Here is a great article—no surprise considering its author, Columbia Law Professor John Coffee—that practically gives the last rites to the “shadow trading” theory recently accepted by a federal district court (see this PubCo post) and a jury (see this PubCo post) in SEC v. Panuwat.  If, that is, the theory ever reaches the Supreme Court. In Panuwat, the jury in a federal district court in California determined that Matthew Panuwat was civilly liable for insider trading on a set of highly unusual facts under the misappropriation theory—misappropriation of confidential information used to trade in securities in breach of a duty to the source of the information. According to Coffee, prior to Panuwat, cases involving the misappropriation theory “seem to have involved conduct by the defendant that caused ‘likely harm’ to the shareholders of the source of the information.”  But not so in Panuwat. Rather than a fiduciary obligation, he suggests, perhaps the duty that Panuwat breached was really a contractual duty owed to his employer? And, in that case, should the SEC be the party enforcing it? His arguments may be highly controversial—certainly the SEC would disagree—but thought-provoking nonetheless and definitely worth a read.  

In August 2021, the SEC filed a complaint in the U.S. District Court charging Panuwat, a former employee of Medivation Inc., an oncology-focused biopharma, with insider trading in advance of Medivation’s announcement that it would be acquired by a big pharma company, Pfizer.  As you know by now, this case has often been viewed as highly unusual:  Panuwat didn’t trade in shares of Medivation or shares of the acquiror, nor did he tip anyone about the transaction.  No, the SEC’s novel—but winning—theory of the case was that Panuwat engaged in “shadow trading,” using the information about the acquisition of his employer to purchase call options on Incyte Corporation, another biopharma that the SEC claimed was comparable to Medivation, based on an assumption that the acquisition of Medivation at a healthy premium would probably boost the share price of Incyte.  Panuwat made over $120,000 in profit. The SEC charged that Panuwat violated Rule 10b-5 and sought an injunction and civil penalties.  (See this PubCo post.) 

After losing a motion to dismiss, Panuwat moved for summary judgment, claiming that this was the wrong case to test out the novel shadow-trading theory: “Incyte and Medivation were fundamentally different companies with no economic or business connection, Medivation’s policies did not prohibit Mr. Panuwat’s investment, and Mr. Panuwat’s reasons for making the investment were entirely separate from the Medivation sale process and consistent with his prior investment  practices.”  The SEC responded that Panuwat’s “actions fit squarely within the misappropriation theory of insider trading” and that his “actions provide strong evidence of his scienter.”  The District Court for the Northern District of California denied the summary judgment motion. Notably, the court did not take issue with the SEC’s application of the shadow trading theory, instead treating the case as just another version of “misappropriation” of material nonpublic information: under Section 10(b), the court explained, citing U.S. v. O’Hagan, “a person commits fraud ‘in connection with’ a securities transaction, and violates §10(b) and Rule 10b-5, ‘when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.’”  The court concluded that the SEC had “shown affirmative evidence sufficient to support a jury finding that Panuwat misappropriated MNPI.” The case went to trial; it took the jury only two hours to find Panuwat civilly liable for insider trading under the misappropriation theory.

Unlike O’Hagan, Coffee observes, in Panuwat, there was no transaction between Medivation, the source of the information, and Incyte, on whose stock the defendant purchased options.  The two companies had “no cross-ownership, common personnel, or any past history.” Just how far can you take the misappropriation theory, Coffee asks? Couldn’t any kind of major development—such as a scientific breakthrough or a bankruptcy—at one company affect its competitors?  

Even beyond the potential  sweep of the “shadow trading” theory, Coffee argues, here, there was no breach of duty by the defendant to these other companies (whereas in O’Hagan, which involved a lawyer, “it was implicit that the two parties to the merger transaction would maintain confidentiality”). In his view, “[t]his difference in the scale and scope of the SEC’s novel shadow trading theory suggests that when and if such a case ever reaches the Supreme Court, the SEC could face an adverse decision….”

Coffee acknowledges that many disagree with him on this point, contending that Panuwat owed a duty to Medivation, the source of the information. But Coffee insists that Panuwat and O’Hagan are fundamentally different. Before Panuwat, he argues, “misappropriation” cases resulted in “likely harm” to the shareholders of the source of the information.  For example, in O’Hagan, the defendant’s option trading “raised the cost of the acquisition to the bidder (O’Hagan’s client) and disrupted the bidder’s timing.” Not so in Panuwat, where his purchases of Incyte options caused no harm to the acquirer or the target. In addition, although some might disagree here, Coffee asserts, Panuwat did not “feign fidelity” to the source of the information, “at least in the same way that O’Hagan did. Owing no duty to Incyte, it is unclear why defendant Panuwat should be liable to its shareholders. This is not to excuse Panuwat’s conduct. He clearly deserved to be fired, and companies, if they want, can monitor their employees’ trading (as brokerage firms do).”

But many profess that there was a duty owed, as did the SEC, pointing to Medivation’s insider trading policy, which expressly covered competitors of the company, and its confidentiality agreement with Panuwat. “But,” Coffee asks, “does this mean that Panuwat breached a fiduciary duty to Medivation?” Wouldn’t it be more precise, he submits, to characterize his conduct as a breach of a contractual duty? “The classic fiduciary duty of loyalty does not require a corporate officer to obey all the preferences and orders of their corporation,” he explains, such as, hypothetically, voting for President as directed by the corporation. Moreover, he contends, assuming that the duty is enforceable, shouldn’t it be Medivation doing the enforcing, not the SEC?

Here, Coffee asks us to give some further thought to the implications: “how much deference should be given by courts to private ordering in the insider trading context”? Provisions in companies’ insider trading policies can differ—especially now after Panuwat. Although Panuwat was a civil case, Rule 10b-5 can involve criminal penalties. But, Coffee maintains, “Rule 10b-5 was never intended to protect or enforce such private ordering on a company-by-company basis.” The “core tradition of the criminal law” is that “the legislature frames the definition of the crime.” It would be inconsistent with that tradition, he maintains, if the law were applied based on the “special preferences of each corporate employer.”  The result would be that corporate issuers could, in effect, “tailor the criminal law to their special needs,” making the application of Rule 10b-5 in the criminal context “uneven and inconsistent.”  And even outside of the criminal context, “the SEC should be enforcing only one standard.”

Is there anything the SEC should do to address this issue?  According to this influential 2020 academic paper, which identified the shadow-trading phenomenon and coined the phrase, Coffee observes, shadow trading is pervasive. One possibility he offers is to adopt a new rule supplementing Rule 14e-3 or Rule 10b-5, but a new rule could face a challenge under the “major questions doctrine” set forth in West Virginia v. EPA.  (See this PubCo post.)

Finally, he takes up the question of whether private action for shadow trading violations would be permitted under Rule 10b-5, and who would be entitled to sue.  In Panuwat, it appeared unlikely that Incyte shareholders would have a case, since Panuwat did not owe them any duty. Coffee later posits that, although it’s not clear whether a duty is required, Incyte shareholders might have recourse to Exchange Act Section 20A, which “gives a cause of action to contemporaneous traders.”  But given that if “any duty was breached by the defendant, it was a duty to Medivation,” perhaps Medivation has a cause of action.  While “Medivation suffered no loss, it might conceivably seek disgorgement, which would be measured by the defendant’s gain (minus any legitimate expenses).” It appears that the shadow trading theory may have opened quite a can of worms.

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