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SEC’s War on Insider Trading
Jared L. Kopel
that defendants engaged in suspicious trading and had “access” to material nonpublic information. While circumstantial evidence plainly may support insider trading charges, the SEC should be required to provide sufficient probative evidence concerning the source of the inside information and not invite the jury to speculate on how the defendant obtained the information. SEC v. Goldinger, 106 F.3d 409 (9th Cir. 1997). A survey of recent cases shows an erosion of these standards. bring insider trading actions based on the newly-created affirmative misrepresentation theory. Also significant is the SEC’s action against Mark Cuban, the billionaire entrepreneur and owner of the Dallas Mavericks basketball team. Cuban had, if not greatness, confidential information thrust upon him that resulted in an ongoing litigation melodrama. Cuban held a 6.3 percent ownership interest in, and although a major shareholder, was not an officer or director. The company’s CEO allegedly called Cuban, and after purportedly obtaining his agreement to keep the information confidential, invited Cuban to participate in a PIPE (private interest in public equity) offering the company was contemplating. The SEC alleged that Cuban was upset because the PIPE offering would dilute his stockholding, and after obtaining additional information from the company’s investment banker, sold all his shares the day before the public announcement of the offering, thereby avoiding a $750,000 loss. The SEC cited Rule 10b5-2(b)(1), which provides that a duty of trust and confidence is created whenever a person agrees to maintain information in confidence. The district court rejected Cuban’s argument that the misappropriation theory required a pre-existing fiduciary relationship and not simply an agreement to keep information confidential. But the district court dismissed the SEC’s complaint on the ground that Cuban’s purported agreement to keep information about the PIPE offering confidential did not automatically include a promise not to trade on the information. The Fifth Circuit reversed and remanded, holding that the SEC’s complaint provided a plausible claim of an understanding between Cuban and the CEO that Cuban would not trade on the confidential information. SEC v. Cuban, 620 F.3d 551 (5th Cir. 2010). The court emphasized that it left for another day the questions of whether a preexisting fiduciary duty is required to invoke the misappropriation theory and the validity of SEC Rule 10b5-2(b)(1).

he Securities and Exchange Commission continues to maintain an aggressive effort against insider trading. The SEC brought 57 insider trading actions in the fiscal year ending Sept. 30, 2011. Much of the attention centered on the cases involving socalled expert networks and the government’s use of “blue-collar tactics,” such as wiretaps, that were traditionally associated with combating organized crime. But away from the headlines, the SEC has sought to extend the boundaries of insider trading law in ways that could have far-reaching consequences.


One controversial decision is SEC v. Dorozhko, 574 F.3d 42 (2d Cir. 2009), which ushered in a third category of insider trading actions that does not require a breach of fiduciary duty. The defendant allegedly hacked into the server of an investor relations firm and learned that one of its clients, IMS Health Inc., would announce quarterly results far below market expectations. Oleksandr Dorozhko allegedly purchased “out of the money” put options, which he sold for a $286,000 profit when IMS’ stock price plunged after public disclosure of the poor earnings. The district court denied the SEC’s request for a preliminary injunction on the ground that Dorozhko did not breach any fiduciary duty to either IMS or the investor relations firm because he had no relationship to either. Reversing, the Second Circuit U.S. Court of Appeals held that a breach of fiduciary duty was required only when there was nondisclosure by a defendant with a duty to disclose, but not where there was an affirmative misrepresentation, which the court considered to be straightforward fraud. The court further held that Dorozhko’s affirmative misrepresentation of his identity to gain access to confidential information in the IR firm’s computer constituted a “deceptive” act for purposes of a §10(b) violation. On remand, the trial court granted summary judgment for the SEC and ordered Dorozhko to pay approximately $580,000 in trading profits, penalty and prejudgment interest. Thus, Dorozhko allows the SEC to

Insider trading is a violation of §10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Insider cases generally fall into two categories. Under the classical theory, a person violates §10(b) and Rule 10b-5 when he trades securities on the basis of material, nonpublic information and is an insider of the corporation whose securities are traded, therefore violating a fiduciary duty owed to that corporation and its investors. Under the misappropriation theory, an individual violates §10(b) and Rule 10b-5 by trading in securities of a corporation in which the person is not an insider, on the basis of material, nonpublic information that has been misappropriated from another person or entity with whom there was a duty of trust or confidence that precluded the use of the information for personal benefit. The SEC also should not simply allege

Jared L. Kopel is a partner at Wilson Sonsini Goodrich & Rosati in Palo Alto.

The litigation since has focused on discovery disputes and Cuban’s so-far unsuccessful allegations that the SEC engaged in improper conduct. But barring a settlement, the courts eventually should determine whether the misappropriation theory encompasses a passive investor who, rather than seeking confidential corporate information, was the recipient of unsought information deliberately conveyed to him by corporate management trying to solicit an additional investment. The Cuban matter also shows that companies should ensure that any communication of confidential information to a shareholder should include an express agreement that the investor will not use the information for personal benefit (which is also important for Regulation FD compliance). Another attempted use of the misappropriation theory was rejected in SEC v. Obus, 06 Civ. 3150 (GBD) (S.D.N.Y. Sept. 20, 2010). The SEC alleged that an employee of GE Capital Corp. tipped a securities analyst about a proposed acquisition that GE Capital was financing, and that the analyst tipped his boss, Nelson Obus, who made approximately $1.34 million trading in the shares of the acquired company. The court dismissed the action, holding that the employee of GE Capital was not an insider of the acquired company, and that the misappropriation theory was inapplicable because GE Capital had no confidentiality agreement with the employee. The SEC also has relied on the so-called “mosaic” theory, which provides that scattered bits of information, not individually significant, when pieced together provided the defendants with material nonpublic information. A leading example is SEC v. Steffes, 10-CV-6266 (N.D. Ill. Aug. 3, 2011). The SEC alleged that an executive of a railway company knew that the CFO asked him to prepare a list of company-owned equipment; there were an unusual number of yard tours; and there were rumors that the company was being sold. The executive’s nephew, a trainman on the railway, allegedly saw numerous yard tours by people wearing business suits and was aware that employees expressed concern about losing their jobs. Both the executive and the nephew were aware of a tour of one yard by representatives of another company, which happened to be a potential acquirer. The ex-

ecutive and the nephew allegedly disseminated the information to members of their family, who in turned shared the information with business associates. All of these individuals allegedly earned more than $1 million in profits by trading prior to the disclosure of the acquisition. Denying the defendants’ motions to dismiss, the court stated that although the SEC’s allegations “are not robust,” the complaint sufficiently alleged that the defendants possessed material nonpublic information and had acted with scienter. In a settled action, the SEC alleged that a man visiting his sister at her office became aware that she was very busy and heard her speak on the telephone with words such as “due diligence file” and “merger structure.” The SEC alleged that the brother later purchased stock and call options in his sister’s company. The SEC did not bring any action against the sister, but accused the brother of trading while in possession of material nonpublic information he had misappropriated from his sister by violating a duty of trust and confidence that was owed to her. The brother consented to entry of an injunction and payment of approximately $315,000 in disgorgement, prejudgment interest and penalty. SEC v. Ni, CV 11 0708 (N.D. Cal. 2011). SEC v. Acord (S.D.Fla. Filed July 15, 2009) is an example of the SEC alleging, with mixed results, that individuals “had access” to material nonpublic information without expressly identifying how the defendants obtained the information. The case concerned allegations that defendants traded with knowledge of a pending acquisition of Neff Corp. by Odyssey Investment Partners LLC. Several defendants settled with the SEC. The SEC alleged that another defendant, Thomas Borell, “had access” to confidential information due to his close relationship with a Neff director and that he made significant purchases of Neff stock just prior to the acquisition announcement. The court, however, granted summary judgment for Borell. The SEC charged that another defendant, Sebastian De la Maza, learned of the proposed acquisition from contact with his daughter, who was married to Neff’s CEO, without identifying the precise conversation in which the information was communicated. A jury found De la Maza

not liable. Another defendant, Alberto Perez, was alleged to have a close relationship with Neff’s CEO and had his office at Neff’s headquarters on the same floor as the executive management. The SEC alleged Perez learned of the acquisition from “this constant access to confidential information” without identifying the source of the information. The jury found Perez liable. However, a magistrate judge, apparently skeptical of the SEC’s allegations notwithstanding the jury’s verdict, denied the SEC’s request for an injunction, and while ordering disgorgement of approximately $562,000 in trading profits, imposed only a $50,000 penalty, far less than the $1.2 million sought by the SEC. SEC v. Perez, 09-CV-21977-MCALILEY (S.D.Fla. 2011). The SEC also has brought claims based on merely suspicious trading, usually in situations where the SEC sought to freeze accounts where there was heavy overseas trading immediately prior to the announcement of a major transaction. Perhaps the most controversial recent insider trading action was the initial proceeding in March 2011 against Rajat Gupta, a former director of Goldman Sachs. Instead of filing a federal suit, the SEC instituted an administrative cease-anddesist proceeding, utilizing a provision of the Dodd-Frank Act that expanded the SEC’s ability to impose monetary penalties in C&D actions. The defense bar protested that an administrative proceeding in an insider trading action raised serious issues, including the limited discovery permitted, the lack of a jury trial and less restrictive rules of evidence than in federal court. Gupta filed a federal court action to block the C&D proceeding, and after a federal judge refused to dismiss, the SEC dropped the C&D proceeding, agreeing that any future insider trading action against Gupta would be filed in federal court in New York. The SEC subsequently filed such an action against Gupta in October, simultaneous with a criminal indictment. But the issue remains whether the SEC still has the appetite for bringing administrative insider trading actions, particularly against market professionals over whom it has regulatory authority. See In the Matter of David W. Baldt, 3-13887 (May 11, 2010).

Reprinted with permission from the January 11, 2012 online edition of The Recorder. © Copyright 2012. ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, call 415.490.1054 or