Is Shadow Insider Trading Illegal?

1.    Panuwat case

The case SEC v. Panuwat marked a new frontier in insider trading enforcement, since the SEC successfully pioneered a new legal theory referred to as “shadow” insider trading. This concept represents a novel form of market misconduct that extends traditional insider trading to situations in which an individual uses confidential information about one company to trade in the securities of another, related firm.

The case against Matthew Panuwat, a former Medivation executive, clearly shows this novel application of the law. In 2016, Panuwat, at the time an executive at the biotech firm Medivation, allegedly purchased options in a rival company, Incyte, shortly after learning that Pfizer would acquire Medivation. When Pfizer’s acquisition became public, Incyte’s stock price rose, netting Panuwat roughly $120,000 in profit.

The U.S. Securities and Exchange Commission (SEC) argued that even though Panuwat did not trade his undertaking’s stock, he purchased the options because he knew they would pay off when the market heard Pfizer was buying his company, and, according to the SEC, his use of non-public information about Medivation to benefit from a correlated company’s stock constituted insider trading.

2.    Key concepts

The first key concept to highlight is the definition of insider trading. This offence may be charged when a corporate insider buys or sells securities based on non-public information, or when someone misappropriates confidential information for trading purposes.

Under the classical theory, the focus is on the breach of the fiduciary duty by the corporate insider. According to the Securities Exchange Act, the use of material non-public information to trade the company’s securities represents a deceptive device^[1] since it breaches the duty of trust and loyalty owed to the company and its shareholders. The misappropriation theory further expands this concept, holding that a violation also occurs when a person misappropriates confidential information, breaching a duty of trust to the source of that information. This theory applies to outsiders who are not corporate insiders but gain access to confidential information through a relationship of trust, like lawyers, bankers, or consultants.

Differently, shadow insider trading occurs when a corporate insider uses confidential, price-sensitive information about one company to trade shares of another company that is closely related to the first one. The key element is that the info indirectly affects the value of the second company because between the two businesses, there is a sufficient market connection in terms of competition, partnerships, or shared market sectors.

An interesting example to understand the difference between the two conducts is Disney Plus. When Disney announced the launch of its streaming service that would rival Netflix and be priced more cheaply, Netflix’s shares dropped by 5%, losing as much as $8 billion in market capitalization in a few minutes of trading. A Disney insider that was aware of the launch of Disney-Plus prior to the public announcement could have profited by purchasing Disney’s shares (traditional insider trading) or by shorting Netflix (a shadow trade).

3.    US approach

At the heart of the SEC’s new theory of the contra-legem nature of shadow insider trading, introduced with the Panuwat ruling, is the breach of duty. In order to prosecute Panuwat for shadow insider trading, the pivotal point for the SEC was proving that he owed a duty of trust and confidence to Medivation, and that his conduct constituted a breach of this duty. Demonstrating this breach was essential for establishing that his actions amounted to securities fraud and were therefore prosecutable as shadow insider trading. It was found that Panuwat was bound by Medivation’s insider trading policy, which expansively prohibited trading (while in possession of Medivation’s inside information) in not only Medivation’s securities, but in any publicly traded securities in which Medivation’s inside information would give its insiders an investing advantage.

Relying on this policy, the SEC argued that Panuwat’s was subjected to an obligation of trust and confidentiality in relation to the of Medivation’s information in any trading context. The court further noted that an inherent duty of trust and confidence arises naturally from the employment relationship, even without an explicit policy or written agreement.Therefore, based on this reasoning, the SEC argued that Panuwat’s actions breached his duty of trust to Medivation and thus constituted securities fraud under Rule 10b-5, prosecutable as shadow insider trading.

Another pivotal point in the SEC’s accusation was proving that Medivation’s confidential information was also materialto Incyte, due to a significant market connection between the two companies. The concept of market connection is used to show that non-public information about one company could reasonably affect the value of the other. The SEC argued that the market connection was evident and therefore information about Medivation’s acquisition was likely to affect investor expectations for similar biotech firms. It supported this by noting that both companies operated in the same sector with only a few viable acquisition targets and they were viewed by analysts and bankers as comparable peers. Further, the rates of covariance and correlation of the two companies’ stocks were very high, meaning that the stocks were expected to move together in a very similar way, in fact Incyte’s stock rose 7.7% following the announcement.

By establishing this market connection, the SEC successfully argued that Medivation’s confidential information was material to Incyte’s stock value. This reasoning broadened the traditional scope of insider trading, showing that materiality can extend beyond direct corporate relationships when the market perceives the companies as economically linked.

In conclusion, Panuwat was held liable of shadow insider trading by the jury. This case represents a landmark ruling since it extended the misappropriation theory of insider trading also to include trading on information about one company that materially affects another company in the same industry.

4.    Comparative analysis – EU legislation

Insider dealing has been the subject of EU harmonisation since the late 1980s, with the current

legislation, namely the Market Abuse Regulation (EU MAR) and the related Market Abuse Directive, dating back to 2014. Art.14 of the Directive provides for the prohibition of insider dealing and of unlawful disclosure of inside information, by stating that a person shall not engage or attempt to engage in insider dealing. Art.8(1) of the EU MAR defines insider dealing as occurring ‘when a person possesses inside information and uses that information by acquiring or disposing of financial instruments to which that information relates’. According to this definition of insider dealing, it appears that the EU MAR equally prohibits traditional insider trading and shadow trading, allowing for no opt-out by contract from any of its prohibitions. If information about Company A is also material to Company B’s stock, anyone who has access to it is prohibited from trading either company’s shares.

More precisely, Art.7(1)(a) of the EU MAR defines inside information as information of a precise nature, not yet made public, that relates directly or indirectly to one or more issuers or financial instruments, and which, if made public, would likely have a significant effect on the price of those instruments or related derivatives.

Although shadow trading is also prohibited under EU law, there has been no known case of enforcement in either the EU or the UK. One may question whether the absence of enforcement reflects that shadow trading simply does not occur in the EU or the UK. However, structural similarities between the US and European markets, such as strong sectoral interconnections and broad insider access to sensitive information, suggest that the opportunity for shadow trading certainly exists. Therefore, we have to conclude that, whilst EU law treats shadow trading exactly in the same way as traditional insider trading, the complete absence of enforcement regarding the former suggests that, at least so far, the law in action in Europe has tolerated it.

5.    Consequences:

The Panuwat ruling represent a significant expansion of the potential liability for insider trading. Academics, public interest groups, and business advocates have criticized this unfair development, since the new doctrine on shadow insider trading was introduced through litigation and rather than regulation. However, from now on, every entity and individual involved in the capital markets, from public companies to retail traders, need to take into account the increased risks that comes with trading in a post-Panuwat market. Companies will have to re-evaluate insider trading policies and educate directors and employees on the new landscape. While securities lawyers need to adjust their advice to clients and strategies for defending insider trading investigations. Ultimately, the shadow-insider-trading doctrine signals that the boundaries of market misconduct are evolving and the market must evolve with them.

^[1] Any act, practice, or scheme intended to mislead or deceive in the securities market.