Shadow Trading: The SEC’s New Theory of Insider Trading

Now more than ever, the Securities and Exchange Commission (SEC) is aggressively investigating and prosecuting illegal insider trading.  With Chairman Atkins at the helm of a SEC Commission that has doubled-down on focusing the Enforcement Division’s limited resources on pursuing fraud-based cases, insider trading is again prominently on the SEC’s radar.

Given this new reality, it should come as no surprise that the SEC has relatively recently significantly expanded its view of what constitutes illegal insider trading.  It is called shadow trading, and its implications are game changing.  In essence, this novel theory of insider trading opens up a whole new category of conduct that may be viewed by the SEC as violative of the federal securities laws and thus subject to civil prosecution, or possibly appropriate for referral to the Department of Justice for criminal prosecution.

What is Shadow Trading?

Shadow trading is a new theory of insider trading being pursued by the SEC.  It occurs when a corporate insider uses material, nonpublic information (MNPI) about their own company (like an upcoming quarterly earnings announcement, a positive drug test result or a merger/acquisition) to trade and profit in the stock of a different, but “economically linked” company.

What Does “Economically Linked” Mean in the Context of Shadow Trading?

It means those companies that have a distinct and meaningful market connection with the source company’s MNPI.  In other words, would the inside information be considered material to investors in the linked company such that it would likely impact the linked company’s stock price.  This is commonly referred to as the “spillover effect.”

An example.  A CFO of a software company (Company A) learns that his company will soon be acquired.  Armed with this knowledge, he buys the stock of a direct competitor of Company A (Company “B”) under the theory that Company B’s shares may go up based on the market’s speculation that it could also become an acquisition target down the road, hence the spillover effect.  This is true notwithstanding that the CFO does not possess any MNPI concerning Company B.

Notably and unfortunately, the SEC has not set forth an explicit legal definition of what constitutes an economically linked company (thus ensuring that this sphere of insider trading will remain firmly in the grey).

What Are Examples of Economically Linked Companies in the Context of Shadow Trading?

• Competitors
• Business Partners, Customers, and Suppliers (particularly if they are within the same supply chain)
• Companies within the Same Market Space

How is Shadow Trading Different Than Traditional Insider Trading?

Traditional insider trading involves trading in the securities of the company to which the MNPI directly relates.  Shadow trading, however, occurs when the MNPI is used to trade in the stock of an entirely separate, but related (economically linked) company.

What Legal Theory of Insider Trading is Shadow Trading Based Upon?

While shadow trading is no doubt considered by most an aggressive stretch, it is based upon a well-established principle of insider trading, namely the “misappropriation theory.”  The misappropriation theory was espoused in the seminal United States Supreme Court Case of U.S. v. O’Hagan, 521 US 642 (1997).  Under this theory, an individual comes into lawful possession of the MNPI but then misappropriates or misuses it in breach of a duty by trading on it for personal financial gain.  In O’Hagan, a securities transactional lawyer at a law firm involved in a tender offer used his knowledge of it to trade in the target company.  While his possession of the MNPI was originally lawful, he engaged in illegal insider trading by buying the shares of the target company for personal gain in breach of his fiduciary duty of trust and confidence owed to his firm’s client.

Why Does the Sec Consider Shadow Trading to Be Illegal and a Violation of the Federal Securities Laws?

The SEC takes the position that shadow trading is illegal for the same reasons it bars other forms of insider trading.

First, because the trader who possesses the MNPI is, in effect, defrauding the counterparty to the securities transaction who does not have the benefit of the MNPI when either buying shares from, or selling shares to, the trader with the MNPI.

Second, because it undermines investor confidence in the financial markets, and thus threatens market integrity, by creating an unfair advantage for those who obtain MNPI and use it in breach of a duty, whether fiduciary based or contractual.

What is the Current State of the Law on Shadow Trading?

The SEC has successfully prosecuted shadow trading, notably in the seminal case of SEC v. Panuwat (N.D. Cal. filed Aug. 17, 2021).  In that case, Matthew Panuwat, a Pharma Executive, utilized MNPI regarding his employer company’s pending acquisition to buy stock options in an economically linked direct competitor, Incyte, before public release of the news.  After hearing all of the evidence, the jury found Panuwat liable for insider trading in 2024.  Currently, the verdict is on appeal before the Ninth Circuit Court of Appeals, which has yet to rule.  This appellate ruling is highly anticipated as if the jury’s verdict is affirmed the SEC will be emboldened and continue to aggressively pursue such cases.  If its reversed, shadow trading may fade to become a mere shadow of itself, leaving the SEC at grave risk of losing this novel prosecution theory.

Why Hire David Chase as SEC Defense Counsel If You Are Under Investigation for Shadow Trading?

David Chase is a former Senior Counsel in the SEC’s Enforcement Division who investigated and prosecuted insider trading cases.  He thus keenly understands how the SEC identifies, investigates and prosecutes illegal insider trading.  Using this insider perspective, he zealously defends his clients with the objective of avoiding charges.  David is also an Adjunct Professor of Law at the University of Miami School of Law where he teaches a course on SEC investigations, including insider trading.  He has been recognized as an outstanding securities lawyer in his field by Chambers & Partners and Super Lawyers, has numerous, highly positive reviews from his former clients, has been widely quoted in the media, including the Wall Street Journal and NBC News, interviewed on Bloomberg Television on SEC matters and has extensively written on insider trading.

Contact SEC Shadow Trading Defense Lawyer David Chase

If you have just been contacted by the SEC or received a subpoena contact David now for a confidential, no cost consultation at: 800-760-0912 or e-mail him at: david@davidchaselaw.com.  To read about David’s SEC defense experience, and the firm’s recent successful insider trading results, please visit the firm’s website at: www.securitiesfrauddefense.net.