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2. Insider Trading Cases Take Center Stage

September 22, 2010, 2:58 pm Peter J. Henning follows issues involving securities law and white-collar crime for DealBook’s White Collar Watch.

Recent court decisions in two civil enforcement cases filed by the Securities and Exchange Commission will put front and center the question of when trading by insiders rises to the level of securities fraud, as both cases appear headed for trial.

The civil enforcement actions against Mark Cuban, the billionaire owner of the Dallas Mavericks basketball team, and Angelo R. Mozilo, the former chief executive of Countrywide Financial, are of paramount importance to the S.E.C. as it tries to re-establish its credibility as the chief protector of the integrity of the securities markets.

Most insider trading cases brought by the S.E.C. are resolved by settlements in which the defendants neither admit nor deny a violation of the law. In the proceedings against Mr. Cuban and Mr. Mozilo, however, neither has shown any inclination to back down in the face of the S.E.C.’s claims that they traded on inside information.

About White Collar Watch

Peter J. Henning, writing for DealBook’s White Collar Watch, is a commentator on white-collar crime and litigation. A former lawyer at the Securities and Exchange Commission’s enforcement division and then a prosecutor at the Justice Department, he is a professor at the Wayne State University Law School. He is currently working on a book, “The Prosecution and Defense of Public Corruption: The Law & Legal Strategies,” to be published by Oxford University Press.

.While the amounts of money at issue are quite different, with the S.E.C. contending that Mr. Cuban avoided a loss of $750,000 while Mr. Mozilo made a profit of approximately $140 million on his stock sales, each case may ultimately require a jury trial to decide whether ambiguous evidence is enough to show whether the men violated the prohibition on trading while in possession of inside information.

The case against Mr. Cuban involves his sale of a block of shares in Mamma.com, a Canadian internet search company now called Copernic, just before it announced a stock offering known as a PIPE, or private investment in a public entity, a transaction that drove down the price of its shares.

According to the S.E.C., when Mamma.com’s chief executive informed Mr. Cuban of the impending transaction, he responded, “Well, now I’m screwed. I can’t sell.”

Mr. Cuban then received additional confidential information from a brokerage firm about the PIPE deal right before selling his stock, the S.E.C. said, and e-mails from Mamma.com executives indicated that Mr. Cuban had agreed not to sell his shares — an assertion he has vigorously disputed.

Judge Sidney A. Fitzwater dismissed the S.E.C. case in Federal District Court in Dallas last year, finding that the S.E.C. had failed to prove a securities violation because there was insufficient evidence of any agreement by Mr. Cuban to refrain from trading.

But on Tuesday, the United States Court of Appeals for the Fifth Circuit overturned Judge Fitzwater’s dismissal and returned the case to the district court for discovery and, in all likelihood, a trial on the insider trading claim.

According to the appellate court, Mr. Cuban’s alleged statement along with his subsequent receipt of confidential information provided “more than a plausible basis to find that the understanding between the C.E.O. and Cuban was that he was not to trade, that it was more than a simple confidentiality agreement.”

The Fifth Circuit Court’s assessment that the allegations are “more than a plausible basis” for finding securities fraud sends a pretty clear message to Judge Fitzwater that there is enough for this case to move forward to trial. The agreement is only an oral one, so proof of it will depend largely on what each side recalls, a classic “he said, he said” situation.

The movie mogul Samuel Goldwyn was reputed to have said that “a verbal contract isn’t worth the paper it’s written on,” and in this case the battle will be to figure what each side understood based on Mr. Cuban’s stray “now I’m screwed” comment and subsequent conduct.

I suspect this is not the type of claim that is amenable to resolution before trial on a summary judgment motion because the conflicting recollections of each side mean that a jury must decide the credibility of the witnesses to find the existence of an agreement by Mr. Cuban not to sell his shares.

The size of the loss that the S.E.C. said Mr. Cuban avoided — $750,000 — would hardly be noticeable to a multibillionaire like him, so one might think the case would settle at this point rather than going through discovery and a trial, with all the attendant legal fees. But, as Peter Lattman described him in The New York Times, Mr. Cuban is “a combative sort” — and that may be an understatement.

Mr. Cuban could appeal the Fifth Circuit Court’s order to the Supreme Court, but it is unlikely that the high court would review a decision on a preliminary motion to dismiss that turns on an assessment of the complaint. The statement that the S.E.C.’s factual allegations furnish “more than a plausible basis” for an insider trading violation probably renders futile any effort to get the Supreme Court to review it.

This is not the only case in which Mr. Cuban is fighting with the S.E.C., either. As I discussed in an earlier post, Mr. Cuban has sued the S.E.C. in Federal District Court in Washington to obtain documents under the Freedom of Information Act related to possible bias against him by enforcement division staff members. So the fight is clearly on, and it is likely to drag on for quite a while.

In the enforcement action against Mr. Mozilo, the S.E.C. plans to put the role of Countrywide Financial in the collapse of the mortgage securities market front and center as part of its claim that executives at the company misled investors about its risks.

The insider trading claim against Mr. Mozilo focuses on his accelerating sales of Countrywide stock in 2006 and 2007 when, the S.E.C. argues, he knew that the lender’s risk profile was increasing substantially.

On Sept. 16, Judge John F. Walter in Federal District Court in Los Angeles rejected a summary judgment motion by Mr. Mozilo and other defendants to dismiss the case. The judge found that there was sufficient evidence of misstatements and omissions in Countrywide’s filings and public statements to warrant a trial in which a jury will decide whether there was fraud. The trial is scheduled to start on Oct. 19.

In rejecting an argument to dismiss the insider trading claim, Judge Walter found that the shift in how Mr. Mozilo treated his Countrywide shares, adopting five trading plans or amendments in a three-month period in 2006 and 2007, was sufficiently striking that it would be up to a jury to decide whether he sold the shares on the basis of inside information that was not disclosed to the market rather than as part of an asset-diversification plan, as he has claimed.

Unlike insider trading cases involving a particular event, like a tender offer or earnings announcement, the S.E.C.’s claim against Mr. Mozilo revolves around his knowledge of Countrywide’s deteriorating financial prospects when he sold his shares. The case is similar to the criminal prosecution of Joseph Nacchio, the former chief executive of Qwest, who also sold a big block of shares before the company’s stock price collapsed.

The case against Mr. Cuban involves a small amount of money and a fairly arcane issue of the scope of the federal securities laws, while the complaint against Mr. Mozilo goes to the heart of securities laws by focusing on the conduct of a chief executive who made $140 million shortly before his company nearly collapsed.

As a symbol of the collapse of the mortgage securities market, the case against Mr. Mozilo will be viewed as an important test of whether fraud lies at the heart of the financial problems that began in 2007.

– Peter J. Henning

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