia
  9. 15 U.S.C. § 78u(d)(3)(A). Cornell LII
  10. 15 U.S.C. § 78p. Cornell LII
  11. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002). Full Text — Congress.gov
  12. United States v. Mahaffy, No. 05-CR-613, 2006 WL 2224518 (E.D.N.Y. Aug. 2, 2006).
  13. Chiarella v. United States, 445 U.S. 222 (1980). Justia
  14. In re Cady, Roberts & Co., 40 S.E.C. 907 (1961). SEC Administrative Decision
  15. Dirks v. Securities and Exchange Commission, 463 U.S. 646 (1983). Justia — Dirks
  16. Carpenter v. United States, 484 U.S. 19 (1987). Justia — Carpenter
  17. United States v. O’Hagan, 521 U.S. 642 (1997). Justia — O’Hagan
  18. SEC v. Cuban, 634 F. Supp. 2d 713 (N.D. Tex. 2009); SEC v. Cuban, 620 F.3d 551 (5th Cir. 2010). SEC Complaint PDF
  19. See Thom Weidlich, Mark Cuban Wins Access to Documents in Feud With SEC, BUSINESSWEEK, 22, 2010. Cuban v. SEC, District D.C. (Sept. 22, 2010)
  20. SEC v. Zandford, 535 U.S. 813, 820 (2002). Justia
  21. Skilling v. United States, 130 S. Ct. 2896, 2930 (2010). Justia — Skilling
  22. Jonathan Dienst, Insider Trading “Rampant” On Wall St.: U.S. Attorney, NBC NEW YORK, (Oct. 21, 2010). NBC New York

Key Case & Statutory Links

About the Authors

Anthony Michael Sabino — Partner, Sabino & Sabino, P.C.; Professor of Law, St. John’s University, Tobin College of Business; Former Judicial Law Clerk to the Hon. D. Joseph DeVito, United States Bankruptcy Court, District of New Jersey. Website: St. John’s University

Michael A. Sabino — Brooklyn Law School (J.D. anticipated 2012); Intern, the Hon. Leonard B. Austin, Appellate Division, Second Department, State of New York. Website: Brooklyn Law School