Introduction to SEC v. Panuwat: Understanding “Shadow” Insider Trading

In the groundbreaking case SEC v. Panuwat, the Securities and Exchange Commission (SEC) successfully pioneered a legal theory referred to as “shadow” insider trading. This concept extends traditional insider trading paradigms to situations where an individual, privy to material non-public information (MNPI) regarding one company (Company A), capitalizes on that knowledge to trade securities in another company (Company B). The facts of the case against Matthew Panuwat, a former executive at Medivation, illuminate this novel application of the law.

According to the SEC’s complaint, Panuwat, an employee of the pharmaceutical company Medivation, became aware that Medivation would soon be bought out. Just a few minutes after learning that information, Panuwat commenced purchasing out-of-the-money, short-term call options in another company, Incyte Corp. The SEC argued that Incyte was a closely comparable company to Medivation, and therefore, these trades in Incyte constitute illegal insider trading.

The “Market Connection”: A Crucial Pivot for Insider Trading Doctrine

Central to the SEC’s argument at trial was the “market connection” between the two entities. The crux of the matter was whether a reasonable investor would perceive the information about Medivation as significantly altering the total mix of information available about Incyte​​. This criterion broadens the traditional scope of insider trading, where direct materiality to the traded company was the benchmark, to a more nuanced view where the information’s relevance to the sector or market environment becomes a determinant of materiality.

Exploring the Misappropriation Theory in the Context of “Shadow Trading”

“Shadow trading” represents a new frontier in the application of the misappropriation theory of insider trading. Traditionally, the misappropriation theory posits that a violation occurs when an individual exploits confidential information, breaching a duty of trust or confidence to the information’s source. Panuwat extends this premise to include trading on information about one company that materially affects another company in the same industry. The verdict—as well as the court’s prior order denying summary judgment—underscores the expansion through litigation (versus legislation or rulemaking) to adapt securities laws to address evolving forms of perceived fraud, as it posits that confidential information, while specific to one entity, can potentially bear material significance to another, thereby broadening the spectrum of insider trading violations​​​​.

The basic idea is that material non-public information from company A is used to trade securities in company B. Notably, The SEC’s complaint survived summary judgment last year before the April 5, 2024 jury verdict.

One key fact that the SEC’s novel theory of insider trading hinges on is the extent to which, in hypotheticals like this, company A is a close comparable to company B. In the court’s ruling on the motion for summary judgment, the phrase “market connection” became the new key catchphrase that may join the ranks of key phrases like “mix of information” and “material non-public” in the securities law lexicon if the SEC’s verdict survives appeal.

If this novel stretch of insider trading doctrine holds up on appeal, these types of cases will likely quickly become part of the battle of the financial economist experts between the SEC and defendants.  In particular, as the parties will call experts to testify  over whether there is a close economic correlation between the analog “Company A” (to which a trading party either owes fiduciary duties or has contracted to secrecy under a misappropriation based obligation) and the company B in which defendant is trading.

There are numerous ways to define economic correlation in this context. Is it a question of historical stock price correlation between the two companies? Is this about the covariance of returns between the two firm stocks in question? Over what prior time horizon? Or is the stock price not the only variable of focus? Could correlation or covariance between income statement or balance sheet items across the two firms be considered as indicia of economic links between the two companies?

Does it matter whether the trading is about an M&A event in company A that signals a likely M&A event for company B, in which case future shadow trading will be limited to the facts of this specific case? In other words, is this uniquely about fact patterns where a buyout of company A signals a likely future buyout of company B (and both companies are small enough that there are no antitrust or other competition issues that limit the prospect of the second buyout) and the defendant happens to, as in this case, uniquely buy call options in company B immediately after learning of the buyout of company A?

Or will this case, if successful on appeal, signal generally that employees of companies now have potential legal risk if they trade in any company in the same sector in which they work? In which case, are a substantial group of price discovery-improving traders who share the highest level of knowledge of a particular market sector going to be excluded from trading at all? This recalls the Supreme Court’s reasoning in SEC v. Dirks, which overturned a lower court SEC victory against a whistleblower because insider trading overreach by the SEC would chill diligence by investment advisors and those with unique knowledge of a company’s value. The whole point of the publicly traded markets, after all, is efficient price discovery. The sort of broad theory the SEC invoked in Panuwat risks destroying a key source of efficient price discovery in the market by discouraging anyone working in an industry from trading in that industry.

Are individuals with material non-public information concerning Company A going to be held to predict whether they can legally trade in any company with economic correlation to Company A? In other words, is someone with material non-public information required to conduct empirical stock price studies of return correlation between their company and the company in which they are seeking to invest?  For these reasons and more, we hope that the U.S. Courts of Appeal and, if necessary, the Supreme Court, reject this harmful, unwarranted, and unfair expansion through litigation of the prohibition of “shadow” insider trading.

Duty and Breach: The Legal Commitments at Stake

At the heart of the SEC’s new theory is the breach of duty.  Panuwat was bound by Medivation’s insider trading policy.  That policy expansively prohibited trading (while in possession of Medivation’s inside information) in not only Medivation’s securities, but arguably in any publicly traded securities in which Medivation’s inside information would give its insiders an investing edge. This inclusive policy was critical to the SEC’s case, illustrating that contractual obligations can extend to trading activities seemingly beyond direct employment restrictions. The policy’s language that includes a list of specific company types, according to the court’s reasoning in the summary judgment ruling, serves as an illustrative example rather than an exhaustive list of prohibitions, amplifying its scope.

Panuwat’s signed confidentiality agreement also played a significant role in the court’s denying summary judgment—and presumably in the jury’s later verdict. By using Medivation’s confidential information to benefit personally from Incyte’s stock options, Panuwat breached the contractual obligation not to use the company’s information for personal gain. Furthermore, the court indicated that an inherent duty of trust and confidence exists under the employment relationship, independent of an explicit policy or agreement​​.

The SEC supplemented their focus on the underlying documents and policies of the firm, which broadly prohibited the use of information about the firm to trade in other companies, with another unique theory of insider trading. This novel theory the SEC threw at the wall was one grounded in principle/agency law which prohibits agents from obtaining secret profits, even in circumstances in which the principal is not harmed, from the principal/agency relationship.

While that is an accurate summary of a black letter agency law, this would be the first time that theory is used as a basis for insider trading liability, which has previously been limited under the classical theory of insider trading to state corporate law fiduciary relationships and under the misappropriation insider trading doctrine to express contractual relationships that promise confidentiality in information. If the SEC’s new principle/agency  theory is upheld, it would be another substantial increase in the reach of insider trading law even beyond the unique “shadow trading” issue that has received the most attention in this case.

Compliance Community Reacts

Professors Karen Woody and Cole Davidson in, their forthcoming piece, advise that amendment to 10b5-1 plans is the way to limit risk when executives trading in securities of other companies within their field. (See https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4692287). This suggestion will be useful to individuals to limit their risk of a shadow trading theory enforcement case no doubt. This approach would not, however, fix the problem that broad application of the shadow insider trading approach will chill price discovery, as it would not allow flexibility for trading based on industry shifts as 10b5-1 plans are increasingly inflexible and rigid in response to recent SEC reforms to the 10b5-1 plan rules. (See https://www.sec.gov/news/press-release/2022-222).

The immediate response among the compliance community to the news of this novel theory was that firms may want to amend their internal compliance policies to broadly prohibit trading in other firms in the same industry as the firm where an employee works. And yet, the opposite may be advisable. After all, the SEC’s central foundation for their case is that, in this instance, the defendant’s employer had a compliance policy that broadly defined restrictions on trading to include trading in other firms in that industry.

The SEC used that broad firm policy in part as a launchpad to bring this novel theory of shadow insider trading.  It is unclear whether the SEC’s theory would have survived summary judgment or the verdict if not for that broad firm policy which created the possibility of a misappropriation doctrine-based justification for this shadow insider trading theory.  Thus, one approach to limiting this type of fallout is not to have broad-reaching internal firm policies that restrict trading outside of trades in the employing firm.

Strategic Considerations for Compliance Professionals

Given the SEC v. Panuwat verdict, compliance officers must be vigilant and proactive in reviewing and updating corporate policies. This includes:

1. Policy Revision: The immediate response might be to restrict industry-wide trading broadly. However, given the specificity required in legal defenses, a more prudent approach may be crafting nuanced policies that define and limit trades based on potential market impact rather than industry categorization alone.
2. Employee Education: It is essential to conduct regular training sessions to educate employees about the implications of the misappropriation theory and the extended reach of insider trading laws. Awareness campaigns should focus on the intricacies of “shadow trading” and the importance of compliance with insider trading policies.
3. Monitoring Systems: Implementing or enhancing systems that monitor employee trading could serve as both a deterrent to potential violations and a means of quickly identifying suspicious trading patterns.
4. Legal Counsel and Expert Consultations: Companies should consider consulting with legal experts to interpret how insider trading policies could impact their specific market position. Additionally, financial economists can help understand the potential economic correlation between companies within the same industry.
5. 10b5-1 Trading Plans: In line with Professors Karen Woody and Cole Davidson’s advice, the amendment of 10b5-1 plans can be a strategic move to limit insider trading risks. These plans should be constructed with an eye towards flexibility to allow for lawful trading based on industry shifts without violating insider trading regulations​​.

Litigation Strategies for Insider Trading Cases

For those defending insider trading investigations and cases, Panuwat presents new challenges requiring new and enhanced strategies:

1. Expert Testimony: As the case law evolves, the role of financial experts becomes increasingly significant. Litigators must rely on these experts to establish or contest the economic correlation between the companies in question.
2. Historical Data Analysis: Litigators should prepare to delve into historical stock price correlations, examine covariance of returns, and possibly examine the income statement or balance sheet items to determine economic links between companies.
3. Policy and Agreement Scrutiny: In litigation, it is crucial to examine closely insider trading policies, confidentiality agreements, and other related contracts. The language used in these documents can either expand or limit the scope of alleged breaches of duty.

The “Battle of the Experts”: Tools and Theories in Shadow Trading Cases

In cases of shadow trading, financial and economic experts will play a critical role in determining whether a “market connection” exists between two firms, a key element underpinning the SEC’s novel theory. These experts might employ various tools and theories to analyze and argue the degree of economic linkage between entities. The primary focus is to establish whether the companies’ securities move in tandem based on certain metrics or events.

1. Covariance and Correlation: These are statistical measures that experts frequently use to gauge the degree to which two securities move in relation to each other.
   • Covariance indicates the direction of the linear relationship between the securities. A positive covariance suggests that the stocks tend to move together when one stock’s price goes up, so does the other’s; if one’s price goes down, the other’s tends to as well.
   • Correlation provides both the strength and direction of this linear relationship, scaled to be between -1 and 1. A correlation of 1 suggests a perfect positive linear relationship, -1 indicates a perfect negative linear relationship, and 0 implies no linear relationship.

Application of Covariance and Correlation: Experts will analyze historical price data to calculate covariance and correlation coefficients. They often segment the analysis by different periods to see if the relationship changes over time, especially around critical events, such as mergers or acquisition announcements. However, these statistics alone may not account for causation; a high correlation does not imply that the movement in one company’s stock price causes movement in another’s.

These measures, however, primarily capture linear relationships and might not fully encapsulate more complex interactions or dependencies. Expert battles over the market correlation issue may hinge on other data points.

2. Beta Coefficient: Beta measures the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. A beta greater than 1 indicates that the security’s price tends to be more volatile than the market, while a beta less than one indicates less volatility. Beta is a useful measure for determining how news about one company might impact another if they share similar betas.

Using Beta in Market Analysis: Beta is typically calculated using regression analysis against a market index. It’s commonly used to argue how sensitive a company’s stock price is to market movements, including reactions to news or events that affect similar companies. Experts may argue that a higher beta indicates a higher likelihood that information about a competitor will affect the stock price. But beta is a backward-looking measure and may not predict future relationships.

3. Tobin’s Q: Tobin’s Q is the ratio of the market value of a company to the replacement value of its assets. It is a tool that can signal how the market values a company’s growth potential and intangibles such as patents or other intellectual property. While Tobin’s Q does not directly measure stock price movement, it could be relevant in showing the attractiveness of a company as an acquisition target, which could be a crucial element in a shadow trading scenario.

The Relevance of Tobin’s Q: Tobin’s Q can be particularly relevant in mergers and acquisitions scenarios. An expert might argue that a high Tobin’s Q indicates that the market sees similar companies as equally attractive targets, suggesting a market connection. However, Tobin’s Q is less about stock price synchronicity and more about corporate valuation, potentially limiting its application in establishing a direct market connection for trading purposes.

4. Event Study Methodology: This involves analyzing the impact of specific events on stock prices, which can demonstrate how information about one company influences another. For instance, an announcement of a merger involving Company A could be studied for its impact on the stock price of Company B.
5. Cross-sectional Analysis: Comparing multiple companies within the same industry can reveal norms or outliers in terms of performance and reaction to industry events, which could underpin an argument for or against the existence of a market connection.

Limits of Cross-sectional Analysis: While this method allows for a comparative look at companies, outliers may distort the understanding of market connections. Cross-sectional data may not be consistent over time, and the analysis may be influenced by unique factors affecting individual companies within the group.

Conclusion: Navigating the Post-Panuwat World and a Call for Legislation

It is difficult to overstate the expansion Panuwat represents for potential liability for insider trading.  To be sure, the defense bar will attack this unfair and unwise regulation-through-litigation, and the defense bar will be joined by academics, public interest groups, and supporters in the business community.  In the meantime, every entity and individual involved in the capital markets—from public companies to retail traders—need to take head of the increased risks and perils that comes with trading in a post-Panuwat market. For companies, this includes at least re-evaluating insider trading policies and educating directors, officers, and employees on the new landscape.  And securities lawyers need to adjust their advice to clients and strategies for defending insider trading investigations, regulatory actions, and prosecutions.

Ultimately, Congress needs to step in and define by legislation what is and is not illegal insider trading, which it has never done to date.  One can debate what should and should not be permitted, but Congressional action would provide the best opportunity for consideration of the competing considerations of the scope and contours of the insider trading laws.