Ryan Fane1Ryan Fane is a J.D. candidate at the University of Chicago Law School, Class of 2023. He thanks the members of the University of Chicago Law Review Online team for their helpful feedback and suggestions.
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An executive at a mid-sized pharmaceutical company learns that her company has just received and accepted a buyout offer from a large competitor. The buyout is set to be announced to the public in three days. The executive, being a savvy investor and an expert in her segment of the pharmaceutical market, has observed that the stock prices of all the companies in the market rise when a large merger is announced by a peer firm. Based on this observation and her knowledge about the impending announcement of her firm’s acquisition, the executive purchases short-term call options for one of the company’s competitors. Days later, the acquisition is announced and, as the executive expected, the competitor’s stock rises above the options’ strike price because of the news. The executive sells the options for a tidy profit.
Is this insider trading? In a complaint filed last year in the Northern District of California, the SEC argues that it is. The SEC has accused Matthew Panuwat of violating insider trading laws by making trades similar to those described in the hypothetical above. Panuwat was a business development executive at Medivation, a pharmaceutical firm that developed oncology-related products. On August 18, 2016, Medivation’s CEO informed Panuwat that the firm would soon be purchased by Pfizer. That same day, Panuwat purchased out-of-the-money stock options in Incyte, a competing pharmaceutical company that developed oncology products. On August 22, 2016, Medivation publicly announced its purchase by Pfizer. Medivation and Incyte’s stock prices both rose significantly the day the announcement was made, and the value of Panuwat’s Incyte options nearly doubled. He later sold the options and made approximately $107,000 in profit. The SEC is now seeking monetary penalties and a ban on Panuwat serving as an officer or director of publicly traded companies.
I. The Classical Theory of Insider Trading
This case raises some difficult theoretical questions about what harms insider trading laws are supposed to prevent and what benefits they are supposed to provide to the marketplace. A typical insider trading case usually involves an insider to a corporation who uses their inside position to trade in the securities of the corporation itself. This situation is what the so-called “classical theory of insider trading” was developed to address. The classical theory, most famously articulated in Chiarella v. United States (1980), holds that insiders must disclose their inside information or abstain from trading when the insider has a fiduciary relationship with the shareholder. The classical theory is thus in some sense a specific application of the general duty of loyalty directors owe to shareholders.
This situation is not particularly analogous to Panuwat’s case because Panuwat never traded in the securities of Pfizer or Medivation, the companies about which he had direct inside information. He clearly did not have a fiduciary relationship to Incyte’s shareholders. As a result, the “classical” theory of insider trading does not provide a sufficient basis for a finding of liability against Panuwat.
II. The Misappropriation Theory of Insider Trading
The second basis for liability, and the one more likely to succeed in Panuwat’s case, is the misappropriation theory of insider trading articulated in United States v. O’Hagan (1997). Zachary Gubler has noted that the misappropriation theory asks not whether a fiduciary relationship exists between the trader and the shareholder but rather if the trading party owes a duty of loyalty or confidentiality to the source of the information. Under this theory, liability arises when an insider uses confidential information belonging to a corporation to trade in securities without the corporation’s consent. Fundamentally, the misappropriation theory is rooted in the law of agency. Bans on insider trading can thus be understood as a particular instance of law’s general prohibition on agents using their relationship with their principal to profit personally.
III. SEC v. Panuwat
Panuwat signed an employment agreement that included a provision prohibiting employees from engaging in insider trading. The relevant provision read:
Because of your access to [non-public] information [about the company], you may be in a position to profit financially by . . . dealing in the Company’s securities . . . or the securities of another publicly traded company. . . . For anyone to use such information to gain personal benefit . . . is illegal.
It appears that Panuwat’s alleged conduct violated this policy. He used Medivation’s non-public information to trade in the securities of another publicly traded company for his personal benefit. He did not disclose his intent to do so or receive permission from his employer. However, questions remain about whether this policy contemplated the specific kind of trade Panuwat executed. The policy may have been written to cover trades in the securities of third-party companies with which the company had a direct relationship in order to avoid the potential misalignment of incentives that allowing such trades may cause.
But does Panuwat’s alleged conduct implicate any real or potential misalignment of incentives between him and his employer? Much has been written about the issue of agency problems in the context of insider trading. Frank Easterbrook has argued, for example, that corporations should not be allowed to permit insider trading because shareholders do not have the ability to police the agency problems that doing so would create.2See generally Frank Easterbrook, Insider Trading as an Agency Problem, in Principals and Agents: The Structure of Business 81 (John W. Pratt and Richard J. Zeckhauser, eds. 1985). The argument essentially turns on the fact that the ability to trade on inside information creates incentives for managers to lead the business in such a way that maximizes the opportunity to generate and then trade on inside information. As a result, law should prohibit insider trading because the managers of a firm would always be incentivized to permit it, and shareholders would be in a poor position to stop it from happening even if their economic interests were harmed by the incentives it creates.
This explanation does not easily track with the facts in Panuwat’s case. The managers in Easterbrook’s example have the direct ability to generate news affecting the share price of their company and then execute trades based on that information before it becomes public. The key issue in this context is that directors can control the price of the security that they are trading in.
Panuwat was trading the securities of a firm he did not control. This fact minimized or eliminated his ability to generate inside information that could serve as the basis for profitable trades. Instead of simply having to manage internal corporate affairs to do so as in the Easterbrook example, Panuwat depended on the actions of another company that was operating at arm’s length to help generate the information. The directors in this company are operating to generate maximum return for their firm’s shareholders. They are not incentivized to collaborate with Panuwat to engage in information-generating activities like a merger unless it is also in the interest of their own firm. Given this fact, it is highly unlikely that a desire to generate inside information about other companies will guide director behavior even without construing trades like Panuwat’s as insider trading. Indeed, the duty of loyalty owed by these executives would still serve as a basis for finding liability should executives or directors use their positions in this way.
Turning specifically to Panuwat’s case, the complaint does not allege that he proceeded any differently in his capacity as Medivation’s business development executive due to the trade. Nor does it allege that the trade directly or indirectly harmed Medivation or Pfizer. In short, the classic agency problems addressed by insider trading law do not seem present in these kinds of trades.
IV. Policy Goals Advanced by Insider Trading Laws
This leads to the main argument of this Case Note: prohibiting Panuwat-style trades under the misappropriation theory does not advance the policy goals of insider trading law. It is a standard principle of both contract law and, since the Chiarella ruling, insider trading law that informational symmetry between trading partners is not a precondition for a legitimate securities transaction. Short of committing fraud, parties do not have to disclose relevant information to the other party even if the information is material to the transaction. Indeed, under the efficient capital markets hypothesis, this is one of the bases for the market’s ability to set prices that reflect the underlying value of assets. As trades occur, the market price for an asset comes to reflect information that is not necessarily available to every participant in the market. As a result, these kinds of trades may actually serve a useful purpose, as scholars like Donald Boudreaux have argued, in helping the market arrive at the correct price for assets. As a result, the policy justification for prohibiting these trades cannot be based on their impact on counterparties.
It is also not clear that prohibiting Panuwat’s trades on the basis of the misappropriation theory would have significant systemic impacts. A frequent explanation for why insider trading should be prohibited is that doing so promotes investor confidence in the market. If insider trading were permitted, the overall value of the market would decrease. Investors would come to view their trading position as irredeemably worse than that of corporate insiders, and they would lose confidence in the relationship between price and value.
Finding liability in Panuwat’s case based on the misappropriation theory does not seem to address this potential systemic risk. To illustrate, consider an alternative set of facts: Panuwat receives the news of the impending acquisition, notifies the board of his desire to trade on the basis of that news, and the board gives him approval to do so. The agency problems are eliminated along with any insider trading liability founded on the misappropriation theory, and the trade goes through. Any systemic effect created by this trade and others like it will still occur despite the disclosure. And indeed, the board might jump at the chance to approve the trade so that they can take advantage of the opportunity, either on behalf of the corporation or themselves.
V. Law Should Help Companies Police Insider Trading Themselves
A better course of action may be for the law to help companies and shareholders to police these agency problems themselves. Companies that are seriously concerned about the potential agency problems that may arise from their executives or employees executing these kinds of securities transactions can prohibit them. They can also implement or strengthen transaction reporting requirements for their employees to enforce these prohibitions. Indeed, a recent paper considering the phenomenon has demonstrated that company policies prohibiting these kinds of trades are successful at reducing their occurrence.
In denying Panuwat’s motion to dismiss, Judge William H. Orrick noted that the Medivation policy governing employee stock trades could be plausibly read to prohibit Panuwat’s conduct. This violation could then serve as the basis for finding a breach of duty by Panuwat and thus a finding of liability for insider trading.
Promoting disclosure of these trades seems like a healthy direction for the law to go. As this Case Note has discussed, insider trading law does not seem to have a very useful role to play in managing the agent-principal relationship in Panuwat’s case. As a result, the trades are primarily suspect as a duty of loyalty violation. Allowing insiders to disclose to their boards that they intend to trade eliminates this concern, and crucially, it allows the shareholders of the company to profit from the information.
Panuwat used his own personal expertise on the correlation of stock prices in the pharmaceutical industry to turn unutilized corporate information into value. The problem in this case is not that he did so, but rather that he did so for his own exclusive benefit. With a disclosure rule, the board could approve the trade and then the company could execute a similar transaction on behalf of the shareholders. Such an arrangement encourages the insiders to look for these opportunities. It also encourages insiders not to appropriate the information for their exclusive benefit. Disclosure rules like this will incentivize corporate insiders to help turn the corporation’s information into value.
The classical theory of insider trading does not explain why Panuwat should be liable. The misappropriation theory might, but in this case, it does not do a good job explaining why securities law should be the mechanism by which the underlying interest, the agent-principal relationship, should be protected. The relationship would be better served by securities law helping companies to manage this behavior themselves by encouraging disclosure of these trades to corporate boards.
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Ryan Fane is a J.D. candidate at the University of Chicago Law School, Class of 2023. He thanks the members of the University of Chicago Law Review Online team for their helpful feedback and suggestions.