Opinion

Alison Frankel

The audacious theory in Elan investors’ insider trading suit vs. SAC

By Alison Frankel
August 15, 2014

Everyone knows that the hedge fund SAC Capital, now known as Point72, made a bundle when it ditched shares of the pharmaceutical companies Wyeth and Elan based on inside information that their jointly developed Alzheimer’s drug, bapineuzumab (better known as bapi), was a bust. SAC supposedly realized $555 million in profits and avoided losses because trader Mathew Martoma got early word about disappointing bapi test results from a doctor involved in the clinical trials. Both SAC and Martoma have, of course, been held to account for the trades: Martoma was convicted at trial and SAC pled guilty. In all, the hedge fund has forked over nearly $2 billion to the government because it illegally traded on inside information about the bapi trials.

Two days after the rest of the world heard about the discouraging bapi clinical trial results – in other words, after SAC had sold off its stake in Wyeth and Elan – Elan revealed even more bad news. Two patients had contracted a rare and frequently fatal brain disease after taking Elan’s major product, the multiple sclerosis drug Tysabri. Shares of the Ireland-based company, which had already taken a beating after the bapi disclosure, fell another 50 percent on the Tysabri news.

SAC didn’t trade on inside information about Tysabri, and the drop in Elan’s share price after the Tysabri disclosure had nothing to do with SAC’s inside information about bapi. Yet according to a decision Thursday by U.S. District Judge Victor Marrero of Manhattan, the hedge fund may still be liable for an additional $107 million it avoided losing because it had already sold its stake in Elan before the Tysabri news broke. Marrero ruled that holders of Elan American Depository Receipts can proceed with class action claims that SAC must disgorge the losses it avoided incurring in Elan’s Tysabri-related stock drop because it had illegally sold its Elan shares based on inside information about an entirely unrelated drug trial.

Um, what?

As SAC’s lawyers at Paul, Weiss, Rifkind, Wharton & Garrison and Willkie Farr & Gallagher pointed out in their motion to dismiss the shareholder case, neither the Securities and Exchange Commission nor the U.S. Attorney’s office demanded that SAC disgorge the losses it avoided when Elan’s stock fell after the Tysabri news. According to SAC, the Federal Bureau of Investigation specifically determined “that including the Tysabri drop in the calculation of the losses allegedly avoided by SAC would be ‘an inappropriate way to calculate loss avoidance.’” Martoma’s prosecutors, SAC’s brief said, even called the Tysabri drop “a ‘distraction’ unrelated to the drop caused by the bapi disclosures.”

But the Elan investors, represented by Wohl & Fruchter and Pomerantz, explained in their brief opposing dismissal that SAC was making a straw-man argument. Under the provision of the Exchange Act of 1934 that gives shareholders a right to sue inside traders, damages are based not on out-of-pocket losses but on the disgorgement of ill-gotten gains. According to the Elan investors’ brief, SAC’s attempt to exclude the Tysabri stock drop claims addressed out-of-pocket loss causation, not case law on disgorgement.

And under the leading precedent on disgorgement and insider trading, a 1980 decision by the 2nd U.S. Circuit Court of Appeals in Elkind v. Liggett & Myers, Elan investors argued, inside traders are liable for all of the gains they realized within a “reasonable time” after the inside information becomes known to the market. (The idea is that the market may need some time to absorb and react to the news, so you can’t tell right away just how much inside traders profited from early access to the information.) “The relevant question is therefore whether this period had elapsed by the time of the Tysabri disclosure, two days after the bapi clinical trial results were announced,” the Elan brief said.

Elan’s lawyers claimed the market was still unsettled after the initial bapi announcement, but the double-whammy of bad news about Tysabri confirmed investors’ fears about the bapi results. The true magnitude of SAC’s ill-gotten gains, they said, became clear only when Elan’s share price plunged on the second troubling disclosure.

SAC said in response that the Elan investors’ theory would result in an improper windfall recovery for Elan shareholders, based on an event that was completely unrelated to SAC’s insider trading. Judge Marrero said that was tough luck for SAC. “SAC had no knowledge of the impending Tysabri drop when it liquidated its position in Elan,” he wrote. “Still, by trading on inside information, SAC assumed the risk that other independent factors could compound the decrease in share value following the disclosure of the bapi results.” When it comes to insider trading, he said, doubts have to be resolved in favor of the victims, not the perpetrator.

Marrero’s ruling just gives Elan shareholders the right to move forward with their claims, so SAC will have more opportunities to erase claims that it owes more than $100 million for a stock drop that had nothing to do with the hedge fund’s criminal trading. Marrero also ruled that both Wyeth and Elan shareholders are entitled to discovery to determine whether SAC’s $275 million disgorgement to the SEC covers all of the potential damages to investors who didn’t have SAC’s inside access to information. The Wyeth shareholders, who don’t have claims based on the Tysabri-related drop in Elan shares, are represented by Scott + Scott and Motley Rice.

In response to my phone call to SAC lawyer Daniel Kramer of Paul Weiss, an SAC representative declined to comment.

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