For at least a quarter century, the Securities and Exchange Commission (SEC) has pursued claims of unlawful insider trading where the information at issue was material to the stock price of the sponsor of a clinical trial. In recent years, almost half of these cases were also prosecuted criminally, some resulting in prison sentences. Because the cases arise out of work in a medical academic setting, those charged may not have understood the broad reach of the law, including the misappropriation theory. Training and prophylactic measures may be deficient. The trading based on inside information about clinical trials is similar to the reports of arguably suspicious trading by government officials based on information about the pandemic, suggesting that more cases where the information is medical may be in the pipeline. Only if the persons who know such information or those who advise them have a greater understanding of the law will the risk of violations in this industry be reduced and will those involved not feel a chill in communicating that could impair the quality of the clinical trial and thus the search for an effective drug.

These cases provide the foundation for our study of how insider trading law has been applied – and may be applied – in a regulated industry where there are many actors in different roles with access to material nonpublic information (MNPI). Our paper presents the legal framework of insider trading law, the regulatory process for drug approval by the Food and Drug Administration (FDA), and insider trading cases in that setting. We then address how the law might apply to a broad array of scenarios. We analyze areas of uncertainty and recommend steps to reduce the risk of wrongful conduct.

The sponsor of a trial is often a publicly traded company seeking to develop a profitable drug. The trial’s success or failure may be material to the sponsor’s stock price. At some point its employees will learn MNPI about the trial. Others, including medical doctors and other scientists, conduct the trial. They are often employed by a research or educational institution, e.g., a hospital or medical school. Any of them, as well as supervisors at the institution, could learn MNPI. FDA personnel receive confidential information. Finally, persons who agree to be subjects of the trial (participants) may learn MNPI. Anyone in these categories who trades in securities of the sponsor while aware of MNPI might violate a prohibition on insider trading, by trading or tipping.

Under the classical theory of insider trading it is unlawful for an employee of the sponsor of the trial to trade while aware of MNPI about how the trial is proceeding. A researcher overseeing the trial or a member of the research team may have a short-term confidential relationship with the sponsor. In that event, the researcher may be a “temporary insider” of the sponsor, and thus be prohibited from trading or tipping if they know MNPI.

Under the misappropriation theory, someone who trades based on MNPI obtained in a relationship of trust or confidence, such as having entered into a confidentiality or nondisclosure agreement (NDA), without first telling the source of the information they plan to trade, violates the law. This theory can be far-reaching in the clinical trial setting. The researcher who has signed an NDA with the sponsor or his employer-institution may be liable if he trades. FDA employees are under strict rules regarding disclosure of information they learn and securities trading, including the STOCK Act.

Interaction between researchers and a potential participant begins when the latter is evaluated to be a participant. Ordinarily information provided by the participant is held in confidence. Information provided to the participant, however, is not typically confidential. While it is unlikely that MNPI would be disclosed to a candidate, it might be revealed to encourage the person to participate or in answer to questions, where the response must be complete. Concerns might be alleviated by conditioning a response on execution of an NDA. But this might deter the person from enrolling. (“What is it about this trial that they don’t want disclosed?”) If the enrollee were to sign an NDA, unlikely though that may be, he becomes vulnerable to application of the misappropriation theory if he were to trade or tip. We do not suggest that this is on the horizon, only – but importantly – that it may be a viable theory to be considered before trading.

Actual enrollment is not typically conditioned on signing an NDA, though language could easily be included in the Informed Consent Form (ICF). The ICF could include an express prohibition on trading. However, exceptions to a prohibition on disclosure are required by FDA and other rules, permitting disclosure to the participant’s medical providers and family. Delineating the scope of these essential exceptions with precision would be difficult, and may change over time, as trials can last for many years.

Signing an NDA, which could provide the predicate for invocation of the misappropriation theory, is undoubtedly the exception. However, an SEC rule (10b5-2(b)(2)) could bring participants within the reach of that theory. That rule provides that a duty of trust or confidence exists when the one who discloses MNPI and the person to whom it is communicated have a “history, pattern, or practice of sharing confidences” when the recipient “knows or reasonably should know that the person communicating the [MNPI] expects that the recipient will maintain its confidentiality.” This might arise when, during a lengthy trial, an investigator and the participant form a bond where they share confidences and the investigator reveals, perhaps inadvertently, some MNPI about the progress of the trial. Or, in response to persistent wheedling by the participant, the investigator reveals some information that he expects will be held in confidence.

It is only awareness of material information that triggers the prohibition on trading. In deciding whether a fact is material it may be necessary, during the evolving trial, to apply the probability/magnitude materiality test. The participant who observes improvement in her health during the trial may conclude that the drug is working, which is likely material – if that fact (if true) can be extrapolated. (What matters is what this person knows, not what the research team knows.) In the typical double-blind study, however, the participant does not know if she is taking a placebo. The threshold of materiality could be reached if the participant observes that others in the trial, who she sees when a group receives treatment or takes medical tests, are improving or she learns this in communicating with fellow participants. There is now more information, though it may still be uncertain in the aggregate. The potential trader must assess, at her peril, whether these observations create a mosaic that is material. A participant may decide to trade, concluding that what she knows is not material. (But then why else did she trade at that time?) Given the propensity for these issues to be judged in hindsight, trading will be risky. Of course, trading is prohibited only if the person has a relationship of trust or confidence with the source(s) of the information, here the co-participants with whom she may have formed bonds, as they often do.

Another crucial issue is determining when information is no longer nonpublic. It may become public when information is disclosed at an internal meeting or external medical conference, even with modest attendance.  If it is deemed public when disclosed, there having been no pledge of confidence for this event or as a matter of general policy for such events, any attendee should be free to trade even before any publication in the popular or scientific press. (Regulation FD would not normally mandate simultaneous public disclosure by the sponsor.) Some peer reviewers of publications of trial results sign an NDA, but not in all cases.

More thought is needed regarding when to require an NDA or when as a matter of policy trading should be prohibited as a condition of disclosure that is made for the benefit of society at large. Better to provide clear guidelines than to expect scientists to decide when they can and cannot trade.

Recent developments suggest the SEC is not averse to testing the limits of the law – not a new perception. A recent ruling accepted in principle the “shadow theory” of insider trading, where an insider of one company allegedly used information about an impending acquisition of that company to buy stock of a similar company (about which he had no inside information), concluding that once the acquisition was announced the stock prices of similar firms would rise because they would be seen as acquisition targets. This application of the misappropriation theory argues for great caution in deciding what securities any of the persons described earlier could safely trade. If a trial goes well, it could present an opportunity to sell short or buy put options in stock of the sponsor’s competitors, or vice versa if the trial is failing. Delineating ex ante how wide the “shadow” might be cast in hindsight will not be easy when deciding when it is safe to trade.

Because the potential reach of the law in connection with clinical trial information is not fully appreciated by everyone in this industry, not only sponsors but also research institutions must institute or upgrade their written insider trading policies and training. A few hours devoted from time to time to this topic could spare embarrassment, not to mention a hefty civil penalty or jail time. This is especially so for nonprofit institutions, who may not perceive insider trading to be something of concern. Their employees must be alerted, in general but perhaps frightening, terms to the potential reach of the law presented in our paper.

This post comes to us from Allan Horwich, a professor of practice at Northwestern Pritzker School of Law and a partner at the law firm of Arent Fox Schiff, and Crista M. Brawley, associate vice president for research at Northwestern University. It is based on their recent paper, “Insider Trading in the Clinical Setting,” available here.