Court Approves Novel "Shadow Trading" Theory in SEC Insider-Trading Case

The opinion can be found here.

In Panuwat, the SEC alleged that defendant Matthew Panuwat misappropriated information from his employer Medivation, a mid-cap biopharmaceutical company that focused on oncology products. According to the complaint, Medivation brought in investment banks to explore a possible merger in 2016. Minutes after Medivation’s CEO sent Panuwat and other company executives an email indicating that Pfizer, Inc. expressed “overwhelming interest” in acquiring Medivation, Panuwat allegedly purchased 578 call options in Incyte Corp., a different mid-cap biopharma company that was comparable to Medivation. In doing so, Panuwat allegedly violated Medivation’s insider-trading policy, which prohibited using nonpublic Medivation information to trade in Medivation securities “or the securities of another publicly traded company.” After Medivation announced the acquisition, the stock price of Incyte and other mid-cap biopharma companies in the same industry increased, allegedly generating Panuwat $107,066 of ill-gotten gains.

In a complaint filed in August 2021, the SEC charged Panuwat with violating Section 10(b) of the Exchange Act, and Rule 10b-5 promulgated thereunder. Section 10(b), 15 USC § 78j(b), makes it unlawful for any person “[t]o use or employ, in connection with the purchase or sale of any security … any manipulative or deceptive device or contrivance” in violation of SEC rules and regulations. In turn, Rule 10b-5, 17 CFR § 240.10b-5, prohibits “directly or indirectly … in connection with the purchase or sale of any security” using “any device, scheme, or artifice to defraud,” the making of “any untrue statement of a material fact” or omission, or engaging “in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.” Rule 10b5-1(a), moreover, defines “manipulative and deceptive devices” to include, in part, “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” owed to the issuer or “to any other person” who is the source of the information.

As Judge Rakoff in the Southern District of New York has observed, given the lack of elements in the statute and rule, “the prohibition of insider trading in the United States has developed in a somewhat ad hoc manner,” and in a “topsy-turvy way,” based partly on “federal common law,” “leaving many unanswered questions.” United States v. Whitman, 904 F. Supp. 2d 363, 367, 369, 372 (S.D.N.Y. 2012). Panuwat raised just such a question—namely, whether a person can trade in the securities of an issuer based on material nonpublic information, unrelated to the issuer, obtained from a company other than the issuer.    

Panuwat contended that the SEC’s novel theory did not state a violation of Section 10(b) or Rule 10b-5 and moved to dismiss for failure to state a claim and failure to plead fraud with particularity. Specifically, he argued that the SEC’s complaint failed to adequately plead that information about the Medivation acquisition was material to Incyte and nonpublic, that he breached a duty to Medivation, or that he acted with intent to defraud. He also asserted that the charges violated his due process rights, averring: “The SEC has never before attempted to bring an insider trading case against an individual based solely on the purchase of securities of a company about which neither he nor his employer possessed any material nonpublic information,” or involving an alleged breach of a duty to an employer by “trading in the securities of an unrelated company operating within the same broadly-defined industry.”

The Court rejected these arguments. At the outset, the Court explained that the Supreme Court has recognized two theories of insider trading that violate Section 10(b) and Rule 10b-5. The “traditional” or “classical” theory involves a corporate insider who trades in the securities of the insider’s corporation on the basis of material nonpublic information. In contrast, the “misappropriation theory” involves a defendant who misappropriates confidential information in breach of a duty owed to the source of the information, and then uses the information to trade. Unlike the classical theory, the misappropriation theory extends to company outsiders, not insiders.

The Court held that the SEC’s complaint satisfied the requirements of a misappropriation theory. Section 10(b) and Rule 10b-5 “cast a wide net,” the Court reasoned, and Rule 10b-5 does not require that the information about the security or issuer—in this case, Incyte—derive from the issuer itself to be material. The news of the impending Pfizer-Medivation acquisition was material to Incyte, the Court concluded, because there were allegedly a limited number of mid-cap oncology-focused biopharma companies with commercial-stage drugs in 2016, and the acquisition would make others in this category more attractive, driving up their stock prices. The Court further held that, as alleged, Panuwat breached a duty to Medivation because its insider-trading policy broadly prohibited trading in securities of other companies, not just Medivation. The Court also held that the complaint adequately alleged scienter.

The Court also rejected Panuwat’s due process argument. While the Court acknowledged that “there appear to be no other cases where the material nonpublic information at issue involved a third party,” as the SEC conceded at oral argument, according to the Court, the theory still fell “within the general framework of insider trading, as well as the expansive language of Section 10(b) and corresponding regulations.” The Court added: “Scienter and materiality provide sufficient guardrails to insider trading liability.”

The Panuwat decision expands the court-created ambit of Section 10(b) and Rule 10b-5 by creating liability for shadow trading—that is, trading in the securities of an issuer based on material nonpublic information obtained from a different company. Only time will tell whether prosecutors follow the SEC’s lead and test this theory in a criminal case. In any event, the decision reinforces that just because nonpublic information a person receives does not involve or derive from a particular issuer, it does not mean that it can lawfully be used to trade in that issuer’s securities. Accordingly, entities that trade in securities should ensure that their policies and training convey this principle to employees.