Insider trading case casts long ‘shadow’ over private markets

The SEC’s successful prosecution of a first-of-its-kind “shadow trading” case changes private equity managers’ risk calculus, experts warn.

“I think all private equity firms – all SEC registrants, frankly – need to review their existing policies and procedures to make sure that they capture the essence of shadow trading, including how to identify shadow trading risks,” said Philip Moustakis, a partner with Seward & Kissel.

A federal jury in San Francisco took a few hours on April 5 before it found that former Medivation executive Matthew Panuwat had committed insider trading when he used confidential information that Medivation was about to be acquired by Pfizer to trade options and shares in a third company. In essence, Panuwat guessed that once Medivation was off the market, it would improve the rival company’s chances of being acquired, too, thus driving up its stock price.

It’s the first time regulators have brought a case of its kind and its implications for the financial services industry are sweeping, experts said.

“It expands the scope of how we think about insider trading,” said Gregory Baker, a partner with Patterson Belknap in New York. “It’s really about misappropriation of material, non-public information.”

Duties of care

The SEC’s case hung mostly on Medivation’s policies and procedures. They warned Panuwat and other executives that they’d likely come upon MNPI in their jobs. They went even further, though. “Because of your access to this information,” the P&Ps state, “you may be in a position to profit financially by buying or selling or in some other way dealing in the Company’s securities… or the securities of another publicly traded company, including all significant collaborators, customers, partners, suppliers or competitors of the Company.”

It was those broadly worded policies, regulators successfully argued, that imposed a duty of care on Panuwat. It’s an object lesson for private equity managers and other financial services firms, who routinely sign confidentiality agreements on everything from potential buyouts to data rooms’ terms of service, experts said. The broader those agreements are worded, the broader the risks now grow.

“Proving the knowledge or recklessness of a firm can be done based on the evidence concerning what any number of individuals have done”

Philip Moustakis, Seward & Kissel

“All of the years of training, and all of the years of inculcation of our employees has been premised on the idea that if you receive MNPI from company A, you can’t trade in the securities of company A,” Moustakis said. “Now we need to train our people to think more broadly about it.”

Private funds may be in an especially vulnerable spot here. More than a year before regulators filed their suit against Panuwat, they issued the first-ever risk alert for the private funds industry. Among their findings: firms weren’t doing enough to manage the risk that MNPI might seep out from their shops.

‘Significant victory’

Medivation had been the subject of a ferocious bidding war in 2016. On August 22 of that year, the company announced that Pfizer had won the war with a $14 billion offer. The SEC claims that Panuwat had learned about the pending announcement four days earlier, when then-Medivation CEO David Hung sent an e-mail around saying that Pfizer had “expressed overwhelming interest.”

Within minutes of getting that e-mail, regulators claimed, Panuwat logged onto his personal brokerage account and bought 578 call options in Incyte. Panuwat knew that once the Pfizer news broke, Incyte would be the next enticing target for a buyout. When Medivation announced the Pfizer deal, the price of shares in Incyte and several other mid-cap pharma companies spiked, regulators claim.

Three pieces of evidence damaged Panuwat’s defense, Morrison Foerster partner Edward Imperatore said. First, he purchased the competitor’s shares immediately after learning about the acquisition. Second, he bought options (“That’s often a red flag to jurors”). Finally, the Commission played Panuwat’s deposition to the jury in which the defendant couldn’t provide a reason for his purchases.

“It was a significant victory for the SEC,” Imperatore said of the case.

After the jury’s verdict came down, SEC Enforcement Division Director Gurbir Grewal took a victory lap.

“As we’ve said all along, there was nothing novel about this matter, and the jury agreed: this was insider trading, pure and simple,” he said in a statement. “Defendant used highly confidential information about an impending announcement of the acquisition of biopharmaceutical company Medivation, Inc, the company where he worked, by Pfizer Inc to trade ahead of the news for his own enrichment.”

‘It’s profitable’

The case is also a victory for a trio of academics who coined the phrase “shadow trading” in a September 2020 paper in The Accounting Review. University of Michigan Economics professor Mihir Mehta, National University of Singapore Accounting professor David Reeb and Renmin University of China Finance professor Wanli Zhao looked at thousands of publicly traded companies’ announcements for earnings, mergers or acquisitions or new products. They then looked back at “informed trading” in advance of those announcements.

“It expands the scope of how we think about insider trading”

Gregory Baker, Patterson Belknap

For every point above standard deviation in a source firm’s news announcement – in other words, the better a companies’ news turned out to be – there was an increase of between 6.4 and 19.2 percent in informed trading in linked firms ahead of those announcements, the researchers found.

“If the SEC’s mission is to make sure the markets are fair, people who have inside information that isn’t just based on their general knowledge are going to profit by it, and that’s an inequity,” lead author Mehta told affiliate title Regulatory Compliance Watch in an interview shortly after the Commission filed its suit against Panuwat. “This has been going on for a long time. And it’s profitable.”

Practice tips

If there’s a silver lining here, it’s this: the risk of “shadow trading” trading is real, but the phenomenon itself is probably not pervasive, experts said. That doesn’t mean firms can ignore the risks. That’s especially true because, as a matter of law, it’s much easier to hold a company accountable for insider trading than it is an individual employee.

“Proving the knowledge or recklessness of a firm can be done based on the evidence concerning what any number of individuals have done,” Moustakis said. “It’s just easier to prove for a prosecutor. And the risk is greater.”

Like many experts we spoke to for this story, Moustakis recommends that you go back through your firm policies to make sure you’re alerting your trading desks and deal teams to the new calculus.

You’ll also want to give careful thought to the agreements your firm signs, Moustakis said. “Take a close look at the agreements you enter into, particularly confidentiality agreements,” he said. “They could be the terms of services to which you agree when you click on a data room. Most asset managers haven’t really focused on the scope of the duty created by these agreements. Because the safe thing used to be to enter into an agreement with a company, and then restrict that company.”

It’ll probably be most helpful if you designate a single point of contact in the compliance office to talk about MNPI and insider trading risks, he adds.

Finally, you’ll want to take a lot of time to train your firm staff carefully, Moustakis said.

“We need to educate our people to spot the risk,” he said. “On the one hand, the SEC never likes a compliance program that requires the investment team to self-identify MNPI. On the other hand, we all recognize the investment team, they’re our first line of defense. If they’re not trained to spot MNPI, then there’s no trigger to get compliance involved.”