Shadow Trading: The SEC’s New Angle on Illegal Insider Trading

Everyone knows that employees cannot buy or sell securities while in possession of material nonpublic information.

However, when we think about material non-public information, we usually think in terms of information about the company where an employee works. Or perhaps information about a company with whom an employee’s company is about to announce a business transaction like a merger.

But the Securities and Exchange Commission wants to make an example of another type of insider trading.

Dubbed “shadow trading” in this academic paper, the SEC has decided to pursue insider trading that involves trading not in the securities of an employee’s company or that company’s merger partner, but in the securities of another company within the same industry.

In SEC v. Panuwat, the SEC alleges that Matthew Panuwat, a former executive at Medivation Inc., an oncology biopharmaceutical company, learned that his company was to be acquired by Pfizer through an email by Medivation’s CEO.

Within minutes, alleges the complaint, Mr. Panuwat “misappropriated Medivation’s confidential information by purchasing—from his work computer—out-of-the-money, short-term stock options in Incyte Corporation (‘Incyte’), another mid-cap oncology-focused biopharmaceutical company whose value he anticipated would materially increase when the Medivation acquisition announcement became public.”

When Medivation publicly announced Pfizer would acquire it, Incyte’s stock subsequently rose 8% and the value of Mr. Panuwat’s stock roughly doubled, profiting $107,066.

The Details

Mr. Panuwat was no babe in the woods when it came to trading in corporate securities. Rather, he was a seasoned trading professional and “held licenses in the securities industry and was registered with the SEC as an associated person of an investment bank in San Francisco that acted as a broker and dealer in securities,” according to the complaint.

Upon employment at Medivation, Mr. Panuwat signed the corporate insider trading policy, which, among other things, stated the following:

… you may be in a position to profit financially by buying or selling or in some other way dealing in the Company’s securities…or the securities of another publicly traded company, including all significant collaborators, customers, partners, suppliers, or competitors of the Company. … For anyone to use such information to gain personal benefit…is illegal. …

[Emphasis added.]

The SEC’s complaint alleges that Mr. Panuwat was closely involved in the steps leading up to the merger, unsurprising given that he was the former senior director of business development at Medivation:

Panuwat, who himself had years of experience as an investment banker and had specialized in deals involving the pharmaceutical industry, worked closely with Medivation’s investment bankers, and with other high-level Medivation executives, to explore Medivation’s alternatives, including a possible merger with another company.

The complaint stated that, during the process, Mr. Panuwat became privy to the similarities between Medivation and Incyte via the investment bankers, “including that both were valuable, mid-cap, oncology-focused companies with a profitable FDA-approved (commercial stage) drug on the U.S. market.”

The SEC alleges that in 2016, Mr. Panuwat knew that “large-cap pharmaceutical companies were interested in acquiring oncology-focused mid-cap biopharmaceutical companies with commercial-stage drugs; that there were only a few—including Medivation and Incyte—left to acquire.”

The complaint explains in detail the nature of Mr. Panuwat’s trading activities upon learning the Pfizer deal was to go through:

Panuwat logged on to his personal brokerage account from his work computer and purchased 578 Incyte call option contracts with strike prices of $80, $82.50, and $85 per share—significantly above Incyte’s stock price of $76 to $77 per share at the time—and the soonest possible expiration date, September 16, 2016. Panuwat was aware that Incyte was not expected to make any significant announcement, such as issuing a quarterly earnings report, before the options expiration date. Rather, Panuwat anticipated that Incyte’s stock price would jump within less than a month on public disclosure of the upcoming Medivation acquisition announcement. Panuwat had never traded Incyte stock or options before.

The complaint alleges Mr. Panuwat acted in violation of Section 10(b) of the Securities Exchange Act of 1934 and Exchange Act Rule 10b–5.

Mr. Panuwat denied that he had done anything wrong, and filed a motion to dismiss the case. In January, the US District Court for the Northern District of California denied Mr. Panuwat’s motion to dismiss, which was a preliminary win for the SEC.

Having said that, it remains to be seen whether the SEC will ultimately prevail in the case at trial.

Takeaways

We know that the SEC often uses academic research to fuel its actions, and shadow trading falls right in line with its past practices.

In 2020, academic research emerged that showed that the shadow trading phenomenon was “an undocumented and widespread mechanism that insiders use to avoid regulatory scrutiny.”

While the outcome of this case remains to be seen, it is prudent to take steps now to consider potential consequences when it comes to corporate insider trading policies.

Whether or not the SEC is ultimately successful in pursuing this strategy may be less important than ensuring that corporate insiders including directors, officers and rank-and-file employees stay out of the SEC’s crosshairs when it comes to this kind of behavior.

Specifically, when providing training to your corporate insiders on the topic of material nonpublic information, it is important to highlight that insider trading rules can apply to the industry broadly and not just to participants to a merger or other transaction.

In addition, some are already speculating how it may impact private fund managers.

The National Law Review highlights the fact that “for fund managers, ‘shadow trading’ risks can raise issues in terms of enforcing policies and procedures to prevent insider trading.”

“For firms that allow employees ‘over the wall’ to analyze potential transactions on a regular basis,” says the article, “determining which companies should be placed on the firm’s restricted list may become more difficult where the information available to the ‘over the wall’ employee does not relate to a specifically identifiable company (such as a party to the transaction at issue) or even to only a small number of identifiable companies.”

Law firm Akin Gump points out, though, that even before Panuwat, “we have seen the Examination Staff [at the SEC] inquire about whether an adviser’s policies and procedures address the perceived risk that an adviser could obtain material non-public information about public issuers from private portfolio companies or other channels.”

Akin Gump also provides four steps that fund managers should take ahead of the outcome of the Panuwat case.

Next Steps

The SEC is clearly serious about insider trading infractions, be it typical ones or non-typical ones involving puns or shadow trading. Remember too that corporations are obligated to take reasonable steps to prevent illegal insider trading.

The concept of shadow trading is a tricky one, so now is a good time to review your insider trading policy to determine if you should refresh the policy in light of the Panuwat case.

Consider as well offering live training with a question-and-answer session for your employees, including directors and officers.

On this last point, remember that Woodruff Sawyer provides customized training on insider trading policies to our D&O insurance brokerage clients for no charge. These are anecdote-driven sessions that employees typically find valuable as well as surprisingly engaging, and are just one of many training modules we offer to help our clients improve their risk profiles.

Contact your Woodruff Sawyer account executive for more information.