SEC’s “shadow trading” case survives motion to dismiss

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In August last year, the SEC announced that it had filed a complaint in the U.S. District Court charging Matthew 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.  But this isn’t your run-of-the-mill insider trading case. Panuwat didn’t trade in shares of Medivation or shares of the acquiror, nor did he tip anyone about the transaction.  No, according to the SEC, he engaged in what has been referred to as “shadow trading”; he used the information about his employer’s acquisition to purchase call options on a separate biopharma company, Incyte Corporation, which the SEC claimed was comparable to Medivation.  According to the SEC, Panuwat made that purchase based on an assumption that the acquisition of Medivation at a healthy premium would probably boost the share price of Incyte. Incyte’s stock price increased after the sale of Medivation was announced.  The SEC charged that Panuwat committed fraud against Medivation in connection with the purchase or sale of securities, with scienter, in violation of Rule 10b-5; he had, the SEC charged, breached his “duty to refrain from using Medivation’s proprietary information for his own personal gain” and traded ahead of the announcement. The SEC sought an injunction and civil penalties. (See this PubCo post.) In November, Panuwat filed a motion to dismiss the complaint under Rule 12(b)(6), calling it “an unprecedented expansion” of the Exchange Act. Last week, the Court denied the motion.

Background. According to the SEC’s complaint, Panuwat was employed in business development at Medivation from September 2014 to January 2017, and as Senior Director of Business Development beginning in 2016.  The complaint states that he had over 15 years’ experience in the biotech industry, including eight years in investment banking and a number of years employed in “business and strategic development“ at several other biotechs. In his role at Medivation, the SEC alleged, he regularly received confidential information involving actual or potential Medivation transactions. In particular, the complaint alleged, as part of his job, Panuwat “closely tracked the stock prices, drug products, and development pipelines of other biopharmaceutical companies,” including Incyte, another “valuable, mid-cap, oncology-focused [company] with a profitable FDA-approved (commercial stage) drug on the U.S. market.”

According to the complaint, when Panuwat joined the company, he signed a confidentiality agreement, including an insider trading policy, which “prohibited employees from personally profiting from material nonpublic information concerning Medivation by trading in Medivation securities or the securities of another publicly traded company.” In particular, the policy advised that he could receive important confidential information in the course of his employment and that, because of his access to this information, he could “be in a position to profit financially by buying or selling or in some other way dealing in the Company’s securities…or the securities of another publicly traded company, including all significant collaborators, customers, partners, suppliers, or competitors of the Company.… For anyone to use such information to gain personal benefit…is illegal. …” (SEC added emphasis.)

In 2016, the complaint alleged, Medivation began to explore its strategic options and engaged investment bankers, with whom Panuwat worked closely, according to the complaint. One of the companies the bankers considered to be a close peer to Medivation was Incyte Corporation, given that “both were valuable, mid-cap, oncology-focused companies with a profitable FDA-approved (commercial stage) drug on the U.S. market.”  The complaint indicated that “Panuwat himself noted to the investment bankers that they might want to consider Incyte a comparable company to Medivation.” According to the complaint, Panuwat knew that there were only a few oncology-focused mid-cap biopharmas and that a number of big pharmas were interested in acquiring them.  He also knew that each “acquisition was material to the remaining companies because it made them potentially more valuable acquisition targets and could thus positively affect the stock price of those companies.”  He had seen similar stock price increases in the past.

As the process continued, the SEC alleged, Panuwat was closely engaged in the discussions and received information about the potential acquirers’ due diligence and share-price bids and participated in board meetings regarding strategic alternatives. In August 2016, he learned that Medivation was going to be acquired soon at a significant premium, with Monday, August 22, as the target date for a public announcement. On August 18, 2016, he (and other execs) received an email from Medivation indicating that the ultimate acquirer had “expressed overwhelming interest in acquiring Medivation” and would call later that day to try to resolve final details. Minutes after receiving the email, without pre-clearance or authorization from or disclosure to anyone at Medivation, the SEC charged, “Panuwat misappropriated Medivation’s confidential information by purchasing—from his work computer—out-of-the-money, short-term stock options in Incyte.”  The SEC alleged that he had never before purchased Incyte call options, and that the reason for his purchase was that he “anticipated that Incyte’s stock price would jump within less than a month on public disclosure of the upcoming Medivation acquisition announcement.” 

Medivation entered into the acquisition agreement two days later and announced the deal on August 22, as expected.  Medivation’s stock price climbed 20% and Incyte’s rose by 8%. Panuwat’s profit on his call options amounted to $107,066.

The SEC charged that

“Panuwat learned the foregoing information through his employment at Medivation, and he knew or was reckless in not knowing that the information was material and nonpublic. Panuwat also knew, or was reckless in not knowing, that the information concerning Medivation’s imminent acquisition was material not only to Medivation, but also to Incyte, a peer company in the biopharmaceutical industry that was also publicly-traded, mid-cap, and oncology-focused. Medivation’s undisclosed acquisition would have been viewed by a reasonable investor in Medivation or Incyte as having significantly altered the total mix of information made available. The public announcement of Medivation’s acquisition at a significant premium to its then-current share price would likely have a positive impact on Incyte’s stock price.”

And, the SEC contended, as a result of his “employment, as well as the confidentiality and insider trading policies that he signed, Panuwat owed Medivation a duty to keep this material nonpublic information confidential, and to refrain from trading on Medivation’s confidential information.” According to the SEC, “Panuwat’s undisclosed, self-serving use of Medivation’s information to purchase securities, in breach of his duty of trust and confidence, defrauded Medivation and undermined the integrity of, and investor confidence in, the securities markets.”

The Court’s Order.  According to the Order, to survive a Rule 12(b)(6) motion to dismiss, the plaintiff must allege “enough facts to state a claim to relief that is plausible on its face.”  In making that decision, the Court accepts the employee’s “allegations as true and draws all reasonable inferences in his favor.”  Claims under Rule 10b-5 must also “state with particularity the circumstances constituting fraud or mistake.”

In the Order, the Court indicated that the SEC brought its claim under the misappropriation theory, which requires that “the SEC must show that Panuwat ‘knowingly misappropriated confidential, material, and nonpublic information for securities trading purposes, in breach of a duty arising from a relationship of trust and confidence owed to the source of the information.’”

The Order summarizes Panuwat’s argument for dismissal as two-pronged: first, that the SEC did not adequately plead that the information at issue was material and nonpublic and that the employee, acting with scienter, breached his duty to Medivation; and second, that the SEC’s claim “is a novel application of the misappropriation theory,”  which would “violate Panuwat’s due process rights,” by improperly expanding insider trading law.

Misappropriation. With regard to the first contention, Panuwat contended that the SEC needed to establish that he had material nonpublic information about the company whose securities he traded; however, he argued, the information about the pending Medivation acquisition was not material to Incyte. The SEC contended that 10(b) broadly prohibits insider trading in connection with “any security,” and that information can be material to more than one company. For example, information about a supplier, customer or peer can also be “about” the subject company.

The Court found the SEC’s contention more persuasive: “[i]mportantly, Rule 10b5-1(a) does not state that the information ‘about that security or issuer’ must come from the security or issuer itself in order to be material…. It only requires that the information be material and nonpublic.” In addition, the Court said, the rule is expressly “not exhaustive” in identification of those manipulative and deceptive devices prohibited by law.  Moreover, the relevant caselaw does not

“foreclose the possibility that information may be significant to an issuer even if it comes from outside the company. If 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. Through this lens, the SEC has sufficiently pleaded that the information about Medivation’s looming acquisition was material to Incyte.  The complaint alleges in adequate detail that, given the limited number of mid-cap, oncology-focused biopharmaceutical companies with commercial-stage drugs in 2016, the acquisition of one such company (Medivation) would make the others (i.e., Incyte) more attractive, which could then drive up their stock price.”

The Court concluded that the assertion that a reasonable Incyte investor would consider the information important in deciding whether to buy or sell Incyte stock was supported by the assertion that Incyte’s stock price increased on the day that the merger was announced. The Court also concluded that the allegations that the information was confidential and nonpublic were adequate.

With regard to the allegation of breach of duty under the misappropriation theory, the Court observed that the parties agreed that Panuwat owed a duty to Medivation; the dispute was about whether he had breached that duty by using the information about Medivation to buy Incyte options. According to the Order, Panuwat contended that there was no breach because the company’s insider trading policy did not prohibit trading in Incyte securities—that is, Incyte was not a “significant collaborator, customer, partner, supplier, or competitor of Medivation” as identified in the policy.  Once again, the Court was not persuaded.  The policy, the Court reasoned, did not purport to be exhaustive, but merely listed examples of the types of other companies to which it would apply. Accordingly, the Court concluded that the allegation that Panuwat had breached his duty was adequate.

The Court then turned to the allegation of scienter. The Court observed that “Courts within this circuit disagree whether scienter requires a defendant to actually use the material nonpublic information in carrying out the trade, or whether she must simply be aware of it.” However, the Court concluded that the complaint adequately alleged both that the employee was aware of the information and that he used it.  In particular, the Court noted that “it was not until after Panuwat received an email indicating a deal was imminent that he purchased the Incyte stock…And he had never traded in Incyte stock before….Taken together, this suggests—at least for pleading purposes—that Panuwat used the information at issue when he purchased the Incyte stock.”

Due Process. According to the Order, Panuwat argued that, because no one previously understood the insider trading laws to prohibit the type of conduct alleged in the complaint, the SEC’s claim of shadow trading “stretches the misappropriation theory beyond what comports with due process.”   Although there were apparently “no other cases where the material nonpublic information at issue involved a third party,” the Court reasoned that

“the SEC’s theory of liability falls within the general framework of insider trading, as well as the expansive language of Section 10(b) and corresponding regulations. Scienter and materiality provide sufficient guardrails to insider trading liability. The SEC’s allegations fit under two underlying principles: that the misappropriation theory ‘reaches trading by corporate outsiders, not insiders,’ and that information may be material to more than one company…. The first is grounded in precedent, the second in commonsense. Panuwat may dispute the number of companies to which information may be material, but, as explained above, the relevant case law does not foreclose the possibility that the number exceeds two.”

In addition, the Court concluded that the language of Section 10(b), Rule 10b-5 and Rule 10b5-1(a) was sufficiently expansive to cover the SEC’s theory of liability. As written, the Court said, “the law and regulations prohibit more conduct than is expressly stated in Rule 10b5-1(a)—and can include Panuwat’s purported actions.” Panuwat contended that, if the SEC’s case proceeded, the allegations would have the effect of making the insider trading laws “entirely unclear.”  But that argument, the Court said, “ignores two important checks on liability: materiality and scienter.” If “those factors are not met, the information will not be material and the trader will not be liable.” 

That the case was unusual should not necessarily lead to its dismissal, the Court reasoned. In support, the Court cited a 1971 case in which SCOTUS “cautioned against dismissing claims of insider trading predicated on new or unusual schemes”:  in the case, SCOTUS interpreted Section 10(b) and Rule 10b-5 to “prohibit all fraudulent schemes in connection with the purchase or sale of securities, whether the artifices employed involve a garden type variety of fraud, or present a unique form of deception. Novel or atypical methods should not provide immunity from the securities laws.”  Accordingly, the Court held that “the SEC’s theory of liability falls within the contours of the misappropriation theory and the language of the applicable law.”

The Court denied the motion to dismiss. According to the Court’s Order, the SEC “has sufficiently pleaded that the information about the acquisition was nonpublic and material to Incyte, as the acquisition would make Incyte a more valuable acquisition target. The SEC has also adequately alleged that Panuwat breached a duty to Medivation by using the information to purchase stock in a publicly traded company. As pleaded, Panuwat acted with scienter. Allowing the SEC to proceed on this theory of liability does not violate his due process rights.”

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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