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1 February 20227 minute read

SEC's "shadow trading" theory defeats motion to dismiss insider trading complaint

In a recent ruling, a federal judge gave the Securities and Exchange Commission (SEC) a green light to pursue a novel theory of insider trading dubbed “shadow trading.” Unlike traditional insider trading, so-called shadow trading involves using material non-public information (MNPI) of one company to trade not in the stock of that company (or an acquiring or target company), but in the stock of an entirely different (competitor) company. 

This theory seeks to broaden the prohibited uses of MNPI to encompass efforts to exploit the securities of an “economically-linked” business. Although the court did not reach the merits, its ruling endorses a sweeping expansion of insider-trading liability carrying potential consequences for all public companies.

Behind the SEC complaint

According to the SEC’s complaint in SEC v. Panuwat, Case No. 21-cv-06322-WHO (N.D. Cal.), Matthew Panuwat was formerly an executive of a pharmaceutical company and had signed an insider trading policy that prohibited, among other things, “dealing in Company’s securities . . . or the securities of another publicly traded company, including all significant collaborators, customers, partners, supplies, or competitors of the Company” for personal benefit. In the course of his duties, he learned about the possible acquisition of the company by another pharmaceutical company, including confidential information regarding the deal negotiations that identified a competitor company as comparable to his employer.  The competitor was uninvolved in the proposed transaction.

Panuwat allegedly purchased call options of the competitor within minutes of learning about the potential acquisition of his employer.  The call options purportedly increased in value when news was released of the acquisition of Panuwat’s company. He allegedly made a profit of more than $100,000 in a matter of days.

Although Panuwat possessed no insider information concerning the company in which he had invested, the SEC alleged that he improperly based these trades on MNPI that he misappropriated from his employer.

The SEC charged Panuwat with insider trading based on a misappropriation theory under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. In constructing its “shadow trading” theory of securities fraud, the SEC claimed that Punawat breached his duty of confidence to his employer when he exploited its MNPIknowing that the deal’s announcement would affect the value of other, similarly situated companies.  Panuwat did not possess any MNPI belonging the competitor in which he invested.  Rather, as alleged by the SEC, the MNPI was the identification of the competitor as comparable by advisors to the transaction in the context of evaluating a proposed acquisition coupled with knowledge of an imminent acquisition.  Panuwat received this information from his employer. Panuwat did not, however, possess any MNPI belonging to the competitor in which he invested.

Panuwat moved to dismiss the SEC’s complaint, arguing that it was deficient because, among other things, it did not allege that he had MNPI regarding the competitor in whose securities he traded and because the shadow trading theory inappropriately expanded insider-trading law, thereby failing to provide adequate notice of what the law prohibits. 

The court’s decision: four points

The court sided with the SEC and denied Panuwat’s motion to dismiss. 

First, the court held that the SEC sufficiently alleged that the relevant information was material, confidential, and nonpublic. The court explained that Section 10(b) and Rule 10b-5 “cast a wide net” that prohibits insider trading of “any security” and noted that Rule 10b5-1(a) does not state that the information “about that security or issuer” must come from the security or issuer itself to be material. 

The court found that the information about Punawat’s company was material to the competitor.  To start, the competitor was one of only a “limited number” of companies in Punawat’s company’s space.  The acquisition of Punawat’s company would make the competitor more attractive, which could drive up its stock price because other potential acquirors would be looking for an alternative acquisition with Punawat’s company off the market.  The rise in the competitor’s stock price after the acquisition was announced confirmed materiality. 

Second, the court held that the SEC had sufficiently alleged a breach of Panuwat’s fiduciary duties by alleging that he had used the information about the acquisition to buy stock options in the competitor.  The court cited Punawat’s company’s insider-trading policy, which noted that signatories “may be in a position to profit financially by buying or selling or in some other way dealing in . . . the securities of another publicly traded company, including all significant collaborators, customers, partners, supplies, or competitors of the Company. . . For anyone to use such information to gain personal benefit . . . is illegal.”  The court held that the policy covered securities of another publicly traded company. 

Third, the court ruled that the SEC adequately pled scienter by alleging that Punawat actually used the MNPI.  The SEC alleged Panuwat bought the competitor’s stock options “within minutes” of learning that the acquisition of his company was imminent.  He had never traded in the competitor’s stock previously, which the court said suggested that Panuwat used the information at issue.

Fourth, the court said that the SEC’s theory of trading, while “unique,” did not violate the Due Process Clause of the Constitution. The court found that the SEC’s theory falls within the “expansive” language of Section 10(b) and the framework of the misappropriation theory, which, by its own terms, reaches trading by corporate outsiders and can involve information that is material to more than one company. Perhaps in a nod to the arguably significant expansion it was blessing, the court stated that “scienter and materiality provide sufficient guardrails to insider trading liability.”

Implications and open questions

This case represents a significant expansion of the potential scope of insider trading enforcement under federal securities laws. Further, it demonstrates how the SEC is seeking to use its enforcement powers to limit the ability of individuals and companies to use (or in its view, misuse) MNPIin this case by pushing the boundaries of the securities laws and expanding insider trading liability to encompass so-called “shadow trading.” 

Of course, it remains to be seen whether the SEC will prevail on the merits of the case. At this stage, the court merely ruled on the facts as alleged in the SEC’s complaint.  We expect, however, that this ruling will encourage the SEC and other enforcement authorities to pursue more investigations and enforcement actions based on “shadow trading” allegations.

Future cases and litigation will likely define the contours and limits of this theory of liability.  Key open questions include:

  1. Is there liability if no corporate policy prohibits trading in the securities of a competitor?
  2. Is there liability for trading in a competitor’s securities if there is no corporate transaction at issue?
  3. Is there liability for trading in a competitor’s securities if a corporate transaction is not imminent? and
  4. Under what circumstances is an insider more generally at risk for insider trading liability if s/he trades in the securities of companies who are involved in the industry of her/his employer?

The SEC’s broad approach to how securities laws apply to the use of MNPI, and to various forms of market intelligence generally, requires companies and individuals to assess their practices when it comes to handling potentially confidential information.  In particular, companies should evaluate, and, if appropriate, make adjustments to, their internal policies and controls related to information access and handling and should train employees on corporate expectations. A failure or gap with respect to these types of policies and controls can increase the risk of a violation or expose a company to adverse issues associated with an enforcement inquiry.

Find out more about the implications of this new theory by contacting any of the authors or your usual DLA Piper relationship attorney.