Stephen M. Bainbridge is William D Warren Distinguished Professor of Law, UCLA School of Law and serves as the WLF Legal Pulse’s Featured Expert Contributor, Corporate Governance/Securities Law.


The SEC recently charged Matthew Panuwat—a former employee of Medivation Inc.—with insider trading after Medivation announced Pfizer Inc. would acquire Medivation (the complaint is here). If Panuwat had traded in Medivation stock, there would have been a strong case against him under the so-called classical (a.k.a. disclose or abstain) theory of insider trading. If Panuwat had traded in Pfizer stock, there would have a strong case against him under the so-called misappropriation theory of insider trading liability. But this is where the wrinkle comes in.

According to the SEC’s press release summarizing the charges:

Matthew Panuwat, the then-head of business development at Medivation, a mid-sized, oncology-focused biopharmaceutical company, purchased short-term, out-of-the-money stock options in Incyte Corporation, another mid-cap oncology-focused biopharmaceutical company, just days before the Aug. 22, 2016, announcement that Pfizer would acquire Medivation at a significant premium. . . . Panuwat knew that investment bankers had cited Incyte as a comparable company in discussions with Medivation and he anticipated that the acquisition of Medivation would likely lead to an increase in Incyte’s stock price. . . . Following the announcement of Medivation’s acquisition, Incyte’s stock price increased by approximately 8%. The complaint alleges that, by trading ahead of the announcement, Panuwat generated illicit profits of $107,066.

This is what insider trading experts call “shadow trading.” Those experts have speculated for some time as to whether shadow trading is illegal, but the Panuwat case is the first time the SEC has ever prosecuted such a case.

As a recent Day Pitney memo noted, some might question whether shadow trading ought to be illegal because Panuwat’s “trade had no impact on his employer, the acquiring company, or their stock price or investors.” Yet, while the facts of the case are somewhat unusual, the complaint arguably states a claim under the misappropriation theory. As Day Pitney explains:

The SEC’s complaint alleges several factors in support of a misappropriation theory of insider trading against Panuwat. These include that Medivation’s investment banker made a presentation (which Panuwat saw) that specifically discussed parallels with its close competitor, Incyte; Panuwat had signed a confidentiality agreement, which included the company’s insider trading policy, prohibiting him from using material nonpublic information to trade in securities of his employer ‘or the securities of another publicly traded company, including all … competitors of’ his employer; Panuwat was an experienced securities trader, and he bought the call options expecting that news of the transaction would not only boost his employer’s stock price but also boost its close competitor’s stock price (which indeed increased by approximately 8 percent after news of the acquisition became public).

The late Justice Ruth Bader Ginsburg explained the difference between the classical and misappropriation theories in U.S. v. O’ Hagan, 521 U.S. 623 (1997):

Under the ‘traditional’ or ‘classical theory’ of insider trading liability, § 10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information. . . . The classical theory applies not only to officers, directors, and other permanent insiders of a corporation, but also to attorneys, accountants, consultants, and others who temporarily become fiduciaries of a corporation.

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. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company’s stock, the misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information.

The two theories are complementary, each addressing efforts to capitalize on nonpublic information through the purchase or sale of securities. The classical theory targets a corporate insider’s breach of duty to shareholders with whom the insider transacts; the misappropriation theory outlaws trading on the basis of nonpublic information by a corporate ‘outsider’ in breach of a duty owed not to a trading party, but to the source of the information. The misappropriation theory is thus designed to ‘protec[t] the integrity of the securities markets against abuses by “outsiders” to a corporation who have access to confidential information that will affect the] corporation’s security price when revealed, but who owe no fiduciary or other duty to that corporation’s shareholders.’

Id. at 651-53 (citation omitted).

These theories were developed to replace an earlier theory—the so-called equal access test—that effectively premised liability on the mere possession of material nonpublic information. As I explained in Equal Access to Information: The Fraud at the Heart of Texas Gulf Sulphur, 71 SMU L. Rev. 643 (2018):

[In SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969),] Judge Sterry R. Waterman’s majority opinion interpreted Securities Exchange Act § 10(b) and SEC Rule 10b-5 thereunder as mandating that:

[A]nyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing it in order to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.

Just over a decade later, however, in Chiarella v. United States, Justice Powell’s majority opinion expressly rejected that proposition, explaining that ‘a duty to disclose under § 10(b) does not arise from the mere possession of nonpublic market information.’

Why did the Supreme Court cut the heart out of TGS? Justice Powell’s main concern was the risk that broad application of the equal access test would criminalize legitimate trading activity. In doing so, however, Powell overlooked an even more fundamental problem; namely, Judge Waterman not only invented equal access out of whole cloth, but also compounded his fraud by outright misrepresentation of the few precedents he cited.

O’Hagan offers a classic example of how subsequent courts used the misappropriation theory to penalize some conduct that had been legalized by Chiarella. O’Hagan was a lawyer at Dorsey & Whitney, which was representing Grand Met in Grand Met’s effort to acquire Pillsbury. O’Hagan traded in Pillsbury stock and was criminally convicted of insider trading.

O’Hagan could not be held liable under the classical theory. He was not an insider of the company in whose stock he traded. He was not an agent or other fiduciary of the people with whom he traded. But Justice Ginsburg affirmed his conviction by validating the misappropriation theory.

Although the misappropriation theory has critics (myself included), it is now well-settled law. Accordingly, if Panuwat had traded in Pfizer stock, although the case would have been the reverse of O’Hagan (Panuwat worked for the target instead of the bidder), no one would have been particularly surprised by the SEC bringing the case.

The problem with the Panuwat case is the way it takes the chief flaw in the misappropriation theory to a new extreme. Securities Exchange Act of 1934 § 10(b) and Rule 10b-5 thereunder, on which the modern insider trading prohibition rests, imposes liability on fraud, manipulation, and other deceptive practices committed “in connection with the purchase or sale of any security.” In U.S. v. O’Hagan, 92 F.3d 612 (8th Cir.1996), rev’d, 521 U.S. 642 (1997), the Eighth Circuit held that because of the “in connection with” requirement Rule 10b–5 imposed liability only where there has been deception upon the purchaser or seller of securities, or upon some other person intimately linked with or affected by a securities transaction. Because the misappropriation theory involves no such deception, the court opined, but rather simply a breach of fiduciary duty owed to the source of the information, the theory could not stand. Absent such a limitation, the court explained, § 10(b) would be transformed “into an expansive ‘general fraud-on-the-source theory’ which seemingly would apply to an infinite number of trust relationships.”

In reversing, Justice Ginsburg essentially punted on this issue. Her opinion for the majority essentially ignored both the statutory text and the cogent interpretative arguments advanced by the Eighth Circuit. Justice Ginsburg’s failure to more carefully evaluate the meaning of the phrase “in connection with,” as used in § 10(b), has long been quite troubling. By virtue of the majority’s holding that deception on the source of the information satisfies the “in connection with” requirement, fraudulent conduct having only tenuous connections to a securities transaction is brought within Rule 10b–5’s scope. There has long been a risk that Rule 10b–5 will become a universal solvent, encompassing not only virtually the entire universe of securities fraud, but also much of state corporate law. The minimal contacts O’Hagan required between the fraudulent act and a securities transaction substantially exacerbated that risk. In addition, the uncertainty created as to Rule 10b–5’s parameters fairly raises vagueness and related due process issues, despite the majority’s rather glib dismissal of such concerns.

Extending the misappropriation theory to shadow trading severely exacerbates these problems. In particular, to claim that Panuwat’s deception of his employer was committed in connection with a securities transaction stretches that requirement to the breaking point. As noted, unlike the usual misappropriation case, Panuwat’s trade could not have negatively impacted  Medivation, Pfizer, or even Incyte. Panuwat’s deception was complete before he used the information to trade. As the Fourth Circuit explained in a pre-O’Hagan decision:

In allowing the statute’s unitary requirement to be satisfied by any fiduciary breach (whether or not it entails deceit) that is followed by a securities transaction (whether or not the breach is of a duty owed to a purchaser or seller of securities, or to another market participant), the misappropriation theory transforms section 10(b) from a rule intended to govern and protect relations among market participants who are owed duties under the securities laws into a federal common law governing and protecting any and all trust relationships. If, as the Supreme Court has held, the fraud-on-the-market theory is insupportable because section 10(b) does not ensure equal information to all investors, . . . a fortiori such a general fraud-on-the-source theory in pursuit of the same parity of information cannot be defended.

U.S. v. Bryan, 58 F.3d 933, 950 (4th Cir. 1995), abrogated by U.S. v. O’Hagan, 521 U.S. 642 (1997).

As the Bryan court correctly recognized, the Supreme Court’s precedents—including O’Hagan—reflect a profound concern that an expansive prohibition of insider trading could easily interfere with the beneficial activities of market professionals whose efforts to find and act upon new information contribute substantially to the efficiency of the stock markets.  As I recently observed in A Critique of the Insider Trading Prohibition Act of 2021, 2021 U. Ill. L. Rev. Online 231 (Aug. 8, 2021):

In Chiarella, Justice Powell noted that a broad insider trading prohibition might ban ‘a tender offeror’s purchases of target corporation stock before public announcement of the offer,’ a step Congress clearly had declined to take when it adopted the Williams Act to regulate tender offers. In the subsequent Dirks opinion, Justice Powell further explained that such a broad policy basis for regulating insider trading implied a ban that ‘could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market.’

To be sure, Panuwat was not acting as a market analyst. It is also true that he had signed Medivation’s corporate insider-trading policy, which prohibited employees from using confidential information concerning Medivation to trade in “the securities of another publicly traded company.”

But did this information really concern Medivation? As a Bryan Cave memo notes, Panuwat “had been involved in discussions within the company and with its investment banking advisers about potential acquisitions of Medivation, a mid-cap oncology company, and had also discussed the market for acquisition of other mid-cap oncology companies by larger pharmaceutical companies. It alleges that he had focused on one particular peer company, Incyte.” Even if one assumes that Panuwat learned material nonpublic information about Incyte in those discussions, which seems implausible, that information had nothing to do with Medivation or an acquisition of Medivation. Instead, the only information Panuwat learned that concerned Medivation was that Pfizer was likely to buy Medivation. He then gambled that speculators would see Pfizer’s bid as signaling potential for other companies in the industry to be acquired. Saying that undisclosed use of such information touched and concerned Panuwat’s trades in Incyte stock seems like a considerable stretch.

To the extent the SEC’s case rests on Panuwat’s alleged violation of Medivation’s insider trading policy, Panuwat may also argue that that policy likely was intended to prevent Medivation employees from using inside information to trade in the stocks of related companies, such as major suppliers or customers. Medivation might well, for example, have wanted to prevent employees from shorting the stock of a supplier that Medivation was about to cease using. But the SEC’s broad theory of this case would suggest that it is now illegal to trade while in possession of any material nonpublic information a corporate employee learns on the job about any company, whether or not that other company is a party to a transaction with the employer. Shadow trading thus moves the SEC a long way in the direction of restoring the equal access to information theory the Supreme Court long ago rejected.

Several questions remain unanswered:

  1. Will Panuwat dare to fight the case? Courts have long imposed disgorgement of an inside trader’s profits (or loss avoided) as a penalty for illegal insider trading in SEC cases. In the Insider Trading Sanctions Act of 1984, Congress created a treble money civil fine that may be imposed in cases brought by the SEC. The fine is imposed over and above the disgorgement penalty. As a result, a convicted inside trader faces a potential civil penalty of four times the amount of his profit. The SEC can often induce defendants with plausible defenses to accept a settlement limited to disgorgement or perhaps disgorgement plus a single multiple of the trader’s profits. Risk-averse defendants will often take such a deal rather than risking the full potential penalty.
  2. Will courts allow the SEC to effectively resuscitate the equal access theory?
  3. If the SEC prevails, will employers clarify their insider trading policies to limit their application to trading in stocks of customers or suppliers (as well as those of the employer, of course)?