by Antonia Apps, George Canellos, and Isabel Pitaro
The Securities and Exchange Commission (“SEC”) has long wanted to find the right case to pursue so-called “shadow trading,” where insiders armed with material nonpublic information about their own company use that information to trade in the securities of another company whose stock is closely correlated, such as a peer in the same industry.[1] In SEC v. Panuwat, filed last year, the SEC may have found the perfect vehicle for extending the insider trading laws to shadow trading. On January 14, 2022, the SEC secured its first victory in the case, when Judge Orrick of the United States District Court for the Northern District of California denied the defendant’s motion to dismiss in a broadly worded opinion that could have far-reaching implications for public companies and the investment community.[2]
The Facts
According to the SEC’s complaint, Matthew Panuwat was the Senior Director of Business Development at a mid-sized oncology-focused biopharmaceutical company called Medivation, Inc. (“Medivation”). His responsibilities included pursuing strategic opportunities to expand Medivation’s drug products and development pipeline through acquisitions.[3] In April 2016, Panuwat was involved in Medivation’s acquisition discussions with potential merger partners and reviewed presentations authored by Medivation’s investment bankers that drew parallels between Medivation and Incyte Corporation (“Incyte”), another mid-size oncology-focused biopharmaceutical firm.[4] Panuwat allegedly learned from the investment bankers that large pharmaceutical companies were interested in acquiring smaller oncology-focused biopharmaceutical companies, and that Medivation and Incyte were two of the only remaining potential targets.[5] Panuwat also allegedly knew that in 2015 Medivation and Incyte’s stock prices had increased materially after another mid-cap oncology-focused biopharmaceutical company announced it was being acquired.[6]
Throughout July and August of 2016, Panuwat knew that Medivation was soliciting and receiving acquisition bids.[7] On August 18, 2016, Panuwat received a confidential email disclosing that Medivation would be imminently acquired by Pfizer at a significant premium over the company’s stock price.[8] Within minutes of receiving the news, Panuwat purchased call option contracts in Incyte with strike prices significantly above Incyte’s stock price at the time.[9] Panuwat had never before traded Incyte securities.[10] Four days later, on August 22, 2016, Medivation publicly announced the Pfizer deal.[11] Over the course of that day the price of Medivation shares rose by approximately 20%, and Incyte’s stock price rose by approximately 8%, earning Panuwat profits of $107,066.[12]
Medivation’s insider trading policy explicitly prohibited employees from trading in the securities of other companies. The policy warned that employees might receive non-public information during the course of their employment that would place them in a position to profit financially “by buying or selling . . . the securities of another publicly traded company, including all significant collaborators, customers, partners, suppliers, or competitors of the Company.”[13] Medivation’s policy declared that using such information for personal gain was “illegal.” Panuwat signed the company’s policy.
The SEC charged Panuwat with violating Section 10(b) of the Securities Exchange Act of 1934 (“Section 10(b)”) and Exchange Act Rule 10b-5 and seeks to have Panuwat barred from serving as an officer or director of a public company.[14]
Judge Orrick’s Decision
In denying Panuwat’s motion to dismiss, the district court made three rulings on the scope of insider trading liability under Section 10(b). First, the court held that information can be material to a company’s securities even if it comes from outside the company. Second, under the misappropriation theory, Panuwat breached a duty of loyalty owed to his employer (Medivation) when he traded in Incyte’s securities because Medivation’s policies were broad enough to prohibit trading in another issuer’s securities. Third, the court acknowledged that there is a split among the district courts in the Ninth Circuit as to whether the SEC must show that a trader actually “used” or was merely aware of the confidential information when trading but held that the SEC’s allegations satisfied even the “actual use” standard.
1. Materiality
A fact is material “if there is a substantial likelihood that a reasonable investor would consider it important” in deciding whether to buy or sell securities. Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988). The SEC argued that information can be material to more than one company, reasoning that business decisions by a company’s supplier, purchaser, or a peer can have an impact on that company. Indeed, Panuwat conceded that information can be material to more than one company in the merger context where the information may be significant to both the acquirer and the target, and potentially other bidders involved in the transaction. But Panuwat contended that the materiality of the information should not extend to all companies in the field. In support of his position, Panuwat cited SEC Rule 10b5-1(a), which defines “manipulative and deceptive devices” to include “the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly or derivatively, to the issuer of that security . . .”[15] In other words, in a somewhat novel argument that sought to blur the materiality and duty elements of insider trading law, Panuwat contended that materiality was inextricably linked to the source of the information.
The court sided with the SEC in finding that Rule 10b5-1(a) did not limit the broad reach of Section 10(b) which prohibited insider trading in “any security.”[16] The court held that Rule 10b5-1(a)’s list of manipulative and deceptive devices was “not exhaustive”; thus, even if the rule required information about an issuer to come from the same issuer, the rule provided but “one example of a manipulative and deceptive device prohibited by law.”[17] Further, the Basic materiality test did “not assign a source to the information at issue” and focused only “on whether the information is significant ‘to the issuer of the securities.’”[18] Thus, the court concluded: “[i]f information may be material to more than one company – as the parties agree – it follows that it may be material to more than the two companies specifically engaged in the transaction.”[19]
Judge Orrick found that the SEC had sufficiently pleaded materiality based on the following allegations: the limited number of mid-cap, oncology-focused pharmaceutical companies with commercial-stage drugs; the number of bidders in the market; the fact that the acquisition of one such company would make the others more attractive; and that the Pfizer-Medivation merger would very likely be consummated.[20] This conclusion was “further confirmed” by the fact that Incyte’s stock price increased significantly on the day that the Pfizer-Medivation merger was announced.[21] Through this analysis, the court effectively held that the potential for Incyte to be acquired by another company qualified as material information even though Incyte was not engaged in merger discussions with any other company, no company had expressed an interest in acquiring Incyte or made any proposal to acquire Incyte, and Incyte had not expressed an interest in being acquired.
2. Breach of Duty
The parties did not dispute that Panuwat owed a duty Medivation. Panuwat contended, however, that Medivation’s policy did not prohibit trading in Incyte securities because the SEC did not allege that Incyte was a “collaborator, customer, partner, supplier or competitor,” – the categories of companies expressly mentioned in the company’s policy – and instead merely alleged that Incyte was a “comparable peer company.” Relying on the broad language of Medivation’s insider trading policy, the court rejected Panuwat’s contention. The court held that the word “including” placed before the list of companies in whose securities trading was prohibited meant that the policy’s reach extended beyond the specifically enumerated categories of companies listed.[22] According to the court, because Incyte was a publicly traded company, it was covered by the policy. This broad interpretation of the company policy set no limits on the types of issuers captured by the policy’s prohibition on trading.
Notably absent from the court’s analysis was whether a company’s insider trading policy, if drafted narrowly, could furnish a defense to potential insider trading charges. Thus, if Medivation’s policy had stopped short of prohibiting trading in Medivation’s competitors, and only prohibited trading in suppliers or purchasers (which would not include Incyte), could the policy be read to implicitly authorize employees to trade in securities of peer firms such as Incyte and thereby vitiate liability under Section 10(b)? In other words, if the prohibition is not contained in the policy, which presumably means there is no duty of trust and confidence with respect to the information, is the insider free to trade? The district court’s opinion makes no mention of this hypothetical because it was, in the court’s view, foreclosed by Medivation’s express policy. However, this question is one that public companies should carefully consider when drafting their insider trading polices.
3. Trading “On the Basis Of”
To establish liability for insider trading under Section 10(b), the SEC must show that the trading was “on the basis of” the material nonpublic information. The SEC has issued a rule stating that trading is “on the basis of” information if the trader “was aware of” (i.e., knowingly possessed) the information; the SEC need not show that the trader actually “used” or relied upon the information.[23] While this issue has long been settled in the government’s favor in the Second Circuit,[24] the Second Circuit’s position was roundly rejected by the late Justice Scalia in a decision denying a petition for certiorari to the Supreme Court, and district courts in the Ninth Circuit have disagreed as to the appropriate standard.[25] Without resolving the issue, Judge Orrick held that the SEC’s allegations satisfied the more stringent “use” standard.[26] Panuwat had never traded Incyte securities previously, and he invested a significant amount of money in out-of-the-money call options “within minutes” of learning that Medivation would very likely be acquired by Pfizer. These allegations provided sufficient circumstantial evidence of actual use.
Analysis and Takeaways
If Panuwat is ultimately found liable, it will be the first case where the SEC has successfully prosecuted an insider of one company for trading in the securities of a different company based on confidential information unrelated to a transaction or potential transaction between the two companies. In arguing the case to the court, the SEC lumped Panuwat’s “shadow trading” into the same category as trading in the securities of companies’ suppliers or purchasers. But there is a difference between trading in a closely correlated but unconnected company, such as peer firms in a small industry, and trading in the securities of a company’s supplier or purchaser. The government prosecuted the latter fact pattern in the expert-networking cases in the 2010s: company insiders, who moonlighted as consultants for expert-networking firms, were prosecuted for tipping confidential information about their companies’ suppliers or purchasers to hedge fund traders who used the information to trade in the securities of the other companies. For example, when a Dell insider disclosed to hedge fund traders material nonpublic information about how many hard-drives Dell had purchased from Western Digital, and the trader then used that information to purchase Western Digital stock, the insider was held to have violated both Section 10(b) and wire fraud under 18 U.S.C. § 1343.[27] But a critical difference between the expert-networking cases and the shadow trading in SEC v. Panuwat is that the companies in the expert-networking cases had entered into confidentiality agreements with their suppliers or purchasers. As a result, disclosure of the suppliers’ or purchasers’ confidential information by the Dell insider violated express confidentiality provisions protecting the supplier’s or purchasers’ information. Indeed, the government took pains to show that Dell had signed a non-disclosure agreement with Western Digital protecting the information confidential to Western Digital, and that the Dell insider was aware of his employer’s confidentiality obligations to its supplier.[28] In Panuwat, by contrast, there is no confidentiality agreement between Medivation and Incyte; indeed, there is no confidential information from Incyte at all. Instead, the scope of Panuwat’s duty is determined solely by the language of his company’s insider trading policy.
The implications of the Panuwat decision could be far reaching. The SEC may be emboldened by this recent decision to pursue its agenda of prohibiting “shadow trading,” whether by bringing actions against public company insiders (the tippers) or the investment advisers and asset managers (the tippees) that may receive the information from public companies. The reasoning of SEC v. Panuwat could apply to any fact pattern in which information concerning one company is likely to affect the stock price of another company or even an entire industry. That would be the case not just when one company’s acquisition foretells the potential acquisition of another company but whenever there is a significant correlation between the stock prices of two or more companies.
For example, investors often look to the just-announced financial results of one company as a predictor of the soon-to-be-announced results of other companies in the same industry. Thus, the announcement of strong earnings by Bank of America may elevate the stock price of Wells Fargo and JPMorgan while the announcement of weak results by Uber Technologies Inc. could depress the price of Lyft, Inc. Is anyone with knowledge of the unannounced financial performance of one company thereby prohibited from transacting in the securities of other companies in the same industry or ETFs that track all stocks in the industry? If so, what level of correlation in stock price performance is necessary to satisfy the element of materiality and thereby trigger application of the insider trading laws?
Public companies should carefully examine the language of their insider trading policies. Given the broad interpretation applied to Medivation’s policy in Panuwat, a policy that simply restricts trading in the stock of the issuer, its customers and affiliates, without specifying other types of companies, may be confusing and encourage the view that trading in the securities of other companies is authorized even if based on information acquired as part of employment. Companies should consider providing employees with additional training on their trading policies in light of the Panuwat decision.
Asset managers, meanwhile, will need to assess whether shadow trading presents a risk to their own investment strategies. Many asset managers receive information under non-disclosure agreements with public companies, gaining access to data rooms that may contain market analyses by the issuer of its competitive position in the marketplace, which, in turn, could include analyses of economically-linked peer firms. Whether information material to one company is also material to another company will need to be analyzed with care, as materiality is an issue that is judged in hindsight by the government. Accordingly, investment advisers should scrutinize the language of their non-disclosure agreements with issuers, keeping in mind that courts may interpret their reach broadly, as the court did in Panuwat.
Moreover, both broker-dealers and SEC-registered investment advisers are required to maintain policies and procedures reasonably designed to prevent the misuse of material nonpublic information in violation of the securities laws.[29] To comply with this requirement, many firms maintain watch lists or restricted lists that include the names of companies with which the broker-dealer or investment adviser has entered into a non-disclosure agreement or is contemplating a strategic transaction and sometimes also the names of material suppliers or customers of such companies. Very few such lists, however, call for restrictions or surveillance of trading in the securities of comparable companies or entire industries. When, if ever, does the law require regulated financial institutions to monitor and/or restrict trading in such securities?
The trading at issue in Panuwat involved the securities of a peer company in a small industry that was closely correlated to insider’s company. The SEC allegations paint a picture of very specific, highly confidential information to one company (Medivation), that was clearly material to the stock price of another company (Incyte), and which did in fact cause the peer firm’s stock price increase. And the company’s insider trading policy was broadly worded to capture trading in any other public company, according to the court. It is unclear to what extent the Panuwat decision will extend beyond cases involving closely correlated or economically linked companies in small industries to the broader examples noted above.
Footnotes
[1] The term “shadow trading” was first coined in an academic article, which claimed that this type of trading has been on the rise. Mihir N. Mehta, David M. Reeb & Wanli Zhao, Shadow Trading, 96 The Acct. Rev., 367 (2021).
[2] SEC v. Panuwat, No. 21 Civ. 6322 (WHO) (N.D. Cal.).
[3] Complaint at ¶ 18, SEC v. Panuwat, No. 21 Civ. 6322 (WHO) (N.D. Cal. Aug. 17, 2021), ECF No. 1.
[4] Id. at ¶¶ 21-22.
[5] Id. at ¶ 22.
[6] Id.
[7] Id. at ¶ 25.
[8] Id. at ¶ 30.
[9] Id. at ¶ 33.
[10] Id.
[11] Id. at 36.
[12] Id. at 36-37.
[13] Id. at ¶ 20.
[14] Id. at 7.
[15] 17 C.F.R. § 240.10b5-1(a) (emphasis added).
[16] SEC v. Panuwat, No. 21 Civ. 6322 (WHO), slip op. at 7.
[17] Id.
[18] Id. (citing Basic Inc. v. Levinson, 485 U.S. at 250).
[19] Id. at 7.
[20] Id. at 7-8.
[21] Id. at 8.
[22] Id. at 9.
[23] 17 C.F.R. § 240.10b5-1(b).
[24] United States v. Whitman, 555 Fed. Appx. 98, 107 (2014) (holding that defendants “violate the law when they trade ‘while in knowing possession’” of material nonpublic information and affirming a jury instruction that the inside information must be “at least a factor” in the trading decision)
[25] Compare In re Countrywide Fin. Corp. Sec. Litig., 558 F. Supp. 2d 1132, 1202-03 (C.D. Cal. 2008) (holding in a civil case that “[s]cienter … for insider trading requires that the insider actually use … the inside information in deciding to make the trade.”) and U.S. v. Smith, 155 F.35 1051, 1069 (9th Cir. 1998) (holding in a criminal case that “Rule 10b–5 requires that the government … demonstrate that the suspected inside trader actually used material nonpublic information in consummating his transaction.”) with SEC v. Moshayedi, No. CV-12-01179, 2013 WL 12172131, at *13-14 (C.D. Cal. Sept. 23, 2013) (holding in a civil case that “to show that [the defendant] traded ‘on the basis of’ nonpublic, material information, the SEC must demonstrate his awareness of possession of that information.”).
[26] SEC v. Panuwat, No. 21 Civ. 6322 (WHO), slip op. at 10-11.
[27] Information, U.S. v. Devore, No. 10 Crim. 1248 (JSR) (S.D.N.Y. Dec. 10, 2010), ECF No. 3.
[28] The Dell policies also explicitly prohibit trading or tipping information about Dell’s suppliers.
[29] See 15 U.S. Code § 80b–4a; 15 U.S. Code § 78o(g).
Antonia Apps and George Canellos are partners, and Isabel Pitaro is an associate, at Milbank, Tweed, Hadley & McCloy LLP.
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