SEC Shadow Trading Case Breaks Ground – But There Remains a Trail to Blaze
A California Court recently allowed the Securities and Exchange Commission (the “SEC” or “Commission”) to proceed with its first insider trading prosecution based on a theory of “shadow trading.” On January 14, 2022, Judge William H. Orrick, sitting in the District Court for the Northern District of California, issued a ruling denying defendant’s motion to dismiss the SEC’s civil action, which alleges a single violation of Section 10(b) of the Securities and Exchange Act of 1934.
Shadow trading is a term recently coined in an academic article to describe when “corporate insiders attempt to circumvent insider trading restrictions by using their private information to facilitate trading in economically linked firms.” The article, Shadow Trading, published in the Accounting Review in October of 2020, was released roughly 10 months prior to the SEC suing Matthew Panuwat, a former securities broker who served as a business development manager for Medivation Inc., a biopharmaceutical company.
The SEC avers that Panuwat learned of the pending acquisition of Medivation by a large pharmaceutical company, Inc. through his position at Medivation prior to the public announcement of the deal. The complaint alleges that Panuwat then purchased out-of-the-money short-term call options for the common stock of Incyte Corporation, an unrelated company that was positioned similarly in the market to Medivation.
Insider Trading – Misappropriation Theory
The Commission’s action turns on its claim that Panuwat “misappropriated Medivation’s confidential information” to buy securities “whose value he anticipated would materially increase when the Medivation acquisition announcement became public.”
Courts currently recognize two distinct theories of liability for insider trading. The “classical” theory is implicated when a corporate insider trades in his or her own company’s securities based on material non-public information. This theory, however, does not apply because Panuwat did not execute any transactions in Medivation securities. The second is the “misappropriation” theory, first recognized by the Supreme Court in United States v. O'Hagan, which is implicated when a person “misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.”
In this instance, the duty owed by Panuwat to Medivation arose from the company’s insider trading policy. While Panuwat sought to claim that Medivation’s policy did not preclude him from trading in other companies’ securities, the court found this argument unavailing, pointing to the “plain language of the policy,” which stated:
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.
One notable conclusion of the Shadow Trading article was that shadow trading occurs less frequently at firms that include the type of restrictions that Medivation’s policy did, rather than simply prohibiting trading in the issuer’s own securities.
With this case highlighting the risk of future enforcement actions, we may see companies update their insider trading policies to include prohibitions of shadow trading, similar to what was included in Medivation’s own policies.
Due Process – Adequate Notice
One interesting question that is raised by this decision is whether the SEC’s shadow trading theory runs afoul of due process protections. The court held that it does not. As a general matter, due process concerns are raised when an enforcement action is taken without adequate notice that specific conduct is prohibited. Here, however, the court noted that use of the misappropriation theory of insider trading in this context was not so far afield of the Commission’s prior enforcement actions so as to render it a violation of Panuwat’s due process rights. The court acknowledged that:
In the absence of notice—for example, where the regulation is not sufficiently clear to warn a party about what is expected of it—an agency may not deprive a party of property by imposing civil or criminal liability.
Here, the court noted, “there appear[ed] to be no other cases where the material nonpublic information at issue involved a third party,” but pointed to Supreme Court guidance interpreting section 10(b) that warned “[n]ovel or atypical methods [of securities fraud] should not provide immunity from the securities laws.”
The court reasoned that “[s]cienter and materiality provide sufficient guardrails to insider trading liability,” noting that the SEC’s theory comports with two principles of misappropriation theory: that the trader need not be a corporate insider, and that information may be material to more than one company.
Accordingly, the court determined that, because “[a]n ordinary trader understands that buying or
selling securities with [the] intent [to profit from material non-public information] is prohibited,” and the SEC had sufficiently alleged both materiality and scienter, Panuwat had sufficient notice for due process purposes that his conduct could subject him to liability.
The First Hurdle – Possibly of Many
The SEC has won the right to pursue such claims under the rubric of insider trading. There remain, however, a number of issues – some thorny – to be resolved by the court below and also likely on appeal.
A key issue is that, because this is a novel enforcement mechanism, courts have not settled upon standards for determining whether and the extent to which unrelated securities issuers are “linked” (in the parlance of Shadow Trading) for the purposes of insider trading. Assuming all publicly traded companies to be linked via the market is likely unworkable.
Will the court adopt a bright-line rule, such as companies within the same industry based on a classification system? Or a more statistical model, such as companies whose share prices exhibit a certain level of correlation over a given period? Could Panuwat have avoided prosecution by purchasing shares of a mutual fund or ETF whose holdings he knew to be heavily invested in Incyte shares – and would such a tactic equally absolve an insider of a larger company such as Apple, Inc. whose shares can move the entire equities market?
Time will tell. And whether and the extent to which higher courts prove amenable to shadow trading enforcement actions may remain unclear for some time to come.
The case is Securities & Exchange Commission v. Panuwat, No. 21-cv-06322-WHO (N.D. Cal.).
 Secs. & Exchg. Comm’n v. Panuwat, No. 21-cv-06322-WHO (N.D. Cal.).
 Id., Slip op. (Jan. 14, 2022).
 See Shadow Trading, M. Mehta, D. Reeb & W. Zhao, Accounting Rev. (2021) 96 (4): 367–404.
 Dkt. 1 at 2.
 See United States v. O'Hagan, 521 U.S. 642, 651 (1997).
 Id. at 652.
 Dkt. 1 at 5.
 Shadow Trading at 28-30, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3689154.
 Slip op. at 11 (quoting United States v. Approx. 64,695 Pounds of Shark Fins, 520 F.3d 976, 980 (9th
 Id. at 12.
 Id. at 13 (quoting Superintendent of Ins. v. Bankers Life & Cas. Co., 404 U.S. 6, 10 n.7 (1971)).
 Id. at 12.
 Id. at 13.