On January 14, 2022, the U.S. District Court in San Francisco denied a motion to dismiss charges filed by the Securities and Exchange Commission under an expansive new theory of insider trading liability. In a matter of first impression, the court ruled in SEC v. Panuwat[1] that a defendant with material nonpublic information (“MNPI”) about an issuer may incur insider trading liability by trading in the securities of a different and unrelated issuer that could possibly be affected by public announcement of the first issuer’s MNPI. As discussed below, this new insider trading theory – now being called “shadow trading” – significantly raises the danger level for market participants who possess nothing more than information that potentially affects an industry.
The SEC’s “Shadow Trading” Claim
Matthew Panuwat was a business development executive at Medivation Inc., an oncology-focused biopharmaceutical company. The SEC’s complaint deemed him an “expert in the biopharmaceutical industry,” based on his undergraduate and graduate science degrees, a top-school MBA, and relevant work experience in investment banking and business development. At Medivation, he worked to expand its product and development pipeline through acquisitions and licensing. In this position, according to the SEC, he “closely tracked the stock prices, drug products and development pipelines of other biopharmaceutical companies.”
Responding to unsolicited interest in acquiring Medivation, the company hired investment bankers to explore options. Working with these bankers, Panuwat saw presentations that listed Incyte Corporation as being among Medivation’s peers as a “mid-cap oncology-focused biopharmaceutical company.” Analyst reports also publicly listed Incyte among its peer companies. The SEC alleged that there were “only a few” such companies left to acquire, and that “each such acquisition was material to the remaining companies because it made them potentially more valuable acquisition targets and could thus positively affect” their stock prices, in anticipation of possible acquisition of these other companies at some future date.
Ultimately, Panuwat saw a summary of bids showing that at least five potential acquirers were proposing an all-cash acquisition of Medivation at a premium. After the bankers solicited final bids, he was copied on an email from Medivation’s CEO indicating that an acquisition of Medivation by pharmaceutical giant Pfizer, Inc. was imminent. According to the SEC, Panuwat promptly bought Incyte call options with strike prices “significantly above” Incyte’s stock price and with the “soonest possible” expiration date.
Following public announcement that Pfizer would acquire Medivation at a 21.4 percent premium to market and a 69.8 percent premium to its 52-week average closing price, Medivation’s stock price rose about 20 percent. The SEC noted that “a number of other mid-cap biopharmaceutical companies’ stock prices also materially increased” following the announcement and that, among these other companies, Incyte’s price rose about 8 percent.
Interestingly, while claiming Panuwat made profits of $107,066, the SEC’s complaint does not request disgorgement, the SEC’s traditional remedy in insider trading and other types of SEC enforcement cases.[2] However the SEC does seek a monetary penalty in an unspecified amount, a bar from serving as an officer or director of a public company, and injunctive relief.
The District Court’s Refusal to Dismiss
The district court acknowledged in its Order Denying Motion to Dismiss (“Order”)[3] that “there appear to be no other cases where the [MNPI] at issue involved a third party,” and noted that the SEC had “conceded this at oral argument.”[4] The court thus knew it was writing on a clean slate as it weighed the SEC’s new “shadow trading” theory of insider trading. For the first time, the SEC was contending that a person may not use MNPI about a company to trade in the securities of an entirely different company that the trader believes could be affected by the information pertaining to the first company. The court’s denial of Panuwat’s motion turned principally on three core elements: materiality, breach of duty, and state of mind.
Materiality Element. The court noted that the “bulk” of the parties’ arguments involved whether the information about Pfizer’s acquisition of Medivation was material to Incyte. Panuwat argued that, in a merger, information is material to the two companies involved – here Pfizer and Medivation – and not to all companies in the field. The court disagreed and said that information about one company can be material to “more than one company.”[5]
Lacking any precedent for the new shadow trading theory, the court relied simply on the Supreme Court’s classic test of materiality set forth in Basic Inc. v. Levinson: [6]that information is material if there is a “substantial likelihood” that it “would have been viewed by the reasonable investor” as having “significantly altered the ‘total mix’ of information” available. The court also noted that, “[b]ecause the standard is considered from the perspective of a ‘reasonable investor,’ it is objective.”[7]
Applying these general principles, the court ruled that, “at this point in the litigation,” the complaint “sufficiently alleged” that the MNPI that Medivation was being acquired was material to Incyte. The court agreed with the SEC that, “given the limited number” of mid-cap oncology-focused biopharmaceutical companies, an acquisition of one such company “would make the others … more attractive,” which in turn “could then drive up their stock price.”[8] Such “would” and “could” claims may suffice on a motion to dismiss, where the court accepts the complaint’s allegations and draws reasonable inferences for plaintiff.[9] Looking forward to the summary judgment or trial stages of the case, Basic will require the SEC to prove a “substantial likelihood” that news of the Medivation acquisition “significantly altered” the “total mix” of information about Incyte, one of several Medivation peer companies.
The materiality question here will ultimately be whether the “reasonable investor” would have been able to figure out that news of a Pfizer takeover of Medivation would materially drive the stock price of another company, Incyte. Related questions will include whether the reasonable investor would have concluded that the set of companies likely to be affected was what the SEC’s complaint defines as “mid-cap oncology-focused biopharmaceutical companies,” how different market definitions that include more or fewer companies would affect materiality, and whether all companies in the defined market would be affected to roughly the same degree.
An objectively-defined reasonable investor may not have made the same determinations as Panuwat, as the SEC concedes that he was an industry “expert,” with science and MBA degrees and years of relevant work experience, and thus not a typical investor.[10]
Breach-of-Duty Element. The court next considered whether by investing in Incyte Panuwat had breached a duty to his employer Medivation. The court analyzed the duty issue under the so-called “misappropriation” theory of insider trading, and thus examined whether Panuwat’s purchase breached “some fiduciary, contractual, or similar obligation to the owner or rightful possessor of the information.”[11] While the SEC charged Panuwat with misappropriating information from Medivation, there was no allegation that Medivation, as “possessor” of the information about its upcoming takeover by Pfizer, planned to use that information for any purpose and obviously not to trade or profit from others’ trading in Incyte securities.
Instead, the court analyzed the duty element by focusing on Medivation’s insider trading policy. The policy, as quoted in the opinion, does not by its terms actually prohibit anything. The policy simply warns employees that it is “illegal” to use “important” nonpublic information about Medivation to trade Medivation securities “or the securities of another publicly traded company, including all significant collaborators, customers, partners, suppliers, or competitors” of Medivation. Panuwat argued that Incyte did not fit into any of the categories enumerated in the policy. Incyte was not a collaborator, customer, partner, supplier, or competitor of Medivation. Rather, Incyte was said to be a peer company of Medivation. The court rejected this argument because it saw the policy’s enumerated categories as “mere examples.” It broadly found that “[b]ecause Incyte is a publicly traded company, it is covered by Medivation’s insider trading policy.”[12]
State-of-Mind Element. The court cited the Supreme Court’s test for scienter, “a mental state embracing intent to deceive, manipulate, or defraud,” and noted circuit authority holding that recklessness may satisfy this standard.[13] The court found scienter, “at least for pleading purposes” (i.e. at the motion to dismiss stage), based on the fact that Panuwat had not previously invested in Incyte, but did so shortly after getting the Medivation CEO’s email saying that an acquisition by Pfizer was imminent.[14]
As the case progresses beyond the dismissal motion stage, other evidence and circumstance may be considered that could be viewed as inconsistent with awareness of wrongdoing. Panuwat may have traded promptly, but traders often act quickly once they decide on a trade lest the market begin to move away from them for unrelated reasons. Panuwat traded “from his work computer,”[15] but company employees with awareness that their trades involve misuse of company information are less likely to trade on a company computer. Panuwat used his “personal brokerage account” for his trade,[16] but traders seeking to avoid detection are less likely use accounts in their own names.
Due Process Defense. The court rejected Panuwat’s fair notice due process challenge to the SEC’s first-ever shadow trading charge. The court acknowledged the absence of any other case where the MNPI “involved a third party.” And it noted Panuwat’s argument that, before this case, “no one … ever understood the insider trading laws to prohibit the type of conduct alleged.” But considering the “expansive language” of Section 10(b) and Rule 10b-5, the court found that the SEC’s shadow trading theory “falls within the general framework of insider trading.” Having already rejected Panuwat’s arguments on materiality and scienter, as discussed above, the court commented that, “[s]cienter and materiality provide sufficient guardrails to insider trading liability.”[17]
Challenges of a “Shadow Trading” Regime
Trading Like an Analyst. In the insider trading context, the Supreme Court has long recognized the importance of not chilling the analyst function. Indeed it quoted the SEC in noting “[the] value to the entire market of [analysts’] efforts cannot be gainsaid; market efficiency in pricing is significantly enhanced by [their] initiatives to ferret out and analyze information, and thus the analyst’s work redounds to the benefit of all investors.”[18] Yet the SEC’s new shadow trading theory creates substantial risk for traders who act as analysts and implicitly for professional analysts who may themselves trade as well as advise their clients to trade.
In Panuwat’s case, the SEC contends that the actual “confidential nonpublic information” at issue was limited just to Medivation and Pfizer. Specifically, the MNPI was “that Medivation was going to be imminently acquired at a significant premium to the company’s stock price” by Pfizer.[19] Nothing more. But Panuwat did not trade either Medivation or Pfizer. He instead traded another company, Incyte, one of multiple companies in what the SEC defined as the same industry.
In picking Incyte to trade, Panuwat was acting as an analyst. He appropriately relied on his own background and publicly available information: (1) his education and experience made him an “expert in the biopharmaceutical industry;”[20] (2) using public information, he had “closely tracked the stock prices, drug products and development pipelines of other biopharmaceutical companies, including Incyte” for some time;[21] (3) in addition to his own judgment, he knew that Incyte was a comparable company from public sources, as “Incyte was frequently listed as a peer mid-cap oncology company to Medivation in analyst reports”[22]; (4) based on this public information and his own judgment, he “anticipated that Incyte’s stock price would jump within less than a month on public disclosure of the upcoming Medivation acquisition announcement.”[23]
Trading With an Industry Focus. Individuals employed in a particular industry often decide to invest in other companies in the same industry. They routinely follow their industry and understand it. The “invest in what you know” principle recommended by the likes of Peter Lynch and Warren Buffett applies with particular force when trading in a company in an industry where the investor works. Yet such public company personnel may also regularly be aware of nonpublic information about their own company. And information about one company in an industry, when made public, can easily affect stock prices of other companies in the same industry.
Likewise, investment professionals, including advisers and analysts, also focus on particular industries. As these professionals do their research, including through interviews with company executives, they may become aware of significant information about a particular company in an industry. Where such information from an insider may arguably be viewed as MNPI about a particular company, the prudent investment professional will not trade that company’s stock until the information becomes public. But the investment professional focuses on the industry as a whole and will still be aware of such information in formulating general industry viewpoints, in advising clients and others trading in other companies in the industry, and possibly in making personal trades in other companies in the industry.
Particularly when viewed with hindsight – as insider trading cases always are – developments concerning one company can potentially look material to a wide range of other companies. Yet it cannot be that all of these other companies will be off limits for investment to those with possible MNPI about the first company. For example, information about strong demand for one company’s product can obviously indicate demand for its industry peers’ products – thus a reason to invest in those peer companies. And information about one company can also indicate demand for raw materials and components offered by its key suppliers – a reason to invest in the suppliers. And such information can likewise indicate demand for retailing, delivery, installation, and other services needed to bring the company’s product to consumers. Information about one company can influence views of numerous other companies.
Compliance Challenges. With the SEC likely to push its new shadow trading theory in future enforcement actions, companies will need to expand their insider trading policies and training programs. In addition to telling employees not to trade in their own company or in other companies engaged in significant dealings with their company, policies and training will now have to explain that employees should not trade in other, unrelated companies in certain situations. This will be a challenge to explain clearly and for employees to fully understand. And it may take years for many companies to do this effectively. In the meantime, employees unaware of the new theory will be in jeopardy as they trade.
The new shadow trading theory will also pose a challenge for the procedures a company may have set up to pre-clear employees’ trading. The individuals designated to pre-clear trading may never have heard of the unrelated company proposed for investment, and thus may not be in a position to evaluate the appropriateness of trading the other company’s securities. Similarly, legal departments that counsel investment professionals may likewise lack a basis to advise whether information about one company should prevent trading in another unrelated company in the same industry. Given the amorphous contours of shadow trading, any attempt to provide such pre-clearance advice would at best be speculative.
Panuwat in Perspective
Context of Insider Trading Expansion. What may be most concerning about the SEC’s new theory is the leap it makes in expanding insider trading liability. For the first quarter-century of the federal securities laws, there were no insider trading cases. Congress in 1934 understood that “the unscrupulous insider may still, within the law, use inside information for his own advantage,” but decided it was sufficient to simply require share ownership reporting by officers, directors and 5 percent holders, as this would “tend to bring these practices into disrepute.”[24] Courts generally held that insider trading did not violate state corporate law.[25] This hands-off approach changed, of course, in 1961 with an SEC finding in an administrative proceeding that insider trading violated the general antifraud provisions of the securities laws.[26]
There followed the decades of expansion that have brought us to the SEC’s present push to punish shadow trading. Under the “classical” theory, the original articulation, a company insider breaches a duty of confidence to the company by using MNPI about the insider’s company to trade or tip others to trade the company’s securities. Foundational cases involved company information like its determination to cut its dividend[27] and information about a company’s major mineral discovery.[28] Courts added the “misappropriation” theory to reach any person who breaches a duty to the source of the person’s MNPI to trade or tips others to trade. This imposed liability on “outsiders” of the company being traded – for example, employees of a company doing a transaction with the company being traded, and employees of various service providers, publications, and other entities that required that certain information be kept confidential and not used for trading.[29]
Need for Clarity. Even before Panuwat, the SEC and the courts stretched the classical and misappropriation theories far beyond their original contours during decades of aggressive insider trading enforcement.[30] But despite the Panuwat court’s attempts to rely on the misappropriation theory, shadow trading is really something different – an entirely new and unanticipated liability theory. For the first time, MNPI about one company may now, in some cases but not other cases, create insider trading liability for trading in other unrelated companies.
When Panuwat decided to trade in Incyte, any lawyer he could have consulted would have told him that the SEC had never charged people aware of one company’s information with investing in an unrelated company. One can then imagine his surprise on learning he was the subject of an SEC enforcement investigation. And while the court rejected his due process defense, it is easy to see the basis for the defense under a long line of cases requiring the SEC and other agencies to give fair notice of what their rules require.[31]
The Panuwat ruling comes amid recent calls for clarity. Over the years, insider trading law has become so amorphous and unpredictable that traders have difficulty identifying points of legal jeopardy, particularly in fast-moving trading environments. And lawyers have difficulty giving sound advice to those traders who have the opportunity to seek counsel before placing a particular trade. But the needed clarity is unlikely to come from the SEC or the courts after decades of incremental expansion of liability in litigated cases. This reality has led practitioners and academics to now ask Congress to codify insider trading law to allow fair and consistent interpretation,[32] and to the actual introduction of proposed legislation for this purpose.[33]
Ever Closer to Parity. Uncertainty chills action, and following Panuwat, mere possession of MNPI about any company may inhibit trading in certain other companies, particularly those in similar businesses, as they theoretically could be indirectly affected by the MNPI. As the Supreme Court warned, “[u]nless the parties have some guidance as to where the line is between permissible and impermissible disclosures and uses, neither corporate insiders nor analysts can be sure when the line is crossed.”[34]
The Supreme Court has consistently rejected what is termed the “parity of information” approach under which, in the absence of any duty to either the issuer or the source of the MNPI, “anyone in possession of material inside information must either disclose it … or must abstain from trading in or recommending the securities.”[35] Indeed, the Supreme Court explicitly rejected parity in its very first insider trading decision, noting that “neither the Congress nor the Commission ever has adopted a parity-of-information rule.”[36]
Yet in the wake of Panuwat, traders may now find themselves effectively operating in what is getting closer to a de facto parity regime, as the new shadow trading theory unpredictably expands liability. Under the SEC’s new shadow trading theory, traders will increasingly worry about where the line is. A wise investment decision that generates substantial profit can also generate close SEC scrutiny, often now guided by algorithmic surveillance and big-data analysis. If the SEC then connects an individual’s trading success to an announcement made by another company in the same industry, the SEC will next inquire what contact the trader may have had with the other company.
With materiality assessed in hindsight by a tough regulator, a thin causal relationship may be sufficient to launch an expensive and career-busting investigation. And what is material may in large part be determined by how the SEC staff defines the companies to include as peers in the supposedly relevant industry or sector – essentially adding a kind of market definition component to its already uncertain materiality analysis. Such further expansion of insider trading liability risk will increasingly push traders closer to the parity-of-information world that is exactly what the Supreme Court said it did not want.[37]
Conclusion
The Panuwat decision is important. It appears to launch a substantial new insider trading theory that will substantially expand liability risk for traders and others, particularly those who focus on a particular industry. Traders who lawfully have information on one company may be in SEC jeopardy when they trade in a different company, without clear guidelines. With presently no way to know how aggressively the SEC will push this new theory, insider trading policies and training programs should be updated to alert employees to the danger at hand. And practitioners should carefully consider the SEC’s contentions in future shadow trading cases.
ENDNOTES
[1] SEC v. Panuwat, 21-cv-6322 (N.D. Cal).
[2] Circumstances appropriate for disgorgement have become more uncertain since the Supreme Court’s decision in SEC v. Liu, 140 S.Ct. 451 (2019), and January 2021 legislation concerning SEC disgorgement that is now codified at Section 21(d)(3)(A)(ii) of the Securities Exchange Act, 15 U.S.C.A. §78u(d)(3(A)(ii).
[3] SEC v. Panuwat, 21-cv-6322, Doc. 26.
[4] Order, p. 12.
[5] Order, p. 7.
[6] Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988), quoting TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
[7] Order, p. 5. Citing U.S. v. Reyes, 660 F.3d 454, 468 (9th Cir. 2011).
[8] Order, pp. 7-8.
[9] E.g., Faber v. Metro. Life Ins. Co., 648 F.3d 98, 104 (2d Cir. 2011).
[10] Complaint ¶14.
[11] U.S. v. O’Hagan, 521 U.S. 642, 663 (1997).
[12] Order, p. 9.
[13] Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 n. 12 (1976); Gebhart v. SEC, 595 F.3d 1034, 1040 (9th Cir. 2010).
[14] Order, pp. 11-12.
[15] Complaint ¶33.
[16] Complaint ¶33.
[17] Order, p. 12.
[18] Dirks v. SEC, 463 U.S. 646, 658 n. 17 (1983).
[19] Complaint ¶2, 26, 30.
[20] Complaint ¶14.
[21] Complaint ¶18.
[22] Complaint ¶23.
[23] Complaint ¶4, 33.
[24] House Report No. 73-1383, 1934 WL 1290 (Leg. Hist.) at *13 (Apr. 27, 1934), accompanying H.R. 9323 (House version of what became the Securities Exchange Act).
[25] Goodwin v. Agassiz, 283 Mass. 358 (1933). Cf. Strong v. Repide, 213 U.S. 419 (1909) (“special facts” may warrant liability where insider deceitfully dealt directly with shareholder of his company); Kardon v. National Gypsum Co., 73 F. Supp. 798 (E.D. Pa. 1947); Speed v. Transamerica Corp., 99 F. Supp. 808 (D. Del. 1951).
[26] Matter of Cady, Roberts & Co., 1961 WL 60638 (SEC Nov. 8, 1961). This inaugural insider trading decision under the federal securities laws was signed by SEC Chair William Cary, for decades one of the country’s foremost securities law scholars, then on leave from Columbia to lead the SEC during the Kennedy administration.
[27] Cady, Roberts.
[28] SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968).
[29] Carpenter v. U.S., 791 F.2d 1024 (2d Cir. 1986), aff’d by equally divided court, 484 U.S. 19, 24 (1987) (journalist with publication’s information about an issuer); U.S. v. O’Hagan, 524 U.S. 642, 652-53 (1997) (attorney with firm representing acquiror of issuer).
[30] E.g. Gupta v. United States, 913 F.3d 81, 86 (2d Cir. 2019) (“personal benefit” element of tipping liability “easily inferable” from tipper’s “good relationship with a frequent business partner,” with no requirement that benefit be of a “pecuniary or similarly valuable nature”); SEC v Bauer, 723 F.3d 758 (7th Cir 2013) (confusion whether classical or misappropriation theories could be applied to insider’s redemption of fund shares); SEC v. Obus, 693 F.3d 276 (2d Cir 2012) (while issuer “did not consider itself a victim,” court still must consider whether individual “negligently disregarded” alleged impropriety of tip and “recklessly traded” in “knowing possession” of MNPI); SEC v. Cuban, 620 F.3d 551 (5th Cir 2010) (“paucity of jurisprudence on the question of what constitutes a relationship of ‘trust and confidence’”); SEC v. Dorozhko, 574 F.3d 42 (2d Cir 2009) (liability for allegedly hacking MNPI, where no duty owed to either issuer or information source).
[31] E.g., WHX Corp. v. SEC, 362 F.3d 854, 860 (D.C. Cir. 2004) (vacating sanction where, “[a]lthough WHX received informal indications that its provision violated the Staff’s understanding of the rule…, there was no formal Commission precedent or official interpretive guideline on point”); Monetta Financial Services, Inc. v. SEC, 390 F.3d 952, 957 (7th Cir. 2004) (vacating sanction where “no rules expressly required disclosure”); KPMG, LLP v. SEC, 289 F.3d 109, 116 (D.C. Cir. 2002) (“the court ‘cannot defer to the Commission’s interpretation of its rules if doing so would penalize an individual who has not received fair notice of a regulatory violation’”); Upton v. SEC, 75 F.3d 92, 98 (2d Cir. 1996) (SEC may not sanction where a “substantial change in its enforcement policy … was not reasonably communicated to the public”); General Electric Co. v. EPA, 53 F.3d 1324, 1328-29 (D.C. Cir. 1995) (due process violated where rule “not sufficiently clear to warn a party about what is expected of it”); Satellite Broadcasting Co. v. FCC, 824 F. 2d 1, 3-4 (D. C. Cir 1987) (due process requires “adequate notice of the substance of the rule,” lest administrative law practice “come to resemble ‘Russian Roulette’”);
[32] Testimony of Professor John C. Coffee, Columbia Law School, before U.S. House of Representatives Subcommittee on Investor Protection, Entrepreneurship, and Capital Markets of the Financial Services Committee (Apr. 3, 2019) (available at https://www.congress.gov/116/meeting/house/109256/witnesses/HHRG-116-BA16-Wstate-CoffeeJ-20190403.pdf).
[33] Insider Trading Prohibition Act, H.R. 2655, which passed in the House of Representatives on May 18, 2021, and has been referred to the Senate Committee on Banking, Housing, and Urban Affairs (available at https://www.congress.gov/bill/117th-congress/house-bill/2655/text). Some observers may feel that this particular legislative proposal does not provide the kind of comprehensive reconsideration and clarity that is needed, but it is significant as a Congressional recognition that some type of reformation of insider trading law is in order.
[34] Dirks, 463 U.S. at 658 n. 17. See Stephen J. Crimmins, “Insider Trading: Where Is the Line?,” 2013 Columbia Bus. L. Rev. 330 (2013).
[35] SEC v. Texas Gulf Sulphur Co., 401 F.2d at 848.
[36] Chiarella v. U.S., 445 U.S. 222, 233 (1980).
[37] In contrast, Europe consciously made the opposite choice and embraced the parity-of-information approach in a 2003 directive that simply prohibited trading by any person possessing MNPI, but that at the same time required issuers to make continuous disclosure of material information as it came available. EU Directive 2003/6/EC on Insider Dealing and Market Manipulation, referred to as the Market Abuse Directive, articles 1 and 6. The EU carried this parity approach forward into the successor Market Abuse Regulation, EU Regulation 2014/596, articles 7 and 8 (including liability for “any person who possesses inside information” and who “knows or ought to know that it is inside information”).
This post comes to us from Stephen J. Crimmins, a member of McGonigle PC, based in New York and Washington, D.C. He defends insider trading and other SEC enforcement investigations and litigation, and he was previously the SEC’s deputy chief litigation counsel and co-managed its headquarters-based Trial Unit. A version of this article first appeared in Wall Street Lawyer.