District Court Denies Motion to Dismiss SEC’s First ‘Shadow Trading’ Complaint

Judge William H. Orrick of the Northern District of California recently denied a motion to dismiss the Securities and Exchange Commission’s (SEC’s) first insider trading case charging a defendant with “shadow trading.”^[1] The SEC alleged that Matthew Panuwat, a biopharmaceutical executive, learned that his employer, Medivation, was due to announce an acquisition by Pfizer and, based on that information, immediately bought call options in a third pharmaceutical company, in the same market as Medivation. The court rejected Panuwat’s arguments that the SEC failed to state a claim against him for insider trading and that allowing the case to proceed under this novel theory would violate his due process rights.

The facts of the case made it a particularly good vehicle for the SEC to test its theory but may also provide a basis for future litigants to draw meaningful distinctions based on their own fact patterns. Panuwat, a former investment banker,^[2] was a senior director of business development at Medivation, a midsize publicly traded biopharmaceutical company that developed cancer drugs. His role was to explore strategic transaction opportunities for Medivation, including researching potential acquisition targets. One company that he allegedly tracked closely was Incyte, which, like Medivation, was a developer of oncology drugs, had an FDA-approved drug on the market and was seen as a potential acquisition target for larger pharmaceutical companies.

Because of his position at Medivation, Panuwat was entrusted with sensitive, nonpublic information. This included a summary of bids to purchase Medivation, five of which were at significant premiums to the then-current stock price; copies of letters, marked “confidential,” soliciting final bids; and an email indicating that Pfizer had an “overwhelming” interest in acquiring the company and that the companies’ CEOs were set to have a call to “resolve final details” of the acquisition. Minutes after receiving that email, Panuwat bought short-dated, out-of-the-money call options for Incyte stock. Despite his long-standing interest in the company, he had never bought Incyte stock or options before receiving the email about the impending acquisition.

According to the complaint, Panuwat had good reason to know that the announcement of an acquisition of Medivation would lead to a material increase in Incyte’s stock price: Panuwat knew that analysts listed Incyte as a peer company to Medivation, he knew that Medivation and Inctye were among the few comparable companies not yet acquired by larger pharmaceutical companies, and he knew that the stock prices of both Medivation and Incyte had begun trading higher when another company with a similar profile had been acquired a year earlier.^[3] Incyte stock rose by 8% on the Medivation announcement, and Panuwat made just over $100,000 on his trades.

The court held that these alleged facts properly stated a claim 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.”^[4] On each of the disputed elements — materiality, breach of a duty and scienter – the alleged facts were unusually detailed. First, according to the court, there was concrete information available to Panuwat to indicate that the Medivation announcement would affect Incyte’s stock price. Second, Panuwat was, because of the nature of his role, entrusted with sensitive material, including documents marked “confidential.” He had also signed the company’s broad insider trading policy, which acknowledged the likelihood that he would receive such information and, in addition to prohibiting the use of that information to trade in the company’s own stock, prohibited using that information to trade in “the securities of another publicly traded company, including all significant collaborators, customers, partners, suppliers or competitors” of Medivation. Third, there was allegedly strong circumstantial evidence that Panuwat knew what he was doing: He had a background in investment banking, understood the market dynamics and made the trade immediately after learning that an announcement was imminent.

The court rejected the defendant’s due process arguments because the language of the statute and related regulations is broad and the allegations of materiality and scienter were compelling. The court acknowledged that “there appear to be no other cases where the material nonpublic information at issue involved a third party” — a fact the SEC conceded — but found this lack of precedent was not a basis to dismiss the complaint.

Instead, the court concluded that the SEC’s shadow trading theory “falls within the general framework of insider trading, as well as the expansive language of Section 10(b) and corresponding regulations.” For example, the court rejected the argument that only information about Incyte can be material to Incyte under Rule 10b-5 because the language of the regulation broadly prohibits insider trading in “any security.”

The court reasoned that this breadth does not present a notice issue because “[s]cienter and materiality provide sufficient guardrails to insider trading liability.” Indeed, the breadth is intentional and is in place to protect markets from “new or unusual schemes.” The court pointed to a statement from the Supreme Court that “[n]ovel or atypical methods should not provide immunity from the securities laws.”^[5]

The application of the SEC’s theory and the court’s decision to other instances of “shadow trading” is not clear. One could conceive of situations where the connection between the defendant’s confidential information and the company in which he traded were more remote. Not all issuers’ insider trading policies prohibit trading in third companies like competitors. Can such a duty not to trade otherwise be implied? The defendant may not be as sophisticated a professional as Panuwat was alleged to be. The reach of the insider trading laws in such situations remains to be determined.

^[1] _{SEC v. Panuwat, No. 21-6322 (N.D. Cal. Jan. 14, 2022) (order denying motion to dismiss).}

^[2] _{Complaint at ¶ 14, SEC v. Panuwat, No. 21-6322 (N.D. Cal. Aug. 17, 2021) (Complaint).}

^[3] _{Complaint at ¶¶ 22-23.}

^[4] _{Order at 5 (quoting SEC v. Talbot, 530 F.3d 1085, 1092 (9th Cir. 2008)).}

^[5] _{Order at 13 (quoting Superintendent of Ins. v. Bankers Life & Cas. Co., 404 U.S. 6, 10 n.7 (1971) (citing A.T. Brod & Co. v. Perlow, 375 F.2d 393, 397 (2d Cir. 1967)).}