Tuesday, November 18, 2008

SEC Accused of "Gross Abuse of Prosecutorial Discretion"

That sounds serious, but given the context and timing of the allegation, maybe not. The accusation comes from Mark Cuban, the billionaire owner of the Dallas Mavericks, in response to an SEC complaint charging him with insider trading.

Cuban was the founder of Broadcast.com, which he sold to Yahoo! for some 6 billion dollars back in the Internet stock heyday.

The underlying allegations occurred in 2004 (does the SEC know that it is 2008? Where they heck have they been for 4 years? They get 4 years to investigate, Cuban will get 30 days to respond. Great system we have).

The complaint alleges that Cuban had a 6% stake in search engine Mamma.com, and was approached by the CEO of Mamma to purchase additional shares in a PIPE offering. According to the complaint, which goes to great pains to repeatedly allege that Cuban was told the information was confidential, Cuban became angry during the conversation, because, according to the SEC, PIPEs dilute existing shareholders and told the CEO, "Well now I am screwed. I can't sell." A very convenient allegation.

That allegation is convenient because it is designed by the SEC to show intent - that Cuban knew that he had material nonpublic inside information that he could not use to trade. They attempt to bolster that allegation by quoting an email from the CEO to the Board of Directors of Mamma, which says that Cuban threatened to sell, after the announcement of the PIPE. In fact, that allegation is gratuitously inserted in the complaint in 4 separate places. Perhaps the staff doth protest too much?

The complaint alleges that Cuban had a second conversation with Mamma's investment banker about the PIPE, and he called his broker, ordering a sale of all of his shares. The broker sold 10,000 shares afterhours at $13.50 and sold the rest of his shares the next morning at $13.29. The announcement of the PIPE was made after the close, and on the next day the stock opened at $11.89.

The complaint also alleges that Cuban has publicly stated that he sold because he did not want to be diluted in the PIPE, and that the Cuban didn't tell Mamma that he was selling, implying that he had an obligation to do so. He did not.

This all sounds very damning, and the Internet is abuzz with stories about the case, with most reporters and bloggers having Cuban convicted, fined, penniless and in jail. (Cuban cannot go to jail over this complaint, it is a civil complaint. The SEC cannot put anyone in jail). That is one of the endearing qualities of the Internet. Everyone has an opinion, everyone can express it, regardless of intellect, or the facts. One reporter said it looked like a Martha Stewart case, which demonstrates sheer lack of understanding, since Martha was a defendant in a criminal case, for obstruction of justice, not insider trading.

This is going to be a tough case for the SEC, as it relies solely on the testimony of the CEO of Mamma, and is going to be a classic "he said, she said" type of case, which is not good for the party with the burden of proof, in this instance, the SEC. An important aspect of the case is what information was given to Cuban in those two telephone calls.

And everyone is excited about the CEO's comments that Cuban knows he can't trade. Well, those allegations are not only convenient for the SEC, they are convenient for the CEO. Obviously, I don't know what happened here, but there is another senario - there is something called tipee liability, which places responsibility for insider trading on the person who disclosed the information. While it doesn't sound like it would apply, it might, and if it did, the CEO has potential liability. If that were to be true, then he has to claim that this tortured conversation about confidentiality, lest he be charged with tipping Cuban, a charge which could lead to him being removed from the Board, and filed millions of dollars. So, there is a bit of incentive there. Again, I am ruminating here, none of this has been alleged anywhere.

Another interesting twist is that Mamma was the subject of an informal SEC investigation during this time, since March 2004. According to the company itself, the SEC was investigating the trading in the company's stock, its acquisition activity and its reporting activity. Not a good omen for the company.

Assuming the Staff can prove the conversations, they have to prove that the information was material and non-public. Cuban's defense will certainly focus on these two elements. The SEC is going to have a tough time with the materiality argument. While the SEC claims that the PIPE was going to drive the price of the stock down, that is not a foregone conclusion, and the facts could lead to a different conclusion.

The effect of a PIPE on the price of a stock depends on the structure of the PIPE. According to some studies, PIPES have a positive impact on the price of the stock, again, depending on the structure of the offering. In this case, it appears that the PIPE was for common stock and warrants, and the warrants were exercisable at nearly $16 a share, which would drive the price of the stock UP, not down. I am doing this based on SEC filings by the company, and have not seen the PIPE offering memorandum, so this could be off.

A review of the underlying trading in Mamma supports this thesis, and belies the SEC's allegation that the stock was going to go down and Cuban knew it.

If you just read the SEC complaint, you would think that the decline from $13.50 to $11.00 in Mamma was significant or unusual. Take a look at a chart of Mamma during this time frame, there is something going on in the stock, and it has nothing to do with Mark Cuban. On May 12, 2004 the stock closed at $10.43 and traded 2 million shares. The very next day, its volume jumps to 22 million shares, and goes up 30%, closing at $13.21. Someone knew something. It then drops back down to 11.

Then it gets interesting. On June 25 it closes at $11.92, with less than half a million shares trading. Mark Cuban owns more shares that the the entire day's trading volume. The SEC alleges that the PIPE was being processed, but not disclosed, at this time. We know from the complaint that the CEO of Mamma is on the phones on the 28th, trying to get buyers for the PIPE. On the 28th, before Cuban sells a single share, the stock jumps from $11.92 to $13.75!

With that price movement, the Staff is alleging that he was trying to avoid a loss? Every objective indicator says that the stock is going UP, not down. The stock has just moved from $11.00 to $13.00 in two days, the company has sold warrants exercisable at $15.82, and is raising $16 million dollars. There is nothing there to suggest that the PIPE is going to decrease the share value.

The SEC is going to be hard pressed to say that Cuban sold his shares to avoid the resulting loss. Cuban is a maverick (no capital letter) and does what he wants. A fair reading of those allegations is that he sold his stock because he was pissed off, felt he was being mistreated, and was not going to be pushed around by some CEO of some rinky-dink second rate, silly-named search engine. So, he sold his stock, undoubtedly trying to sell all of it in one shot, all 8 million dollars of it.

It looks like he tries to sell it after hours, only gets off 10,000 shares, and then he dumps his 590,000 shares the next morning. Cuban, who is a savvy investor, dumps his entire holdings the next day. His sales alone will push the stock price down, he is selling more than the entire daily volume in the stock on some days. If you want to impute knowledge to Mark Cuban, he knows that putting in an order to sell 600,000 shares of a stock that trades less than a million shares a day, is going to depress the price of the stock. And he doesn't care!

This is not a man looking to avoid a loss. This is a billionaire making a point - don't bully me, don't push me around, and don't try to dilute me. I am out of here.

That is hardly insider trading. That is an aggressive business man, making a point.

And you gotta love him. He response to the SEC's press release?

I am disappointed that the Commission chose to bring this case based upon its Enforcement staff’s win-at-any-cost ambitions. The staff’s process was result-oriented, facts be damned. The government’s claims are false and they will be proven to be so.


The SEC Insider Trading complaint is online at the Commission's website.

Mark Cuban's response is at his blog, under the post "The SEC."

It will be interesting to watch.
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