SEC’s New Theory – Shadow Trading

Insider trading is a broad and murky area. However, now, the SEC has complicated matters with the introduction of a new theory — shadow trading. Unlike insider trading, where a person trades in the stocks of a company in which they have MNPI (material non-public information), shadow trading involves trading in an economically linked company with the MNPI of a target company (entirely different company). Coined by Mehta, Reeb and Zhao in their research paper titled “Shadow Trading ”, this concept was first put to test by the SEC in SEC v. Panuwat. The SEC slapped charges on Panuwat stating that he misappropriated material information about his pharmaceutical company, Medivation, to trade in the stocks of their competitor, Incyte Corporation. Since shadow trading was rather a novel concept, the SEC brought claims under the misappropriation theory of insider trading where trading is forbidden on the basis of MNPI obtained by someone who is not a corporate insider (i.e., a corporate outsider) in breach of a duty.

The SEC alleged that Panuwat, upon receiving confidential information from Medivation’s CEO about the imminent acquisition by Pfizer, misappropriated the information by swiftly purchasing out-of-the-money stock options in Incyte Corporation from his work computer. When the merger was made public the share prices of both companies rose and Panuwat reaped illicit profits of $107,066. Panuwat was charged with violating Section 10(b) and Rule 10b–5 of the Securities Exchange Act of 1934. Panuwat hit back by arguing that SEC failed to show that the information was material and unavailable to the public, there was a breach of fiduciary duty and that he possessed scienter (intent). However the Court ruled against him and dismissed his motion for summary judgment.

The Court held that Panuwat had material information regarding the merger and its disclosure would have been viewed by a reasonable investor as material when deciding to trade in those securities. While Panuwat did point out that he did not possess any information about Incyte when he purchased the stock options, SEC said that the market viewed Medivation and Incyte to be complementary to each other. SEC blamed Panuwat for narrowing the meaning of materiality and held that the information would have been material for more than one company. SEC showed evidence from reports and articles that linked Medivation and Incyte, Panuwat’s positive comments about Incyte months before he bought stock options and Panuwat’s awareness of the market reports which influenced his perspective on the biopharmaceutical market. It was also established that Panuwat had MNPI since he had access to confidential information through summary of bids, letters soliciting final bids and internal emails related to the merger.

These allegations were further strengthened when SEC successfully established breach of fiduciary duty. The Court held that Panuwat was bound by Medivation’s insider trading policy that prohibited all employees from using the company’s sensitive and confidential information for profit by trading in securities. Panuwat breached this duty by using MNPI’s of Medivation to trade in Incyte’s securities. Lastly, the Court held that Panuwat possessed intent, when he actually used information about Medivation’s acquisition to purchase stocks in Incyte. Panuwat immediately purchased stocks right after he received an email showing that the merger was to move forward.

However it is to be noted that Judge Orrick was careful to place the liability on Panuwat because of the broad language of Medivation’s insider trading policy that prohibited their employees from trading in any stock or security. It is unclear whether Panuwat would still be liable under the section absent the broad language or explicit prohibition in the policy. Furthermore, this fact pattern could be applied to any scenario where it is found that information from one company can be linked to the stock price of another. This is unreasonable since any corporate insider could be liable for trading in stocks with the information of their own company.

Shadow trading is still a relatively new concept and Panuwat’s case is only at its initial stage. Shadow trading is not an uncommon phenomenon and the SEC has claimed to take up the task of mitigating illegal trading in all forms starting from Panuwat. It is also a caveat to the ones who interpret insider trading laws narrowly, that the courts are willing to accept the broad powers of the SEC. Needless to say if this is accepted in the future it is a threat to the corporate insiders and would have far reaching effects. Therefore it is important to adopt policies to curb insider trading litigation with the Panuwat decision in mind. After all, prevention is better than cure.