“Shadow Trading” – District Court Upholds the SEC’s Shadow Insider Trading Theory
Back in August 2021 the Securities and Exchange Commission filed a first-of-its-kind “shadow” insider trading case against Matthew Panuwat. Mr. Panuwat filed a motion to dismiss the SEC’s case arguing that the SEC’s shadow theory of insider trading was not supported by existing insider trading law. On January 14, 2022, the District Court for the Northern District of California denied Mr. Panuwat’s motion and held that the SEC had properly stated a cause for actin for insider trading consistent with exiting law. The outcome is not surprising, as this blog foreshadowed in September of 2021 (available here), because shadow trading is actually not a new concept (see prior article) and does fit squarely within the existing conceptual framework of insider trading law.
The SEC’s complaint alleges that Mr. Panuwat improperly traded after learning that his employer, Medivation Inc., was to be acquired by Pfizer, Inc. However, and this is the novel part of the case, he did not trade in the securities of Medivation or Pfizer, but instead bought call options in Incyte Corporation, a similar “peer” company to Medivation. The SEC, in fairly convincing allegations, asserts that Mr. Panuwat knew that the news of Medivation’s acquisition would cause the price of Incyte’s stock to rise because Medivation and Incyte were very similar companies. In other words, the material information about Medivation’s acquisition was also material as to Incyte. The SEC further alleges that Medivation’s insider trading policy specifically prohibited trading in the securities of Medivation “or the securities of any other publicly traded company” on the basis of confidential information. Circumstantially supporting its case, the SEC complaint alleges that “within minutes” of receiving an email from the CEO of Medivation informing Mr. Panuwat of the acquisition, Panuwat purchased short-dated, out of the money Incyte call options. He had never before traded Incyte securities or traded options.
In his motion to dismiss Mr. Panuwat argued that the SEC’s theory was not supported by existing insider trading law and, as the first shadow trading case brought by the SEC, he was not on notice that such trading was illegal (a due process violation). Denying the motion, the court held that the shadow theory was within the bounds of existing law under the misappropriation theory of insider trading and the broad language of Section 10(b) of the Exchange Act. Specifically, the Medivation insider trading policy established a duty not to trade in the securities of any company on the basis of material, nonpublic information (there was no dispute that the information was nonpublic). Materiality, the court held, is not limited to just the company the information is directly about, but can be material to other companies as well. As to scienter (intent), the facts of the case – specifically the timing of the options trades – sufficiently pled the required intent for insider trading (scienter is rarely an issue in civil insider trading cases as the circumstances of the trading and possession of the information is usually enough to establish the trader’s intent). For these same reasons the court held that Mr. Panuwat was on sufficient notice that the alleged conduct was prohibited by law and therefore not a due process violation.
The facts in this case, as alleged in the complaint, are particularly good for the SEC’s position and the court’s holding is therefore not a surprise (at the motion to dismiss stage the court assumes the allegations of the complaint are true and does not consider other evidence). What remains to be seen is how far these concepts extend. For example, what about the case where the company’s insider trading policy does not specifically prohibit trading in the securities of other companies? Does a general confidentiality obligation in a company policy suffice to create a duty when trading in the securities of other companies? From a compliance point of view traders should assume it does, although the issue has not been addressed in a shadow context. Insider trading is one of those areas of the law where it is far better to be safe rather than sorry (or in federal detention), and traders should assume that any breach of any obligation in connection with obtaining or using information is sufficient to establish the duty element of insider trading.
And what about materiality? Incyte, as alleged in the SEC’s complaint, was very similar to Medivation and therefore the materiality of Medivation’s acquisition to Incyte is hard to argue with. But at what point are companies dissimilar enough that information about one is not material to the other? The answer is that materiality is a defined concept, and if a reasonable investor would believe the information is important in making an investment decision about the second company – then it is material to the second company. That approach, however, runs up against the problem that in the real world materiality is often a vague concept – what exactly would a reasonable investor believe important in making an investment decision, and especially as relates to a second company that the information is not directly about? While on the ends of the spectrum materiality is easy to gauge, in the wide middle part it often is not. Compliance departments have therefore placed greater reliance on assuring that there is no breach of duty to avoid relying on the vagaries of the materiality definition. That means, where there is any question about materiality, many investment firms often restrict trading in a company’s securities if there has been a breach of duty in obtaining or using information about the company. That approach, however, is not as useful in a shadow trading context since it could mean restricting an entire industry group. Instead, where a breach of duty exists traders will need to identify other companies that the information could be material to and then make materiality judgments as to each of those companies. Not easy decisions to make in many situations – and hopefully the government realizes this in being careful to only bring shadow cases where the information is clearly material to the second company.
For years astute investors have recognized these issues and steered clear of trading in shadow situations. With the SEC having brought the first shadow case and a court upholding the approach, all traders are well-advised to explicitly address shadow trading in their policies and compliance programs.