An Unusual Insider Trading Case

Insider trading isn’t really my specialty – that’s John’s area – but everyone’s talking about SEC v. Panuwat, which means I feel like I need to weigh in.

In short: Company insider (Panuwat) obtains confidential information from his employer that the firm is to be acquired.  He immediately trades in the stock of a similar but unrelated company – recognizing, correctly, that news of the acquisition will lift the stocks of comparable firms.  Has he violated Section 10(b) and Rule 10b-5 by misappropriating confidential information from his employer?

First, I note that Panuwat’s trades took place on August 18, 2016 and the SEC filed its complaint on August 17, 2021.  Which, you know, tells you something about the SEC’s ambivalence and risk assessment for this case. (The statute of limitations for imposing a penalty is 5 years).

Second, this problem has been considered before.  Here’s Ian Ayres and Joe Bankman on the subject (h/t to the Twitter birdie who called this to my attention), and here’s a recent empirical paper by Mihir N. Mehta, David M. Reeb, and Wanli Zhao concluding that these kinds of trades are relatively common (discussed in this Law360 article).

There’s probably a lot that can be said about the policies regarding the prohibition on insider trading and whether they should be extended to this scenario – Ayres and Bankman cover that, and John’s recent posts are all about different justifications for prohibiting inside trading – but I actually want to make a small doctrinal analogy to something that I know more about, namely, misstatement cases under Section 10(b).

In that context, courts have occasionally addressed the issue of what to do when a false statement about one company artificially inflates the stock price of a different company.  For example, in Semerenko v. Cendant Corp., 223 F.3d 165 (3d Cir.2000), Cendant falsified its financials, and then proposed a stock-for-stock takeover of ABI.  In response, ABI’s stock price rose, only to fall when the fraud at Cendant was revealed and the merger called off.  Were statements about Cendant’s financials made in connection with ABI’s stock?  The Third Circuit said maybe, and remanded for further inquiry (offering somewhat contradictory standards as to how the inquiry would be conducted for the Cendant defendants versus the auditor defendants).

Then there’s Ontario Public Service Employees Union Pension Trust Fund v. Nortel Networks Inc., 369 F.3d 27 (2d Cir. 2004).  In that case, Nortel made false statements about its financial condition, and when the truth was revealed, the stock price of JDS Uniphase fell, because Nortel was its largest customer.  When JDS Uniphase shareholders sued Nortel, the Second Circuit said that JDS shareholders had no standing to pursue claims against Nortel.

And recently, Juul – which is a private company – made false statements about its marketing tactics – which, when the truth was revealed, ultimately caused Altria’s stock price to fall because of Altria’s 35% investment in Juul.  A district court allowed Altria’s investors to sue Juul and certain of its managers, because “the connection between JUUL’s allegedly false statements and Plaintiffs purchase of Altria’s stock lacks the remoteness found in Nortel Networks.” Klein v Altria Group, 2021 WL 955992 (E.D. Va. Mar. 12, 2021)

What does all of this have to do with SEC v. Panuwat?  I guess that’s in the eye of the beholder.

On the one hand, you could say the situations are entirely distinct.  Section 10(b) prohibits fraud in connection with a securities transaction.  And when someone makes false statements about a particular company, there are limits to whether that fraud is related to securities transactions in other companies.

When it comes to misappropriative insider trading, though, the question is whether confidential information was used (in violation of a relationship of trust and confidence) for the purpose of a securities trade.   See U.S. v. O’Hagan, 521 U.S. 642 (1997) (“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.”).  One might argue that, unlike in the misstatement context, there’s nothing in that standard that requires the securities trade to be of the same, or even a related, company; indeed, the whole reason we have a “misappropriation” theory of insider trading in the first place is to address what happens when an insider of one company – in O’Hagan, a fiduciary of an acquirer planning to launch a tender offer – uses confidential information to trade in the securities of a different company – in O’Hagan, the target.

Plus, I mean, as a practical matter, courts don’t like securities plaintiffs, but they also don’t like employees who trade on confidential information, so you can anticipate outcomes through that realist lens.

But!  I think there’s another wrinkle here.  When the Nortel court rejected the plaintiffs’ claim, it explicitly expressed concern about a slippery slope. Everything in markets affects everything else; that’s why quants develop whole strategies based on minute market correlations.  If traders could sue for losses experienced by one company due to statements by a different company, that could dramatically expand 10(b) liability – which, many argue, already should not extend as far as it does.  It would mean, for example, that if a drug company lies about the efficacy of a new treatment, traders who short its competitors could sue.  If a company lowballs its earnings (not uncommon when they’re trying to cram through a merger), traders who go long on its competitors could sue.  And on and on.

You could argue that these concerns are not present when we’re talking about insider trading, because there’s a limiting principle: The trader must have misappropriated inside information.  If that’s proved, then we may be less concerned about which securities he or she traded.

But is that true, though?

Because here’s the thing.  There’s a longstanding debate within insider trading doctrine about whether liability turns on the trader using the confidential information to trade, or whether liability is triggered whenever someone trades while in possession of confidential information, or whether – splitting the baby – trading while in possession gives rise to an inference of “use” which can then be rebutted.  See, e.g., footnote 2 of Zachary Gubler’s A Unified Theory of Insider Trading Law.  The SEC’s longstanding position is that trading in possession is sufficient to trigger liability in most circumstances.  See Rule 10b5-1 (“a purchase or sale of a security of an issuer is ‘on the basis of’ material nonpublic information about that security or issuer if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale”).  And the proposed Insider Trading Prohibition Act that recently passed the House also prohibits trading “while aware of material, nonpublic information relating to such security …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.”

So now imagine an employee who has confidential information about his or her employer.  Under the SEC’s rule, trading in any public company stock that might be affected by the information is prohibited under 10b-5 – regardless of whether the employee used the information, or not.  The door is blown wide open.

Now, in the complaint against Panuwat, the SEC doesn’t merely rest on a “trading while in possession” theory.  Instead, the SEC explicitly alleges that Panuwat used the confidential information he acquired from his employer:

within minutes of receiving the Medivation CEO’s email on August 18, 2016, and while knowing or being reckless in not knowing that such entrusted information was material and nonpublic, Panuwat used this information concerning the Medivation acquisition to trade. Specifically, Panuwat logged on to his personal brokerage account from his work computer and purchased 578 Incyte call option contracts with strike prices of $80, $82.50, and $85 per share—significantly above Incyte’s stock price of $76 to $77 per share at the time—and the soonest possible expiration date, September 16, 2016. Panuwat was aware that Incyte was not expected to make any significant announcement, such as issuing a quarterly earnings report, before the options expiration date. Rather, Panuwat anticipated that Incyte’s stock price would jump within less than a month on public disclosure of the upcoming Medivation acquisition announcement. Panuwat had never traded Incyte stock or options before.

(emphasis added)

Which may cover this case specifically but unless the SEC is planning to tweak its own rules on this more generally, I think here’s where the problem arises.