On Tuesday, the SEC announced that it had filed a complaint in the U.S. District Court charging 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 it's not what you might think. The employee 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 used the information about his employer's acquisition to purchase call options on a separate biopharma company, Incyte Corporation, which the SEC claims was comparable to Medivation. According to the SEC, the employee 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 the employee breached his "duty to refrain from using Medivation's proprietary information for his own personal gain" and traded ahead of the announcement, in violation of Rule 10b-5. Will the SEC succeed or is the factual basis of the charge just too attenuated?
SideBar
In this paper, the authors refer to this type of trading as "shadow trading." They describe it as "a novel, undocumented phenomenon that corporate insiders can use to circumvent insider trading regulations and SEC scrutiny. The premise of shadow trading is straightforward: private information held by insiders can also be relevant for economically-linked firms and exploited to facilitate profitable trading in those firms." The authors contend that the "legality of shadow trading appears to be relatively untested due to the lack of a clear breach of fiduciary responsibility by insiders who use private information to facilitate trading in other firms. Indeed, in the U.S., prosecutions for shadow trading are virtually non-existent." The study showed that shadow trading was "significantly higher when source firms do not prohibit employees from engaging in shadow trading relative to when they prohibit shadow trading. Although mostly untested in the U.S. judicial system, such company regulations arguably create a fiduciary responsibility for employees not to exploit their private information in economically-linked firms."
According to the SEC's complaint: Matthew Panuwat was employed in business development at Medivation from September 2014 to January 2017, and as Senior Director of Business Development beginning in 2016. According to the complaint, 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, he regularly received confidential information involving actual or potential Medivation transactions.
When Panuwat joined the company, he signed a confidentiality agreement, including the 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.)
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In this article in Law 360, which discusses the shadow trading theory, critics questioned whether using confidential information to trade at another company involved a breach of a fiduciary duty to Medivation—that issue might rest in part on factual questions about the extent of the company's policies. Commentators also questioned whether the information he received from Medivation was material to Incyte; was Panuwat's trading based on that confidential information or was it instead based on his own market analysis and other information?
In 2016, Medivation began to explore its strategic options and engaged investment bankers, with whom Panuwat worked closely, accoridng 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 indicates 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 charges, "Panuwat misappropriated Medivation's confidential information by purchasing—from his work computer—out-of-the-money, short-term stock options in Incyte." The SEC alleges 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."
SideBar
In U.S. v. O'Hagan, decided in 1997, SCOTUS upheld the misappropriation theory of insider trading. According to the Court, under
"the 'traditional' or 'classical theory' of insider trading liability, §10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information....The 'misappropriation theory' holds that a person commits fraud 'in connection with' a securities transaction, and thereby 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....Under this theory, a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information.
"The two theories are complementary, each addressing efforts to capitalize on nonpublic information through the purchase or sale of securities. The classical theory targets a corporate insider's breach of duty to shareholders with whom the insider transacts; the misappropriation theory outlaws trading on the basis of nonpublic information by a corporate 'outsider' in breach of a duty owed not to a trading party, but to the source of the information. The misappropriation theory is thus designed to 'protec[t] the integrity of the securities markets against abuses by 'outsiders' to a corporation who have access to confidential information that will affect th[e] corporation's security price when revealed, but who owe no fiduciary or other duty to that corporation's shareholders.'"
The misappropriation theory, the Court reasoned, "comports with §10(b)'s language, which requires deception 'in connection with the purchase or sale of any security,' not deception of an identifiable purchaser or seller." The Court agreed that "misappropriation, as just defined, satisfies §10(b)'s requirement that chargeable conduct involve a 'deceptive device or contrivance' used 'in connection with' the purchase or sale of securities."
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 contends, 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 complaint charges Panuwat with committing fraud against Medivation in connection with the purchase or sale of securities, with scienter, in violation of Rule 10b-5. The SEC is seeking an injunction and civil penalties.
SideBar
In May this year, the House passed the Insider Trading Prohibition Act by a pretty big bipartisan majority—350 to 75. Currently, there is no explicit statutory prohibition on insider trading and prosecutors have relied on general fraud statutes to pursue charges. The bill would add to the Exchange Act a new Section 16A that would define insider trading and make it illegal. The bill would make it "unlawful for any person, directly or indirectly, to purchase, sell, or enter into, or cause the purchase or sale of or entry into, any security, security-based swap, or security-based swap agreement, while aware of material, nonpublic information relating to such security, security-based swap, or security-based swap agreement, or any nonpublic information, from whatever source, that has, or would reasonably be expected to have, a material effect on the market price of any such security, security-based swap, or security-based swap agreement, if such person knows, or recklessly disregards, that such information has been obtained wrongfully, or that such purchase or sale would constitute a wrongful use of such information."
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