March 23, 2023

Shadow Trading: Report Raises the Profile of “Potentially Troubling” Trading Patterns

The SEC scored a big win last year on a novel “shadow trading” case that it brought in 2021, when a federal court allowed the litigation to proceed. That case hasn’t been decided – but if the SEC is feeling lucky, a ProPublica investigation that was published last week may give the Enforcement Division a jumpstart in finding more trades to investigate. Here’s an excerpt:

ProPublica analyzed millions of those trades, isolated those by corporate executives trading in companies related to their own, then identified transactions that were anomalous — either because of the size of the bets or because individuals were trading a particular stock for the first time or using high-risk, high-return options for the first time.

The records give no indication as to why executives made particular trades or what information they possessed; they may have simply been relying on years of broad industry knowledge to make astute bets at fortuitous moments. Still, the records show many instances where the executives bought and sold with exquisite timing.

Such trading records have never been publicly available. Even the SEC itself doesn’t have such a comprehensive database. The records provide an unprecedented glimpse into how the titans of American industry make themselves even wealthier in the stock market.

Bloomberg’s Matt Levine pointed out that there are situations where executives may be making these types of trades for non-nefarious reasons, such as hedging:

One possibility here is that he was deeply informed about the auction, he had nonpublic information that made him think that Nationstar would win, and he bought Nationstar stock to bet on it going up. Another possibility is, look, there was an auction, somebody was going to win, and it would be good for him if his company won and bad for him if another company won. He did his best to win, but he bought shares in the other company to cushion the blow in case he lost. If Ocwen had won this auction, presumably he’d have a loss on his Nationstar shares, but he’d have a gain on his Ocwen shares and his career generally; this $157,000 gain was the consolation prize.

If the SEC starts pursuing this theory more aggressively, that type of bet may not be worth the risk. The Commission is already using data analytics to find irregular trades, and so is the DOJ! So, this new “data trove” may add to the regulators’ arsenal.

The question for us compliance folks is whether the insider trading policy should include a broad prohibition on trading in other public company securities, including competitors. Having that language could make it more likely that an insider would face consequences for “shadow trading” – but it may also provide more protection to the company, if it gets caught up in the investigation. Ideally, it also would keep everyone out of hot water in the first place. This report could help executives take the prohibition to heart.

Liz Dunshee