Venture capital firms should pay close attention to a lawsuit brought by the SEC that focuses on so-called “shadow trading.” Whether or not the SEC wins its case, a federal judge has given it the green light to try shadow trading in court. VCs need to be very careful about what they do with material, non-public information that they routinely learn about.
The case centers on Matthew Panuwat, a former executive at biopharma company Medivation. Regulators say he broke the law when, learning that pharma giant Pfizer was about to acquire Medivation, he traded on shares in Incyte, one of Medivation’s rivals. Panuwat correctly guessed that, with Medivation off the block, Incyte was the next likely mid-sized pharma company to be acquired.
The SEC cleared a hurdle in late January when US district judge William H Orrick denied Panuwat’s motion to dismiss the case. The SEC’s case is “unique,” Orrick said, but it “falls within the contours of misappropriations theory and the language of applicable law.”
Orrick’s ruling effectively expands the definition of insider trading.
Under “classical” insider trading theory, you break the law if a) you’re in a position of trust of a given company, b) you learn material, non-public information about that company and c) you trade on that insider information. Regulators or prosecutors must prove all three elements to win a case.
Under “misappropriation” theory, which is just a few decades old, you are guilty of insider trading if you trade on information you hear from someone to whom you owe a “duty of trust or confidence.” Classical theory usually drags in company executives, while misappropriation cases often involve executives’ friends or relatives.
The Panuwat case is a misappropriation case. It hangs entirely on Medivation’s policies and procedures. Those policies forbade Medivation executives from trading in “any securities” using MNPI they learned while working at Medivation. Those broadly worded policies, the SEC claims, imposed a duty of trust and confidence on Panuwat and other Medivation execs. By trading on insider knowledge related to the acquisition of Medivation, Panuwat breached his duty to Medivation.
The shadow trading theory hits venture capital funds right in the solar plexus, said Philip Moustakis, a former SEC enforcement attorney who is now of counsel to Seward & Kissel in New York.
“You better take it more seriously, because the theory has real traction,” he said. “The industry has to be prepared for the idea that the SEC may indulge in other novel theories of insider trading.”
The SEC has made clear that it’s no longer enough for private fund advisers to protect against insider trading. Regulators want firms to protect insider information from leaking out altogether. Just ask Omega Advisors, Deerfield Management Company, Cannell Capital and Ares Capital Management, all of which have settled MNPI cases with the SEC in the past five years.
As part of their normal course of business, venture capital managers constantly sign confidentiality agreements. Any broadly worded language about who can trade and when – a la Medivation’s policy – could impose a duty on private funds like the one imposed on Panuwat.
“It’s extraordinarily difficult for a firm to defend against insider trading charges when one of its employees was in possession of MNPI,” Moustakis said. “When an individual is being prosecuted, the prosecutors must prove that the individual knew about the information. It’s much easier to prove that an institution had the information. Any individual taints the firm, absent an ethical wall.”
This is where VC funds’ leanness works against them. Big firms can afford to build up ethical walls to prevent the leakage of MNPI through clean desk policies, key-card entries at different floors, etc. It isn’t clear if small and mid-sized firms can afford to take the same steps.
“Historically, if you’re a small or mid-sized firm and you come into some MNPI, you restrict trading on a given company until you’re clear of MNPI,” Moustakis says. “Now you’ve got to go look very carefully at the scope of duties created by that confidentiality agreement.”
Bill Myers covers private fund policy from Washington, DC. He can be reached at firstname.lastname@example.org.