Academic journal article Northwestern University Law Review

Insider Tainting: Strategic Tipping of Material Nonpublic Information

Academic journal article Northwestern University Law Review

Insider Tainting: Strategic Tipping of Material Nonpublic Information

Article excerpt

"The CEO prefaced the call by informing Cuban that he had confidential information to convey. . . . Cuban became very upset and angry during the conversation . . . . At the end of the call, Cuban told the CEO 'Well, now I'm screwed. I can't sell.""

A joke in the private fund space: The holders will know who each other are, who owns 2%. They'll say "Wise guys! Let's send this [information] over to them!"

INTRODUCTION

Across legal domains-from commodities to securities, contracts to property-we assume that everyone wants information. Yet, as Dallas Mavericks owner Mark Cuban discovered, knowledge can be a curse. American securities law prohibits trading on the basis of "inside information," such as an early tip about corporate strategy sure to presage a swing in the stock price.1 Cuban became the subject of a nine-year-long SEC insider trading enforcement action because of one such tip. He sold his stake in Mamma.com soon after the CEO told him about a confidential plan to dilute the existing shareholders by issuing new shares. The sale may have saved Cuban $750,000.2 But Cuban claimed that he had preexisting plans to sell his shares and that he did not need or want additional reasons to do so.3 The CEO's tip put Cuban in a difficult position: either cancel the planned sale or endure almost a decade of costly and risky litigation.

From the CEO's perspective, discouraging Cuban's sale was not a bad thing. After all, Cuban was the company's largest shareholder with 6.3% of the stock.4 A sale by such a major investor would have sent shock waves through the shares of the small company, frustrating the planned securities offering. Relatedly, Cuban's large stake might have been a sufficient toehold for an activist investor to agitate for change at Mamma.com. Cuban's sale of shares endangered the managers' plans and their jobs.

Thus the management of Mamma.com had several reasons to try to keep Cuban from selling shares, and the discussion of confidential stock offerings could have helped bind him in place. By tainting Cuban with inside information, the managers heaped risk into Cuban's exit path; more prudent investors would have relented and retained their shares.

The Mark Cuban case offers a glimpse into the secretive world of "insider tainting." Whereas most informational tips open doors, insider tainting closes doors. Rather than empowering and enriching the recipient, the tipper conveys information precisely in order to constrain the tippee. Tainted with inside information, the tippee faces legal risks to her preexisting or potential trading plans. By leveraging high-stakes public law to serve as a threat, insider tainting confers power over the trades of others.

It may seem surprising that tainting is possible. Criminal law is supposed to punish only the culpable, and even civil offenses in the securities world are supposed to require scienter (i.e., "intent to deceive, manipulate, or defraud"5). Moreover, familiar features of insider trading law would seem to protect innocent traders. It is usually lawful to trade on a hot tip unless you assumed a duty of trust and confidence or unless your source breaches such a duty by sharing the secret with you in order to secure a personal (often pecuniary) benefit.6 Yet the victims of insider tainting do not intend any wrongdoing, they do not promise confidentiality, and their antagonists act out of spite rather than to some kind of quid pro quo.

Nevertheless, insider tainting is viable. Some forms of insider trading are illegal even if the trader assumed no duty, conferred no benefit, and genuinely tried to avoid the tip.7 More importantly, insider trading cases are characterized by expansive law and ambiguous facts, and so there are numerous circumstances where traders may rationally fear that trading could lead to trouble even when the law is on their side. Cuban escaped liability by proving that he never promised confidentiality, but it took nine years for him to establish his version of the facts, and he may only have succeeded because the accusing CEO refused to testify against him. …

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