August 27, 2021

Insider Trading: Panuwat Case Will Test Whether “Shadow Trading” Is Legal

I blogged last week about the SEC’s insider trading case against Medivation’s former biz dev guy – and I confess I struggled with the headline! I wasn’t really sure what to make of the allegations. Thankfully, a couple of members sent resources – and we’ve been posting additional memos in our “Insider Trading” Practice Area. This Wachtell Lipton memo expands on issues the case could turn on:

Most corporate insider trading policies include a provision similar to Medivation’s prohibition of trades in the securities of other companies on the basis of the employer’s information. But the Panuwat allegations are quite different from the concerns that usually animate such policies; for example, companies recognize that their employees may learn of confidential plans to enter into a material contract with a supplier, to acquire a target company, or to terminate a material relationship with a vendor, and accordingly, their policies prohibit trading in the securities of the supplier, target or vendor before the news becomes public.

By contrast, the connection between the information that Panuwat allegedly received and the company in whose securities he traded was indirect, and the information did not arise from any dealings between his employer and Incyte. As the Panuwat litigation proceeds, the issue of materiality is likely to be hard-fought. The courtroom battle can be expected to center on issues such as how likely or uncertain it was that the Medivation news would affect Incyte’s stock price, as well as on the indirect nature of the connection between Medivation’s information and the securities in which Panuwat traded. The case will likely also test the SEC’s assertion that Panuwat misappropriated Medivation’s information when he traded. The courts will ultimately need to determine whether the misappropriation theory of insider trading liability extends to these facts.

In this 20-year old article, Yale Law Prof Ian Ayres & Stanford Law Prof Joe Bankman call this type of transaction “trading in stock substitutes” – and say that it’s legal and somewhat common. A similar analysis from just last year by Mihir Mehta, David Reeb and Wanli Zhao calls it “shadow trading.” According to the authors, shadow trading remains pretty widespread. But it’s an untested legal theory because it’s almost never prosecuted – in part because it’s difficult to detect. This new case suggests that the SEC’s data analytics are getting more advanced, and now a court has a chance to weigh in on whether or not this activity is legal. Here’s another nugget from the study:

Firms have incentives to prohibit employees from using their private information to facilitate shadow trading as the public revelation of such activities could adversely affect their business relationships and thus, their operations and profits. … [F]irm-mandated prohibitions appear to be effective. Our results show that shadow trading is significantly higher when source firms do not prohibit employees from engaging in shadow trading relative to when they prohibit shadow trading. Although mostly untested in the U.S. judicial system, such company regulations arguably create a fiduciary responsibility for employees not to exploit their private information in economically-linked firms.

As I pointed out last week, Medivation’s policy did contain that type of broad prohibition, according to the SEC’s complaint. That could end up being an important fact. For more analysis, see this Cooley blog.

SEC Enforcement has been busy on insider trading cases. Last week, they also announced charges against former employees of a popular streaming service who were allegedly tipping non-public info about subscription numbers to friends & family who traded in advance of earnings announcements – to the tune of $3 million in profits. In another recently announced case, the complaint alleges that the wife of a guy on a deal team traded in target stock unbeknownst to her spouse. All good fodder for your compliance programs…

Liz Dunshee