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The SEC’s novel shadow insider trading theory is back in the spotlight again thanks to an article appearing in the Wall Street Journal earlier this week. The SEC’s case is going to trial next month, which will test the SEC’s theory that an individual can commit an insider trading violation when trading in the stock of an unrelated company based on material nonpublic information that the individual has about his or her own company. The article notes:

No court has ever tackled the idea that executives can go too far when they deploy their specialized knowledge or expertise to trade in the shares of rivals, said Karen Woody, a professor at the Washington and Lee University School of Law.

“I do think this is a push of the law and they are seeing if they can get a court to bless what is a bit of a stretch of the existing parameters,” Woody said of the SEC’s case.

The SEC says two facts about Panuwat’s trading show it was illegal. First, his employer, Medivation, had a policy that forbade trading other companies’ shares when employees had material nonpublic information about Medivation. And second, Panuwat traded on his work computer just seven minutes after he allegedly learned that Pfizer would buy his company.

The press attention to the case has prompted questions again as to what changes should be made to insider trading policies as a result of the SEC’s shadow insider trading case.

The panel that I moderated at the Northwestern Pritzker School of Law’s Securities Regulation Institute last month delved into this topic in some depth, and I was surprised to learn that a significant number of companies that were the subject of a recent academic study had very broad language in their insider trading policies that prohibited trading in other companies’ securities based on material nonpublic information, rather than more targeted language that prohibited trading in the securities of other companies with which the employer did business or was negotiating a potential transaction. Those companies that have the very broad formulation in their insider trading policies should revisit those policies to tighten up the prohibited conduct, so as not to create duties for employees that could potentially be seen as breached under the shadow insider trading concept. Here is our coverage of the topic from the January-February 2023 issue of The Corporate Counsel:

The SEC has been pushing the envelope on quite a few things these days, and one of those areas is with insider trading law. Back in January 2022, a federal district court denied a motion to dismiss a novel insider trading enforcement action brought by the SEC based upon a theory now known as “shadow insider trading.” In SEC v. Panuwat, No. 4:21-cv-06322 (N.D. Cal. Aug. 17, 2021), the SEC took the position that the insider trading laws apply where an insider uses material nonpublic information about his or her own company to trade securities of another company, such as a competitor or peer company in the same industry.

As noted in the court’s decision, the defendent, Panuwat, had a role at his company that included following the stock prices of certain peer companies. Shortly after receiving an internal email stating that his company would be acquired, Panuwat bought short-term out-of-the-money options of one of his company’s peers. Shortly after the acquisition of Panuwat’s company was announced, the stock price of the peer company increased, and Panuwat made more than $100,000 in profits from the options trade. The SEC alleged that Panuwat’s conduct constituted insider trading.

In the decision, the court’s determination of whether the SEC adequately alleged that Panuwat had breached his duty to his employer turned entirely upon the broad wording of his employer’s insider trading policy. The court did not consider whether Panuwat’s conduct would have been unlawful absent the written insider trading policy that prohibited it. The court concluded that the company’s insider trading policy, which prohibited employees from using the company’s confidential information to trade in the securities of “another publicly traded company,” was broad enough to prohibit trading in the securities of any public company based upon the company’s confidential information.

While it is hard to say how far the SEC’s shadow insider trading theory will go, the Panuwat case highlights a need to avoid overbroad language in the insider trading policy that could potentially broaden the scope of liability for those who are subject to the policy. With that in mind, we have revised the language in the Model Insider Trading Policy regarding trading of securities of other companies while aware of material nonpublic information to be more specific as to the relationship with those companies and how the information is obtained by the individual in the course of their work for their employer.

In our model insider trading policy materials that were included as a special supplement to the January-February 2023 issue, we tightened up the language on this topic to now read:

In addition, it is the policy of the Company that no director, officer or other employee of the Company (or any other person designated as subject to this Policy) who, in the course of working for the Company, learns of material nonpublic information about a company (1) with which the Company does business, such as the Company’s distributors, vendors, customers and suppliers, or (2) that is involved in a potential transaction or business relationship with Company, may engage in transactions in that company’s securities until the information becomes public or is no longer material.

It will be interesting to see how this first shadow insider trading case goes at trial, but even if the SEC does not prevail in the litigation, I think it makes sense to adopt the more specific policy language identified above.

– Dave Lynn