Insider trading: The case of misappropriation theory

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The U.S. Securities and Exchange Commission (SEC) has become increasingly aggressive in bringing insider trading charges. In this first of two columns on the topic of insider trading, we discuss a case that has the potential to expand commonly understood definitions of what constitutes insider trading.

Keep in mind that the law of insider trading is complex.  A legal analysis of the case is beyond the scope of this column.

Insider trading basics

One important component of the SEC’s tripartite mission is to maintain the integrity of our domestic trading markets. To that end, Congress enacted laws and the SEC adopted rules that prohibit insider trading. These “anti-fraud” provisions generally prohibit any person or entity from trading in any security on the basis of material nonpublic information (MNPI) in breach of a duty of trust or confidence. To be liable for insider trading, a person must have acted with “scienter” a Latin term that means “knowing,” (it’s the “scien” in “science”), and which is generally used in law to mean fraudulent intent.

Over the years, two specific theories of insider trading liability have developed as a result of case law and administrative decisions:

Classical theory. The classical theory of “insider trading” derives from longstanding prohibitions on trading by insiders of a public company. Although the term “insider” is not defined precisely by federal securities laws and rules, the term has been construed by courts to refer to a person or entity that, as a result of a fiduciary relationship with an issuer of securities, has access to MNPI. Individual insiders include individuals who stand in a position of trust and confidence to the issuer and its shareholders, e.g., officers, directors, controlling shareholders and certain employees.

Misappropriation theory. The misappropriation theory of insider trading liability extends to individuals who are not necessarily insiders of a public company. Under this theory, a person commits fraud in connection with a securities transaction when he or she misappropriates MNPI and trades on that information in the public securities markets in breach of a pre-existing duty to the source of the information. Liability under the misappropriation theory results from a duty of trust or confidence between the misappropriator and the source of the information, even if the information has not been misappropriated from the issuer whose securities are then traded. The case below illustrates the evolving elasticity of this theory.

SEC v Matthew Panuwat

The SEC’s case against Matthew Panuwat takes a close look at Panuwat’s activities of during his employment with Medivation, Inc., a mid-sized biopharmaceutical company headquartered in San Francisco, CA, whose specific focus was oncology. The SEC brought charges against Panuwat last year, alleging that he had traded ahead of a public announcement that his employer would be acquired by pharmaceutical giant, Pfizer Inc. Notably, Panuwat’s trading activities did not involve the purchase or sale of Medivation shares. Panuwat traded in the securities of Incyte Corporation, a comparable biopharmaceutical company which also had a specific focus on oncology.

The SEC has alleged that Panuwat received a confidential email from Medivation’s CEO on August 18, 2016, informing him that Medivation would be acquired imminently by pharmaceutical giant, Pfizer, Inc., and that within minutes of receiving this information, Panuwat misappropriated the information by purchasing, from his work computer, out-of-the-money, short-term stock options in Incyte Corporation in anticipation that the value of Incyte securities would increase when the Medivation acquisition announcement became public.

Six days later, on August 22, 2016, Medivation publicly announced that it would be acquired by Pfizer in an all-cash tender offer at a significant premium to the price at which Medivation shares had been trading. Following the announcement, the price of Medivation shares rose by 20% and the price of Incyte shares rose by 8%. The value of Panuwat’s Incyte options doubled. The SEC contends that, by purchasing the Incyte options ahead of the announcement of the Medivation acquisition, Panuwat obtained illicit profits of $107,066.

Notably, the SEC has not alleged that Panuwat received MNPI about the company whose options he purchased. Rather, it has alleged that because Panuwat was entrusted by his employer with confidential information involving actual or potential transactions, including potential acquisitions of or by Medivation, Panuwat had a duty to not use the information for his own personal gain. The SEC also alleged that Panuwat agreed in connection with his employment at Medivation, that he would keep information that he learned during his employment confidential and would not make use of such information, except for the benefit of Medivation. According to the SEC’s complaint, Panuwat had signed Medivation’s insider trading policy, which prohibited employees from personally profiting from MNPI concerning Medivation by trading in Medivation securities or securities of another public company. The case is currently pending in the Federal District Court for the Northern District of California.

Panuwat sought to have the case dismissed, asserting, among other things, that the SEC’s theory was a novel application of the misappropriation theory which would improperly expand the law of insider trading. In its ruling against Panuwat’s Motion to Dismiss, the court concluded that the SEC’s theory of liability falls within the general contours of insider trading liability.  Specifically, the court rejected the argument that only information about Incyte can be material to Incyte under applicable rules because the language of those rules broadly prohibits insider trading in any security.

Additional thoughts

The court’s denial of Panuwat’s Motion to Dismiss certainly does not mean that the SEC will win its case. Nevertheless, the possibility exists that the SEC’s novel theory will further expand liability under the misappropriation theory. We will be watching the case closely.

Patricia Foster is a securities law attorney whose experience in­cludes representation of clients in both registered and exempt securities offerings, as well as in various sectors of the financial services industry, including broker-dealers, investment advisers and investment companies. This column is a collaborative work by Patri­cia Foster and David Peartree. David Peartree is an adviser with Brighton Securities Capital Management, Inc., a registered investment adviser offering fee-only investment and financial planning ad­vice. The information in this column is provided for educational pur­poses and does not constitute legal or investment advice.

© 2022. Patricia C. Foster. All Rights Reserved.