Insider trading is a murky country, whose borders are uncomfortably fluid. And now, they have been greatly expanded by a victory in a case brought by the SEC, SEC v. Panuwat, 21 cv. 6322 (N.D. Cal), creating considerable risk for both companies and insiders.

Insider trading: What is It?

Insider trading is usually defined as having three components:

• (1) buying or selling a security;
• (2) in breach of fiduciary duty or other relationship of trust and confidence (usually but not always through employment);
• (3) on the basis of material non-public information (MNPI) about the security.

Traditionally, the MNPI related to the entity whose securities were being transacted. For example, a corporate executive might be liable for insider trading for selling their shares in their employer in advance of the announcement of poor quarterly earnings. Or a corporate insider in a biotech company learns of positive market-moving news – for example FDA approval of its major drug, or its acquisition by another company – and purchases securities of their company in advance of that information becoming publicly available. 

The Panuwat case, however – which culminated in a jury victory for the SEC – extended insider trading to trading stock in companies about which the trader had no specific information, but which were seen to be economically linked to a company about which the trader did have inside information – or “shadow trading.”

Shadow trading

In Panuwat, a corporate insider at a healthcare company learned his company was being acquired by one of the larger healthcare companies and calculated that a healthcare company with a similar product would become a target of other acquirers. He then purchased securities of such a competitor.

The SEC charged Panuwat with insider trading in what became the first test of an extension of insider trading liability to shadow trading – or trading in the securities of companies that were seen as economically linked to the company about which the insider had MNPI. 

On April 5, 2024, the jury returned a verdict finding Panuwat liable for insider trading.

Implications

The Panuwat case presented a fairly straightforward fact pattern typical of insider trading cases. Panuwat had agreed in writing not only to keep information learned during the course of his employment confidential, but also not to use MNPI to trade the securities of other companies. Plus, the transactions were done shortly after he learned of the MNPI and were short-dated out-of-the-money options – acts very typical of insider traders.

So is this a narrow, unusual case, one not likely to lead to additional shadow trading enforcement actions?

That seems unlikely. It is not unusual for the SEC to start an enforcement strategy with a case whose facts are as favorable (to the SEC) as possible, in order to set a precedent. The SEC then uses that precedent as a basis for additional enforcement action in cases with less clear evidence of wrongful intent.

Moreover, the SEC is not presenting its win as one based on unusual facts. Indeed, in a press release about the verdict, Enforcement Director Grewal explained that there was nothing unusual about the case: “As we’ve said all along, there was nothing novel about this matter, and the jury agreed: this was insider trading, pure and simple.”

What might this mean for future cases? How broadly will the SEC interpret “economically-linked” firms? What if an insider at, say, a car company sees an uptick in defaults on car loans and bets against financial firm stocks, on the theory that this portends a slowdown in finance? Or mortgage payments?

While the connectivity of companies in the same or different sectors might seem obvious in hindsight, those links might be tenuous at the time of the securities transactions in question. Continuing the car loan example, if car loan defaults are then followed by home mortgage defaults, there will be a temptation to retrospectively link them causally – even if that link was not reasonably foreseeable but merely hypothetical at the time of the car loan defaults.

New enforcement risk

The uncertainty in how closely correlated two firms will have to be for the SEC to charge insider trading based on a “shadow trading” theory raises questions regarding how corporate policies and procedures should evolve to reflect the new enforcement risk. In order to avoid any potential liabilities, will firms prohibit insiders in possession of MNPI from engaging in all securities transactions until the information is made public? Or simply preclude trading in companies in the same sector?

And how is “same sector” going to be defined? Should these kinds of prohibitions be put in place? Will companies without such prohibitions in place be investigated for not having appropriate procedures?

Having won such a significant victory, it is hard to predict how far the SEC will take this theory. Typically, the SEC will use this kind of win as leverage to expand its enforcement remit as expansively as possible, and it is likely it will do so in this case. At the very least, the risks are now far greater for all entities subject to SEC authority, be they public companies, investment advisers, or asset managers of any kind.  

Given the uncertainty regarding how far the SEC will take this victory, what can firms do to protect themselves? How can they minimize the risks of an SEC investigation, or shareholder lawsuits?

Minimally, firms need to not only adopt policies that reinforce the importance of employees’ preserving MNPI; importantly, they should also state explicitly that improper trading potentially includes not just securities of the employing company or its direct counterparties, but also companies that might be seen as economically linked to those firms.

These policies might include “black-out periods” that prohibit trading in economically linked companies (however defined) until the MNPI is publicly available – although that might appear overbearing to employees. Such policies might prohibit employees from timely exiting losing positions in an economically linked company based on MNPI about the employer.  

Whatever policy is adopted, it is now essential to have a policy about shadow trading in order to limit firm liability. To effectively communicate the policy to personnel, best practice is to require personnel to expressly agree to comply and to document their agreement. While there are always personnel who will disregard such policies if they see a potential to make a quick profit and believe they will be undetected, express, confirmed prohibitions will help protect the firm.

How far will the SEC seek to extend the scope of shadow trading? What will be seen as economically linked sectors? In the Panuwat case, both companies were healthcare companies in the same subsector; but will the SEC see all healthcare companies as related enough to justify a shadow trading case? (One can imagine a subspecialty of expert witnesses developing to opine on these issues).

Considering that these are open questions, it is unclear how restrictive trading policies should be. The only thing that is certain is that we are likely to see more enforcement activity in this area, and that firms need to be prepared for this expansion of liability.