Last month, the Securities and Exchange Commission did something rather extraordinary. It charged an individual with insider trading – a form of securities fraud – even though the defendant trader was neither an insider of the corporation whose stock he traded nor was he privy to any inside information about that company itself.
Rather, the trader engaged in what is called “shadow trading,” a practice by which the trader trades in a stock of a company where he was not an insider and had no insider information, but does so based on inferences gleaned from inside information obtained from a different company.
In the recent case, Matthew Panuwat was a business development executive at Medivation, a biopharmaceutical company. Through his employment, Panuwat learned that Medivation was about to be acquired by pharmaceutical giant Pfizer, an event which would likely cause Medivation’s share price to jump substantially. As alleged, Panuwat used this highly confidential information, not to trade in securities of Medivation, but rather in the stock of a different “peer company” with the same business focus and market capitalization as Medivation.
In short, Panuwat’s alleged offense was trading on his analysis that the Medivation acquisition would cause the market to view the peer company’s stock as more valuable and its share price to jump. Panuwat turned out to be correct, and his trading resulted in profits of more than $100,000.
How did we get here? Don’t you need to be an “insider” of the company you’re trading in to be guilty of insider trading? Panuwat was not an insider of the company whose stock he traded.
Don’t you at least need to possess inside information about the company to be guilty? But Panuwat had no inside information about the peer company, only about his own company, Medivation.
A Bit of History of Insider Trading
Insider trading has taken a long and circuitous path in the law since it was first announced by the courts. That’s right. There is not now nor has there ever been a statute prohibiting insider trading, though Congress is currently considering one. Insider trading is, rather, a judicially created offense, though one rooted in the antifraud provisions of the Securities Exchange Act of 1934, one of the principal New Deal era statutes designed to protect investors in the securities markets.
In the 1980 case Chiarella v. United States, the Supreme Court formally endorsed SEC and lower court decisions holding that “a corporate insider [such as an officer or director] must abstain from trading in the shares of his corporation unless he has first disclosed all material inside information known to him.”
The theory is that such insiders have, for two reasons, an affirmative duty to disclose to those with whom they trade. First, the insider has access to inside information only as a result of a special relationship giving the insider access to information intended to be available only for a corporate purpose. And second, because it would be unfair to allow a corporate insider to take advantage of that information by trading without disclosure.
The same case formally rejected a so-called “parity-of-information” theory of insider trading which proposed that all participants in market transactions must forgo actions based on material, nonpublic information. Under this theory, it would be unfair for only some traders to have access to confidential information and therefore all market participants should be required to disclose any material, nonpublic information to the market before trading.
The Court rejected this theory. Rather, the Court held, the basis for prohibiting insider trading is rooted in a “duty” arising from a specific relationship between two parties – i.e., the corporate insider, who owes a duty to shareholders and only obtained confidential information as a result of his position with the company, and the company’s shareholders.
As things stood after Chiarella, insider trading was restricted to “insiders” of the corporation as it was only they who owed the shareholders a special duty. But things didn’t stand there for long. Three years later, in Dirks v. SEC, the Supreme Court considered so-called “constructive insiders” – such as lawyers, accountants and investment bankers – who receive confidential information from a corporation while providing services to the corporation. Dirks held that these constructive insiders are also liable for insider trading violations because they entered into a special confidential relationship in the conduct of the business, are given access to information solely for corporate purposes and therefore have, like typical insiders, at least an implied duty to shareholders.
The next major expansion of the class of those upon whom insider trading liability could be imposed officially came in the 1997 decision United States v. O’Hagan with the Court’s announcement of the “misappropriation theory” of insider trading (though unofficially this happened in the mid-1980s not long after Dirks). O’Hagan was a partner in a law firm representing company that was considering a tender offer for Pillsbury Company. O’Hagan used inside information he acquired by through his firm’s work on the deal to trade in Pillsbury stock earning profits of over $4.3 million. O’Hagan claimed that because his firm worked for the acquiror and not Pillsbury, neither he nor his firm owed a fiduciary duty to Pillsbury, so he did not commit insider trading.
The Court rejected O’Hagan’s arguments and upheld his insider trading conviction, announcing a new “misappropriation theory.” Unlike the “classical” or “traditional” theory that imposes liability only on insiders or constructive insiders, the “misappropriation theory” holds that a person commits insider trading when he misappropriates confidential information for securities trading purposes, in breach of a fiduciary duty or similar relationship of trust and confidence owed to the source of the information and uses that information in a securities transaction.
The crucial point is that, in contrast to the traditional theory, the misappropriation theory does not require a duty to the buyer or seller of securities (as in the case of trading by an insider). Rather, the duty may be owed to any source of nonpublic 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 the information. In other words, the fraud is not against the buyer or seller of the stock, but rather the one in possession of the confidential information.
In the years since O’Hagan, courts have applied the misappropriation theory in a wide variety of contexts to find insider trading liability. Examples include a financial printing firm employee who figured out, and traded upon, the identity of takeover targets based on tender offer documents he received in the course of his employment; a journalist who provided advance information to a trader about an investment advice column that was known to have an impact on the stocks it discussed; and, in a case recently argued by this author, the principal of an investment fund who provided a friend with updates about a potential merger he was negotiating.
Which brings us back to Matthew Panuwat. As an employee of Medivation, Panuwat promised not to use the company’s confidential information to trade in securities, including the stock of other companies like Medivation’s “collaborators, customers, partners, suppliers, or competitors.” In many ways, the charge against Panuwat is consistent with the misappropriation theory. After all, Panuwat did misappropriate confidential information from his employer and allegedly used it to make the decision to trade in the stock of the peer company. And Panuwat had allegedly agreed with his employer not to do so.
But imposing insider trading liability for trading based on inference or analysis – even where that inference or analysis stems from misappropriated confidential information – takes things yet a step further. It begs the question at what point, if any, does the initial piece of confidential information become too remote to a trading decision to impose insider trading liability?
Consider as a thought experiment an employee of a candy company who learns, confidentially, that the candy company’s large sugar supplier, Supplier A, is having record production and profits. A prohibition on trading in the securities of Supplier A based on the information the employee learned about the supplier in the course of her employment makes sense. But what about trading in the securities of a manufacturer of a different sugar supplier, Supplier B, based in another part of the country? While confidential information about Supplier A’s business may be relevant to the performance of Supplier B, it is a fairly remote basis to impose insider trading liability, given the many factors that likely distinguish the two suppliers. And what then about trading in Supplier B’s own suppliers or customers?
How much further will Panuwat take us from the “traditional” theory of insider trading? At least at this point, the SEC seems ready to push the outer limits.
Elisha Kobre is a partner at Bradley in Dallas and is a member of the firm’s government enforcement and investigations practice. He is a former assistant district attorney for the Southern District of New York.