Do You Need a Policy to Address Shadow Trading?
August 31, 2021
As a fan of mystery novels and police procedurals, I love me a good insider trading case. The facts involved in insider trading complaints are often about as salacious as equity compensation can get and the moral of most of these stories is usually that crime doesn’t pay. In TheCorporateCounsel.net blog, Liz Dunshee discusses a recent SEC complaint that takes a new approach to insider trading enforcement.
Most insider trading cases involve employees (or their spouses, friends, and family members) trading in company stock based on information they learned about their employer during the course of their employment. Sometimes the cases involve employees trading in the stock of a business partner or party to a change-in-control involving their employer.
But what about a situation where employees learn material, non-public information about their employer that they think will also impact the stock of a competitor. If employees then trade in the competitor’s stock, is that insider trading? The SEC thinks so.
The Facts: SEC v. Panuwat
Earlier this month, the SEC announced insider trading charges against the former head of business development at Medivation, a company that was acquired by Pfizer in 2016. The SEC’s complaint alleges the following:
The Medivation employee in question knew that large pharmaceutical companies were interested in acquiring smaller oncology-focused biopharmaceutical companies with commercial-stage drugs and that there were only a few left to acquire.
The employee knew that an acquisition of any of these smaller companies would make the remaining companies potentially more valuable (and that a prior acquisition of another company had resulted in the material increase of the stock prices of both Medivation and a competitor company, Incyte).
Medivation’s insider trading compliance policy prohibited employees from personally profiting from material nonpublic information concerning Medivation by trading in Medivation securities or the securities of another publicly traded company.
The SEC states that, on August 18, 2016, Medivation’s CEO sent an email to the employee indicating that Medivation was likely to be acquired by Pfizer. Within minutes of receiving this email, the employee purchased underwater options on competitor Incyte’s stock. Once the merger was announced, Incyte’s stock price increased enabling the employee to realize a gain from the options.
No Case Is Too Small
One thing this case shows is that the SEC is willing to pursue insider trading charges even when the gains are not that large and the trades occurred half a decade ago. The SEC alleges that the employee realized ill-gotten gains of only a little over $100,000.
Is Shadow Trading Illegal?
The colloquial term for what the SEC is alleging is “shadow trading.” It refers to a situation where an employee learns material non-public information about their employer and trades in the stock of another company that is likely to be affected by the news. This allows the employee to economically benefit from the material non-public information without trading their employer’s stock.
You might think that this must surely be illegal, but, as noted in several law firm memos on the SEC’s charges, the answer isn’t as clear cut. A memo by Troutman Sanders notes that “the SEC’s complaint pushes the boundaries of established case law in insider trading.” The memo explains that, in traditional insider trading cases, the insider owes a fiduciary duty to the company and its shareholders; the trade violates this duty.
But with shadow trading, the insider doesn’t work for the company whose stock was traded and doesn’t owe a fiduciary duty to the company or its shareholders. Instead, the SEC is arguing the Medivation employee misappropriated information learned from his employer.
A Wachtell Lipton memo notes:
The issue of materiality is likely to be hard-fought. The courtroom battle can be expected to center on issues such as how likely or uncertain it was that the Medivation news would affect Incyte’s stock price, as well as on the indirect nature of the connection between Medivation’s information and the securities in which Panuwat traded. The case will likely also test the SEC’s assertion that Panuwat misappropriated Medivation’s information when he traded. The courts will ultimately need to determine whether the misappropriation theory of insider trading liability extends to these facts.
Does Your Insider Trading Policy Cover This Scenario?
A key tenet of the SEC’s complaint is that Medivation’s insider trading policy specifically prohibited trading not only in Medivation’s stock but in the stock of any public company. In her blog, Liz offers the following bit of advice for her readers that serve as outside counsel (which I think is helpful for employers as well):
Sometimes when you’re reviewing an insider trading policy, the client asks whether it’s really necessary to include the part about prohibiting transactions in the securities of other companies. These charges are a reminder that it is—because it shows the company is doing its part to prevent transactions that could be illegal, and hopefully it keeps your employees out of hot water too.
A Case to Watch
I leave you with the conclusion that the authors of the Troutman Sanders memo come to:
The case is one to watch, because if the SEC is successful, the results would have broad implications for increasing the potential liability for corporate insiders trading in stocks of economically linked companies while in possession of material, nonpublic information.