Novel SEC "Shadow Trading" Theory Expands Insider Trading Liability

5 min

The SEC recently unveiled a novel "Shadow Trading" theory that expands insider trading liability. "Shadow Trading" describes when an insider with material, non-public information regarding their own company uses that information to trade in the security of another, peer company. On January 14, 2022, U.S. District Judge William Orrick denied a motion to dismiss what appears to be the first case that the SEC has brought asserting this novel theory, permitting the SEC to proceed with its shadow trading theory of liability.

Def.'s Mot. to Dismiss, SEC v. Panuwat, No. 21-cv-06322-WHO (N.D. Ca. Nov. 1, 2021)

In SEC v. Panuwat, the SEC alleges that Matthew Panuwat, a former executive at Medivation Inc., used material, non-public information about an imminent deal between Pfizer and his employer to buy stock options in a peer pharmaceutical company, Incyte Corp. The SEC alleged that given the high number of offers Medivation received and Pfizer's "overwhelming interest" in acquiring the company, Panuwat anticipated a spike in demand for other, similar companies. After a confidential email confirmed the impending deal with Pfizer, as alleged by the SEC, Panuwat immediately and secretly purchased 578 Incyte call option contracts. Panuwat had never traded Incyte stock or options before and earned $107,066.00 in profit when the Pfizer-Medivation deal was announced days later.

As part of the motion to dismiss, Panuwat argued that shadow trading was an "unprecedented expansion" of insider trading liability and that "no one . . . ever understood the insider trading laws to prohibit [this] type of conduct . . . ." The SEC countered that although this was the first case where material non-public information involved a third party, its theory "fell within the general framework of insider trading" and "the expansive language of Section 10(b) and corresponding regulations." Although broadened, the Court believed that liability would be limited by elements of materiality and scienter.

In denying Panuwat's motion to dismiss, Judge Orrick found that the SEC sufficiently pleaded that the information about the acquisition was non-public and material to Incyte; that Panuwat breached a duty to Medivation by using the information to purchase stock in Incyte, a publicly traded company; and that Panuwat acted with scienter. Additionally, Judge Orrick found that allowing the SEC to proceed on its shadow trading theory of liability did not violate Panuwat's due process rights. Specifically, the Court found that the SEC met the pleading standards for the following elements.

Confidential, Material, and Non-public Information: The information about Medivation's imminent acquisition, Judge Orrick found, was material to Incyte because "a reasonable Incyte investor would consider it important in deciding whether to buy or sell Incyte stock." The Court held that "information can be material to more than one company," even to those not directly involved in a deal or discussion. In making its ruling, the Court found that Section 10(b) of the Exchange Act and Rule 10b-5 broadly cover trading "any security" using "any deceptive device," without limitation, based on the source of the information.

Breach of Duty: The Court agreed with the SEC and found a breach of Panuwat's duty to Medivation, which arose from corporate confidentiality and insider trading policies. These policies stated that Panuwat would not use any information "not yet publicly disseminated . . . to profit financially by buying . . . the Company's securities . . . or the securities of another publicly traded company, including all significant collaborators, customers, . . . or competitors of the Company." The Court clarified that by using the term "including," the policy was simply providing examples, rather than an exhaustive list of potential sources.

Scienter: The Court found that the SEC adequately pleaded that Panuwat used the information in trading Incyte stock, based on circumstantial evidence; Panuwat did not buy Incyte's stock until he received an email confirming the imminent deal with Pfizer, and he acted on that information "within minutes," despite never having traded on Incyte stock before.

Due Process: Although Judge Orrick recognized that the SEC's theory of liability was "unique," he found that it comports with the case law as well as the expansive language of Section 10(b), Rule 10b-5, and Rule 10b5-1(a). Any resulting "vagueness concerns" are negated by the fact-specific requirements of scienter and materiality. This new theory blends the idea of misappropriation by a corporate outsider with the idea that "information can be material to more than one company" to ensure new schemes do not "provide immunity from the securities laws."

Implications and Considerations Moving Forward

Judge Orrick's decision could have significant implications, but the scope of these implications cannot be known currently, because it is uncertain how Judge Orrick's rationale would apply to different facts. For example, the SEC's misappropriation theory of insider trading depends on a defendant's breach of a duty owed to the source of the information. Here, that breach was established by the expansive language of Medivation's insider trading policy, which included the trading of other "publicly traded compan[ies]." A breach may be harder to establish where policy language is more narrowly drawn.

Nevertheless, the decision potentially expands the breadth of conduct that constitutes insider trading. Indeed, as Panuwat unsuccessfully argued, the facts of this case are different from those of other insider trading cases. The SEC has never brought a case similar to this one—where material non-public information regarding one specific issuer was used as the basis for an insider trading charge for trading in the shares of another issuer.

From a practical perspective, it is unclear how broadly the SEC will interpret which companies are off-limits when an insider is in receipt of material non-public information that could potentially affect the stock price of another issuer. To highlight the potential limitless liability flowing from the SEC's shadow trading theory, Panuwat posited in his motion to dismiss, "Would trading in the securities of all 'industry' 'comparable' companies be prohibited when in receipt of any material nonpublic information? If not all, which ones? Under what circumstances? … Within what time period?"

The Panuwat decision raises questions about where the outer limits of insider trading liability lie. Companies and financial professionals should revisit their insider trading policies to clarify expected standards.