Gensler SEC Expands Scope of Insider Trading Enforcement

According to the complaint, within minutes of learning that his employer, Medivation Inc., would be imminently acquired by Pfizer Inc., Senior Director of Business Development Matthew Panuwat purchased out-of-the-money call options in a competitor’s stock whose value Panuwat predicted would increase in the wake of the merger announcement. The SEC also alleges that Panuwat failed to seek required internal approvals for his trades, and that Panuwat had not traded the competitor’s securities before buying the options at issue.

According to the SEC, Panuwat had agreed to keep information that he learned during his employment confidential and not to use any of Medivation’s confidential information for personal gain. Panuwat also had agreed to abide by Medivation’s insider trading policy, which, in addition to prohibiting trading in Medivation securities on the basis of material nonpublic information, noted that employees “may be in a position to profit financially by buying or selling … the securities of another public traded company.” The policy cautioned that “[f]or anyone to use such information to gain personal benefit … is illegal.”

Significant Legal Issues

The SEC will need to overcome several legal hurdles in order to pursue this enforcement action. At a high level, this case presents the novel legal question of whether, and under what circumstances, acquiring material nonpublic information from one issuer to which an individual owes a duty of trust and confidence should prelude trading in the securities of another issuer. (The practice is often referred to as “shadow trading.”)

Central to those questions is a determination of whether the so-called “misappropriation theory” of insider trading, upon which the SEC’s complaint seems to rely, applies to the trading at issue. Under the misappropriation theory, liability is based on a breach of a duty or trust that is owed to the source of material nonpublic information (as opposed to the classical theory, where liability is based on a breach of a duty between the trading parties; see United States v. O’Hagan, 521 U.S. 642 (1997)). The court will need to determine whether Panuwat breached a duty that he owed to his employer by using the employer’s confidential information to profitably trade in the securities of another company.

There could also be a dispute regarding whether the pending merger between Medivation and Pfizer was material to the competitor when Panuwat purchased call options for the competitor’s stock. The fact that the competitor’s stock price increased by approximately 8 percent on the news of Medivation’s acquisition suggests that the information was material. And as the SEC alleges in its complaint, Panuwat had reviewed investment banker analyses that had concluded that a merger between Medivation and Pfizer made Medivation’s competitors more valuable acquisition targets. Significantly, the SEC’s complaint also alleges that Panuwat knew that following a previous announcement of an acquisition of another mid-cap competitor, there had been an increase in stock price of both Medivation and the competitor whose call options Panuwat had bought, suggesting that Panuwat was aware that news of a potential transaction could have a sector-wide impact.

Finally, Panuwat may be able to rely on a defense based on the Securities Exchange Act of 1934 Rule 10b5-1(a)’s apparent requirement that the SEC prove that a defendant traded in the securities of an issuer on the basis of material nonpublic information “about that security or issuer.” There remains an open question as to whether the information that Medivation was planning to merge with Pfizer is information “about” a competitor for purposes of insider trading law. The extensive case law applying the anti-fraud provisions of the securities laws to insider trading has developed almost entirely in the context of insiders who trade or tip others to trade on the basis of confidential information about their own company, or outsiders who misappropriate information from a specific company and then trade in the securities of that company. The District Court in the Panuwat case will need to determine whether confidential information about one company can constitute material nonpublic information about competitors under Rule 10b5-1(a), absent other contributing factors.

Aggressive Insider Trading Enforcement

As many commenters (including the co-authors of this article) predicted, Chair Gensler appears to be refocusing the SEC’s enforcement efforts on traditional securities misconduct, including insider trading. The Panuwat case is emblematic of the SEC’s aggressive approach and suggests that the Enforcement Division is willing to advance novel legal theories—particularly when it uncovers bad facts (e.g., the purchase of options within minutes of learning confidential information and disregarding procedures requiring pre-clearing of securities transactions). While novel for the U.S., the SEC’s theory in Panuwat seems to align with the European Union’s insider trading regulations, which shift the focus of the analysis from breach of duty and scienter to whether an insider has an unfair trading advantage by virtue of having acquired material nonpublic information.

Before Panuwat, in the early days of Gensler’s tenure, the Commission filed several high-profile insider trading matters, including a case against three former Netflix engineers and another enforcement against an individual for selling material nonpublic information on the dark web. And on the rulemaking front, Chair Gensler has indicated that he plans to closely examine whether 10b5-1 plans that allow corporate insiders to trade company securities based on predetermined schedules are being used to hide unlawful insider trading.

Tellingly, on August 18, Chair Gensler appointed Sanjay Wadhwa as Deputy Director of the Division of Enforcement. Wadhwa, who previously served as the Senior Associate Director of the Division of Enforcement in the SEC’s New York Regional Office, first rose to prominence at the agency when he built the insider trading case that led to convictions and enforcement actions against Raj Rajaratnam and others in connection with the Galleon insider trading matter. In our view, Wadhwa’s elevation to the Enforcement Division’s front office is another signal that the SEC will continue to aggressively police insider trading, including by pursuing novel theories of liability.

Potential Action Items

The Panuwat enforcement action has significant implications for broker-dealers, investment advisers, and corporate insiders, among others. Although the theory of the SEC’s case is novel, investors and other market participants should assume that the emboldened Enforcement Division will continue to pursue insider trading based on a shadow trading theory.

To address that risk, legal and compliance officers should consider revising policies and procedures (including Codes of Ethics subject to Investment Advisers Act of 1940 Rules 204A-1 and 206(4)-7) to identify instances in which confidential information regarding one company could constitute material nonpublic information regarding other issuers. Once those instances are identified, policies and procedures should also provide guidance regarding the scope of any trading restrictions (e.g., sector-wide, industry-wide). Regulated entities with supervisory obligations should also consider whether to update any monitoring or surveillance systems to detect shadow trading. Finally, companies should consider providing additional training to ensure that employees understand the scope of company policies regarding material nonpublic information, including in relation to shadow trading.

Unless and until Congress passes an insider trading statute (the House of Representatives passed a bill on May 18, 2021, which is currently awaiting action in the Senate), the rules of the road regarding material nonpublic information will always be somewhat ambiguous and subject to change. For that reason, market participants must exercise considerable caution to ensure that their policies, procedures, systems, and controls are reasonably designed to detect and prevent insider trading, and these efforts should be undertaken on a regular basis as the law evolves based on judicial opinions as well as SEC guidance and enforcement actions.

For specific questions, please consult the authors of this article or the Pillsbury attorneys with whom you regularly consult.