On January 14, 2022, in a closely watched decision, a federal judge in the Northern District of California denied a motion to dismiss a complaint brought by the US. Securities and Exchange Commission ("SEC") that presented a novel application of the insider trading laws on the basis of "shadow trading."1 The theory of "shadow trading" has developed around trading by an insider in shares of another company (the "competitor") while in possession of material non-public information ("MNPI") about the insider's own company, where the shares of that competitor are "economically linked" to the insider's company.2
This denial affirms the SEC's extension of the misappropriation theory of insider trading beyond targets of acquisitions, to companies "economically linked" to such targets. While the decision was based on the pleadings and depended on the specific factual allegations in the case, it has far-reaching consequences for traders and companies. Companies may now want to consider explicitly restricting trading by insiders in shares of "economically linked" companies while in possession of MNPI of the insider's company, including companies with which they do not directly do business, going beyond the traditional formulation of restricting trading in shares of business partners. Likewise, traders must be cautious about trading in the securities of a company that is not the subject of the MNPI, but is "economically linked" to the insider's company.
As discussed in our prior client alert, the SEC filed insider trading charges against Matthew Panuwat, a former employee of Medivation Inc., a mid-sized oncology-focused biopharmaceutical company, for trading ahead of the announcement that Medivation would be acquired by Pfizer Inc. The trades were not in Medivation shares. Rather, he traded in the securities of a third-party company, Incyte Corporation, which was a comparable mid-cap oncology-focused biopharmaceutical company that had traded similarly to Medivation after a previous announcement of a merger in their sector. The SEC's insider trading charges have now survived a motion to dismiss.
The SEC had alleged that "within minutes" of learning confidential information that Pfizer would acquire Medivation, Matthew Panuwat, the then-head of business development at Medivation, purchased "out-of-the-money, short-term stock options" in Incyte.3 Following the announcement of the deal, Incyte's stock price rose by approximately 8%, and Panuwat made $107,066 on his call options as a result.4 The SEC charged Panuwat with violating Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act") and Rule 10b-5 thereunder and sought to have him barred from serving as an officer or director of a public company.5
The SEC brought this case under the misappropriation theory of insider trading,6 which prohibits a person who is not an insider at a company (i.e., a corporate outsider) from trading based on MNPI obtained in breach of a duty owed to the source of the information.7
Departing from the cases typically brought under this theory, the SEC sought to expand the trading prohibition to securities of an unaffiliated company to which the trader owed no fiduciary duty and which was not part of the deal between Medivation and Pfizer. The SEC's core argument was that, considering that several potential acquirors had expressed an interest in purchasing Medivation, and that Incyte was a competitor to Medivation in an industry with very few mid-cap companies, Incyte's stock price would likely increase following the announcement of the merger as Incyte would become more attractive to potential acquirors.8 According to the SEC, Panuwat engaged in insider trading because the information of Pfizer's potential acquisition of Medivation was material to Incyte and was used with scienter in breach of a duty of confidentiality that he owed to his employer.
The Court Agrees with the SEC's Novel Application of the Misappropriation Theory of Insider Trading
Calling the SEC's allegations an "unprecedented expansion" of the Exchange Act, Panuwat moved to dismiss the SEC's complaint on several grounds.9 He argued that the SEC failed to plead adequately that (1) the information at issue was material and nonpublic; (2) he breached his duty to Medivation; and (3) he acted with intent to defraud.10 He also asserted that the SEC's theory in this case was a novel application of the misappropriation theory, which would improperly expand the insider trading law, and therefore violate his due process rights.11 The court was not convinced by any of these arguments.
The Information Was Material to Incyte
According to Panuwat, the information was not material to Incyte because Rule 10b5-1(a) requires the SEC to prove that he traded in Incyte's securities "on the basis of [MNPI] about that security or issuer" (e.g., Incyte) and not MNPI about Medivation.12 Conversely, the SEC alleged that the language of Section 10(b) and Rule 10b-5, which broadly prohibits insider trading in connection with "any security," encompasses "information that is material to more than one company."13
The court found the SEC's interpretation more persuasive because in light of "the limited number of mid-cap, oncology-focused biopharmaceutical companies with commercial-stage drugs in 2016," and the number of other potential acquirors of Medivation, it was reasonable to infer that the acquisition of Medivation would make the similarly situated companies (e.g., Incyte) more attractive to those firms that were unsuccessful in acquiring Medivation.14 For this reason, it was reasonable to infer that the stock price of Incyte would increase following the announcement, which was confirmed by the fact that Incyte's stock price increased on the day of the announcement.15 The court also quickly dispensed with Panuwat's argument that the information was public at the time of his trading.
Panuwat Breached His Fiduciary Duties to Medivation
The parties did not dispute that Panuwat owed fiduciary duties to Medivation, but Panuwat instead argued that the company's insider trading policy only prohibited trading in Medivation or certain enumerated entities. Medivation's insider trading policy prohibited trading "in the Company's securities…or the securities of another publicly traded company, including all significant collaborators, customers, partners, suppliers, or competitors of the Company" while in possession of "important information that is not yet publicly disseminated…about the Company."16 Panuwat argued that this policy only prohibited trading in Medivation and "collaborators, customers, partners, suppliers, or competitors."17 The court was not convinced by his argument and found that the plain language of the policy broadly covered "the securities of another publicly traded company" and that the word "including" simply conveyed an illustration of the types of companies listed.18 Accordingly, the court held that since Incyte is a publicly traded company, it was covered by Medivation's insider trading policy.19
Panuwat Had Scienter
The court found that the SEC's complaint sufficiently alleged Panuwat traded with scienter or intent whether the SEC had to plead facts demonstrating Panuwat used the information to trade, or merely that the SEC had to show Panuwat was simply aware of the MNPI at the time of the trades. The court found that Panuwat was aware of the MNPI at the time of the trades because he had received an email from Medivation's CEO detailing the impending acquisition. The court also found that he used that information when he traded because he purchased Incyte's securities "within minutes" after receiving the email and because he had never traded in Incyte's stock before.20
The SEC's Theory of Liability Did Not Violate Panuwat's Due Process Rights
In light of the novelty of this case, Panuwat argued that the SEC's approach "stretche[d] the misappropriation theory beyond what comports with due process" since "no one…ever understood the insider trading laws to prohibit the type of conduct alleged."21 While the court conceded that there have been "no other cases where the [MNPI] at issue involved a third party,"22 it nonetheless ruled that the SEC's theory of liability "falls within the general framework of insider trading" and the expansive language of Section 10(b).23 Notably, the court observed that the misappropriation theory reaches corporate outsiders and may involve information that is material to more than one company.24 The court also concluded that in any event the requirements of scienter and materiality provide "sufficient guardrails to insider trading liability," which prevent novel theories of liability from becoming "entirely unclear."25
The court's decision represents a significant victory for the SEC as it appears to validate the agency's novel "shadow trading" theory. It remains to be seen, however, whether the SEC can convince a jury that the information about the Pfizer-Medivation merger was in fact material to Incyte and whether the Ninth Circuit will ultimately validate the SEC's approach.
In addition, considering that the court expressly relied on the specific facts of the case, notably the fact that Medivation and Incyte were direct competitors operating in a small market, it is unclear whether the outcome would be the same with different fact patterns, such as trading in the securities of a company that is not a direct competitor or operates in a larger industry.
Nonetheless, this decision, combined with the SEC's recent proposal strengthening the requirements for Rule 10b5-1 insider trading plans, puts companies and traders on notice that the SEC may aggressively pursue novel theories of insider trading. As a result, companies should consider including, with input from counsel, explicitly restricting in their insider trading policies trading by insiders in third party companies that could be considered "economically linked."
An example of such language is below, with the "shadow trading" concept captured in bold:
"No Insider may buy or sell securities of another company at any time when the Insider has Material Non-Public Information about that company or has Material Non-Public information that could affect the share price of that company" (emphasis added).
In addition, as companies typically do, this case is a good reminder of the importance of special blackouts that prohibit trading by insiders in possession of MNPI during the pendency of an acquisition transaction.
1 Order Denying Motion to Dismiss, SEC v. Panuwat, No. 21-cv-06322-WHO (N.D. Cal., Jan. 14, 2022), ECF No. 18, available here.
2 See Mihir N. Mehta, David M. Reeb & Wanli Zhao, Shadow Trading, 96 The Acct. Rev., 367 (2021) (defining the term "shadow trading" and arguing that this type of trading is rising).
3 Complaint at 7-8, SEC v. Panuwat, No. 21-cv-06322-WHO (N.D. Cal. Aug. 17, 2021), ECF No. 1.
4 Id. at 9.
5 Id. at 9-10.
6 Order Denying Motion to Dismiss, supra note 1, at 5.
7 See United States v. O'Hagan, 521 U.S. 642 (1997) (finding insider trading where a partner in a law firm, who was retained to represent the acquirer in a tender offer, traded in the stock of the target of the acquisition).
8 Complaint, supra note 3, at 7.
9 Order Denying Motion to Dismiss, supra note 1, at 1.
10 Id. at 5.
12 Id. at 6 (emphasis added).
14 Id. at 7-8.
16 Id. at 1-2.
20 Id. 10-11.
21 Id. at 12.
22 Id. In their study of shadow trading, Mehta, Reeb and Zhao conclude that, except for a rare case involving employees tipping information about their employer's business partners, "prosecutions for shadow trading are virtually non-existent." Mehta, Reeb & Zhao, Shadow Trading, at 1.
23 Order Denying Motion to Dismiss, supra note 1, at 12.
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