Wednesday, October 20, 2010

Taking on a Business Partner

If you are thinking of taking on a business partner, you may want to check out the article I published on that topic in the September/October issue of N.E.T. Business Resources magazine.  It can be found here:

Thursday, October 14, 2010

Is Mark Cuban Gordon Gekko?

Mark Cuban, of course, is the billionaire owner of the Dallas Mavericks.

Gordon Gekko is the fictional anti-hero portrayed by Michael Douglas in the classic 1987 film Wall Street.  Gekko is perhaps the person most associated with insider trading in U.S. popular culture.

So what does Mark Cuban have in common with Gordon Gekko?  Too much, alleges the United States Securities and Exchange Commission (SEC).  

Factual Background

In 2004, Cuban sold his entire 6.3% stake, or 600,000 shares, of Inc. (the Company) just before the Company announced a stock offering which would be dilutive to the Company’s existing shareholders.  The stock offering was poorly received by the stock market and the Company’s stock price dropped.  As a result, Cuban was able to save approximately $750,000 by liquidating his shares just before the stock offering was announced.  Cuban learned of the stock offering one day before the investing public when the Company’s CEO called Cuban to inform Cuban of the offering and to give Cuban an opportunity to participate in the offering as an investor.  Based upon the documents in the public record, those facts appear to be undisputed.

It is less clear exactly what was said when the Company’s CEO called Cuban, but the SEC alleges that Cuban agreed to keep information regarding the stock offering confidential.  In fact, the SEC claims that Cuban reacted to the information by saying, “Well, now I’m screwed.  I can’t sell.”  Cuban has denied that there was any confidentiality agreement between him and the Company.

The SEC filed suit against Cuban alleging that Cuban was guilty of insider trading.  Specifically, the SEC claims that Cuban traded the Company’s securities while in possession of material, non-public information in violation of a duty of “trust and confidence” that he owed to the Company.  If the SEC can prove those charges, Cuban may be found to have violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 (the Exchange Act), and/or Rule 10b-5 under the Exchange Act.

So is Mark Cuban guilty of insider trading?  There are a number of legal and factual issues that must be resolved by the courts before that question can be answered.

The Law of Insider Trading

There is no federal securities law that directly prohibits insider trading.  Instead, the SEC has attempted to restrict investors from trading in securities while in possession of inside information by relying on the general anti-fraud provisions of the federal securities laws. 

Under the so-called “classic theory” of insider trading, an insider (such as an officer or director) of a company is deemed to have a duty to the shareholders not to buy or sell stock while in possession of material, non-public information.  Because the company insider has a fiduciary duty to the shareholders, it is considered fraud under federal securities laws for the insider to take advantage of the company’s shareholders by trading on the basis of information that is actually the property of the shareholders themselves.  Accordingly, the insider has a duty to disclose inside information or abstain from trading while in possession of inside information.

Classic insider trading theory does not reach Company outsiders, however, who have no duty to the Company’s shareholders.  So under classic insider trading theory, company outsiders cannot commit securities fraud on the shareholders because the outsiders have no duty to the shareholders.  Without a duty being breached, the outsider could not be guilty of deception as required under the anti-fraud provisions.  This result seemed unfair to the investing public, so the courts developed the “misappropriation theory” of insider trading.  Under the misappropriation theory, any person who acquires material, non-public information as a result of a relationship of “trust and confidence” cannot misuse that information by buying or selling securities without committing securities fraud.  The misappropriation theory uses the violation of such “trust and confidence” to establish the deception needed to prove securities fraud.  For example, the Supreme Court has ruled that an attorney who acquires knowledge of a confidential takeover attempt through the “trust and confidence” of the attorney-client relationship cannot use that inside information to trade in securities of the company that was the target of the planned takeover attempt.      

Cuban’s Defense

So far, Cuban has raised several defenses to the insider trading claims, including, among other things, the following:

  1. He never agreed to keep the information confidential.  Accordingly, the conversation between Cuban and the Company’s CEO did not create a relationship of “trust and confidence” between the Company and Cuban which could give rise to insider trading liability.

  1. Even if he did enter into a confidentiality agreement with the Company, he never agreed to not to trade upon the information.  Accordingly, the trading itself did not violate anyone’s “trust and confidence,” and thus cannot be deemed insider trading.  

  1. Even if he did enter into a confidentiality agreement with the Company, he did not otherwise have a relationship of “trust and confidence” with the Company.  A “naked” confidentiality agreement, without more, does not by itself create a fiduciary-like relationship of “trust and confidence” similar to the relationship of a company officer or director with the company’s shareholders or an attorney-client relationship.

The Dallas district court accepted Cuban’s argument #2 above and dismissed the SEC’s case.  The court reasoned that the duty to keep information confidential was logically distinct from a duty to refrain from trading on the basis of such information.  Thus, by failing to allege that Cuban had agreed not to trade on the confidential information, the SEC failed to allege facts that could support a breach of a duty not to trade by Cuban.  Without such a duty, Cuban could not have breached a duty that would give rise to an insider trading claim.

The SEC appealed the district court’s decision to the Fifth Circuit Court of Appeals.  The SEC argued, among other things, as follows:

  1. An agreement to keep information confidential encompasses and necessarily implies an agreement not to trade the Company’s securities until the information became public.  Such a duty is recognized by the SEC’s Rule 10b5-2 under the Exchange Act and by common sense.  The Company would not have volunteered detailed confidential information about the pending stock offering if it had known that Cuban would promptly trade upon the information.  Likewise, a reasonable recipient of such confidential information would not believe that such trading was authorized.  

  1. Even if the court was unwilling to rule that all confidentiality agreements implied a duty not to trade, this particular confidentiality agreement included an understanding of the parties that it included a duty not to trade.  That understanding was evidenced in part by Cuban’s comment, “Well, now I’m screwed.  I can’t sell.”
The Fifth Circuit court reversed the district court and remanded the case for further fact gathering proceedings.  The court reasoned that the SEC’s allegations provided a “more than plausible” basis to find that there might have been an understanding between the Company and Cuban that Cuban would not trade on confidential information.  If so, such an understanding might be the basis for a relationship of “trust and confidence” which might give rise to an insider trading claim.  The court noted that there is little jurisprudence on the question of what constitutes a relationship of “trust and confidence” for the purposes of insider trading law and that such a determination is “inherently fact-bound.”  Therefore, the court concluded that further development of the factual record would be necessary.
The Takeaway      

It may be quite a while before the factual and legal issues arising in this case are fully resolved.  In the meantime, it would be wise for any public company seeking private financing or otherwise considering privately disclosing material, non-public information to consider obtaining a written confidentiality agreement from the party receiving such confidential information prior to disclosing the information.  The confidentiality agreement should include an agreement by the receiving party not to disclose OR USE the confidential information, including trading securities issued by the disclosing company, until the information becomes publicly available.  

Further Information

Copies of the key pleadings and court decisions related to this matter are available of the University of Denver’s website here:

Wednesday, October 6, 2010

Representations and Warranties

 "Why do we have to have all these Representations and Warranties?" 

That is a common complaint in merger and acquisition transactions (and other transactions for that matter).  For example, a 75-page purchase and sale agreement might have 30 pages of reps and warranties in which the seller certifies various facts about the seller's company. 

The Seller's reps and warranties serve at least three important functions in a purchase and sale agreement:

(1) They serve a disclosure function.  By asking the seller to rep and warrant facts about the seller's company, the buyer learns valuable information about what may be less-than-perfect about the seller's business.  For example, if the purchase and sale agreement asks the seller to rep and warrant that the seller's company has no pending litigation, the seller would (or at least should) disclose that the seller's company has just been sued by one of its largest customers.

(2) They give the buyer an "out" to avoid closing.  The purchase and sale agreement typically provides that the deal will not close unless all of the seller's reps and warranties are true and correct in all material respects as of the signing date and as of the closing date.  Therefore, if the buyer becomes aware of an inaccurate rep or warranty during its pre-closing due diligence period, the buyer may be able to refuse to close the deal or may be able to demand concessions from the seller prior to the closing.  For example, if the buyer learns before the closing that the seller's company has spilled hazardous materials on one of its properties that was not disclosed by the seller in the purchase and sale agreement, the buyer might request a reduction of the purchase price. 

3) They give the buyer the right to sue the seller.  If the purchase and sale agreement provides that the seller's reps and warranties "survive" the closing, then the buyer can typically sue the seller for breach of contract during such survival period if the buyer can prove that one or more of the seller's reps and warranties was inaccurate as of the closing date. 

Of course, no seller likes to make pages and pages of representations and warranties, but those reps and warranties are typically critical to a buyer to assure the buyer is really getting the company that the buyer expects.