Recent SEC “Shadow Trading” Case Signals Potential Expansion of Insider Trading Law

Recent SEC “Shadow Trading” Case Signals Potential Expansion of Insider Trading Law

May 8, 2024, Covington Alert

The Securities and Exchange Commission’s recent trial victory could signal significant changes in the law of insider trading and present new challenges for public companies. On April 5, 2024, a federal jury in the Northern District of California found a company employee liable in an insider trading case with unique underlying facts—unlike the typical insider who trades in the employer’s securities, the trader here traded in the securities of a third party, not the source or subject of the material nonpublic information. While this decision provides an opportunity for public companies to re-examine and possibly clarify their insider-trading policies and guidance for employees, the decision rests on important, particular facts that may limit its applicability to other situations.

The defendant in the SEC trial, Matthew Panuwat, worked in business development at Medivation, where his role (according to the SEC’s complaint) included the close tracking of “the stock prices, drug products, and development pipelines of other biopharmaceutical companies, ... as well as merger and acquisition activity in the biopharmaceutical industry.” Panuwat had been involved in discussions at Medivation about a merger or acquisition, and the SEC alleged that he “reviewed presentations authored by the [company’s investment] bankers that discussed Medivation’s peer companies in the biopharmaceutical industry.” Ultimately, Panuwat learned that Pfizer was planning to acquire his employer, and, according to the SEC, his experience with the pharmaceutical industry led him to conclude that a Medivation sale to Pfizer would cause an increase in the stock price of Medivation peers. According to the SEC allegations, Panuwat purchased a large number of call options on a peer of Medivation—Incyte—within minutes of getting the information about the impending Pfizer acquisition. Panuwat had never before traded in stock of Incyte.

In addition, the SEC complaint alleges that Medivation’s insider trading policy covered not only the company’s securities but also “the securities of another publicly traded company, including all significant  . . . competitors of the Company.” Panuwat argued that the policy did not apply to Incyte. In the usual insider trading case, Panuwat might have bought stock in Medivation or in Pfizer ahead of the acquisition to profit from his insider knowledge. Instead, according to the SEC, Panuwat deduced that the impending merger likely would have an impact on the fortunes of a competitor—Incyte—that was not party to the transaction. So Panuwat bought that company’s stock. He proceeded to make a significant amount of money on the trade.

The SEC asserted that Panuwat’s conduct constituted insider trading, claiming that Panuwat violated the Securities Exchange Act of 1934 and the implementing regulations. Section 10(b) of the Act proscribes the use of any “deceptive device” “in connection with” a covered securities trade. SEC Rule 10b-5 likewise prohibits the employment of any device to defraud or deceive another person “in connection with” a securities trade. Under United States v. O’Hagan, 521 U.S. 642 (1997), the idea is that the insider has “misappropriated” confidential information for securities trading purposes, thereby breaching a duty owed to the source of the information. Because of Medivation’s particular insider trading policy, the SEC was able to argue that using the information regarding Pfizer’s acquisition of Medivation to trade Incyte securities breached his duty to Medivation.

The SEC interprets these laws to encompass Panuwat’s conduct—the use of insider information about a transaction to trade on the stock of a company that was not part of that transaction. The SEC admitted at oral argument on a motion to dismiss “that there appear to be no other cases where the material nonpublic information at issue involved a third party.” Panuwat’s case provided a ready-made opportunity to test that interpretation in federal court, and Judge Orrick agreed with the SEC’s understanding when he denied Panuwat’s motion to dismiss and his motion for summary judgment. Not surprisingly, Panuwat has moved for judgment as a matter of law, so Judge Orrick may have another opportunity to pass on the SEC’s legal theory.

If the SEC’s interpretation of Rule 10b-5 in the context of so-called “shadow trading” gains traction in other courts, public companies will have to be mindful that greater enforcement in the context of shadow trading is forthcoming. These companies and their employees will face more enforcement risk as a result. Consequently, companies should revisit the scope of their insider trading policies to consider whether their insider trading policies and procedures would guard against potential shadow trading liability. Companies should review their guidance so that it accurately reflects what they would consider to be misappropriation of material information, given that the SEC is now likely to assert that information has been misappropriated even if used in the market of an entity with which the company has no dealings.

Still, Panuwat’s case features a couple of noteworthy facts that could distinguish it from most other circumstances of trading by employees in securities unrelated to the relevant employers. First, as discussed above, Panuwat's job at Medivation gave him unique insights into the possible effects of its merger on the securities of other public companies. In other words, the implications of the Pfizer acquisition on Incyte made that information material. Second, other companies may not have a similarly expansive insider trading policy that covers other companies, a fact that Judge Orrick seemed to weigh heavily in his pre-trial orders. Different facts could have driven a different outcome—suggesting that the reach of this precedent may yet be limited.

Nevertheless, this case indeed represents a potential expansion of insider trading law—a challenge for companies. Any public company should therefore reevaluate the scope of its insider trading policy and how broadly that policy defines what it considers to be material nonpublic information that it expects insiders to safeguard.

If you have any questions concerning the material discussed in this client alert, please contact the members of our Securities practice.