The U.S. Securities and Exchange Commission (“SEC” or “Commission”) is advancing a novel insider trading theory known as “shadow trading.” See Mihir N. Mehta, David M. Reeb, and Wanli Zhao, “Shadow Trading,” The Accounting Review (July 2021). Individuals who engage in “shadow trading,” the theory goes, impermissibly circumvent insider trading restrictions when they use confidential information about one company to make an investment decision about the company’s competitors or supply chain partners. The SEC adopted this expansive take on the classical insider trading theory last year in the Panuwat case. Since then, the SEC has given signals that Panuwat may not be a one-off – the Division of Enforcement and Division of Examinations are actively scrutinizing investment advisors’ and individuals’ use of confidential information when they place bets on so-called “economically-linked” companies.
In our view, Panuwat does not suggest a need to rethink compliance completely. Although the SEC’s “shadow trading” theory has the potential to engulf all manner of trading, we suspect the practical application will have a narrower reach. Firms need not immediately set about rewriting their trading policies or increase compliance headcount just yet. In many instances, advisers can address the SEC’s concerns by augmenting their existing policies and procedures to encourage internal reporting and probe the reach of potential material nonpublic information (“MNPI”). To do so, firms must understand the “shadow trading” landscape.
The Panuwat: SEC’s First “Shadow Trading” Action
The SEC’s insider trading charges against Matthew Panuwat marked the agency’s first-ever “shadow trading” action. See SEC Charges Biopharmaceutical Company Employee with Insider Trading, SEC Litigation Release No. 25170 (Aug. 17, 2021). The SEC alleged that Mr. Panuwat had confidential information about his employer’s impending acquisition by a larger company and, on the basis of that information, he purchased out-of-the-money, short-term stock options in one of his employer’s competitors—a similarly-sized company in the same industry that was also ripe for a business combination (an “economically-linked company” in “shadow trading” parlance). Mr. Panuwat believed the competitor’s stock price would jump when news of his employer’s acquisition broke. He was right. The competitor’s stock went up 8% on the news, and Mr. Panuwat profited roughly $100,000 on his trades.
The SEC alleges that this conduct—trading in securities of a third party—constitutes insider trading. They argue that Mr. Panuwat had a duty not to trade in a competitor’s stock because his employer’s insider trading policy prohibited him from using MNPI obtained at work to trade in “the securities of another publicly traded company, including all significant collaborators, customers, partners, suppliers, or competitors of the Company.” See SEC v. Panuwat, 4:21-cv-06322 (N.D. Cal., filed Aug. 17, 2021). The SEC argues, too, that the information was material with regard to the competitor: various factors tied together the fortunes of the two companies at the time the acquisition was announced, and the information must have been material because the competitor’s stock price jumped when the merger was announced. (The price went up, the SEC observes, so the venerable “reasonable investor” must have considered news of the merger important in making investment decisions – a kind of securities law res ipsa.)
Generally, to prevail in an insider trading case, the SEC must demonstrate that a trader knowingly bought or sold a security, while in possession of MNPI, in breach of a duty of confidence or trust. The SEC’s case against Mr. Panuwat raises two critical questions that will shape the “shadow trading” theory: (1) whether an insider trading policy creates a duty of trust that extends to trading in a competitor’s stock, and (2) whether the nonpublic information Mr. Panuwat possessed was material with respect to an unrelated third party.
Unfortunately for firms grappling with the implications of Panuwat, those questions remain unresolved. In January, the U.S. District Court for the Northern District of California ruled that the SEC made a sufficient showing to survive a motion to dismiss, extending the case. The Court found that “the SEC’s theory of liability falls within the contours of the misappropriation theory and the language of the applicable law,” and declined to toss the case simply because the SEC was pursuing a new theory. See SEC v. Panuwat, No. 21-CV-06322-WHO, 2022 WL 633306, at *1 (N.D. Cal. Jan. 14, 2022).
Many observers hoped that the Court in Panuwat would reject the SEC’s novel theory outright or, in the alternative, provide guidance on the reach of the theory. The Court did neither. Thus, the industry is left to grapple with Panuwat’s compliance implications, trying to divine which steps are necessary and appropriate, and which are pointless shadow boxing.
EXAMS Focus on Trading in “Similar Industries”
In April, a Divisions of Examinations’ (“EXAMS”) Risk Alert on “Investment Adviser MNPI Compliance Issues” signaled the SEC’s intention to continue looking for instances of “shadow trading.” See Division of Examinations Risk Alert, “Investment Adviser MNPI Compliance Issues” (April 26, 2022). The alert details “notable deficiencies” the EXAMS staff observed during recent examinations of registered investment advisers. Among the deficiencies, the staff noted firms’ failure to implement adequate policies and procedures relating to their expert network consultants, including “[r]eviewing relevant trading activity of supervised persons in the securities of publicly traded companies that are in similar industries as those discussed during calls.”
This evidently common deficiency smacks of the kind of “shadow trading” the Enforcement staff targeted in Panuwat – and marks the first time the SEC has explicitly stated a requirement to address “shadow trading” through advisory firms’ compliance apparatus. The alert is characteristically light on specific guidance, but nevertheless signals that staff throughout the agency are focusing on “shadow trading.” The Risk Alert makes clear that firms should consider whether they need to do more to address the risk that supervised persons are executing trades in the securities of publicly traded companies “that are in similar industries” to companies about which they possess potential MNPI.
A Focus on Private Equity
Unsurprisingly, perhaps, the staff is likely to focus on advisers to private funds. In its 2022 Examination Priorities, EXAMS counted private funds first among its “Significant Focus Areas,” given “the significance of examination findings over the past several years, and the size, complexity, and significant growth of this market.” See Division of Examinations 2022 Examination Priorities (January 2022). The recent EXAMS Risk Alert confirms that the division views oversight of advisers to private funds as a programmatic imperative.
In 2020, the Commission brought an enforcement action against Ares Management, which creates a path for the SEC to craft an enforcement action against a firm that fails to address risks of “shadow trading” even if the SEC cannot prove any illicit trading. In Ares, the SEC alleged that the investment firm failed to implement and enforce adequate policies and procedures to prevent the misuse of “potential” MNPI. See Private Equity Firm Ares Management LLC Charged with Compliance Failures, SEC Press Release 2020-123 (May 26, 2020). The SEC’s charges centered on Ares’s failure to implement adequate policies and procedures to ensure that the company had not obtained MNPI about a portfolio company for which one of its traders served on the board of directors. Notably, the SEC faulted Ares’s compliance personnel for allowing supervised employees to “self-evaluate” whether potential MNPI was “material,” suggesting that Ares’s compliance personnel should have independently probed whether the “potential MNPI” was in fact MNPI. The SEC charged the firm for these purported compliance failures, though it did not allege that the firm actually misused the potential MNPI at issue.
Ares marked the first time the SEC faulted an adviser for its failures with respect to “potential MNPI” – and effectively ramped up the compliance burden to continuously assess potential MNPI. In this light, the SEC’s increased focus on “shadow trading” is particularly expansive.
Understandably, the SEC’s interest in “shadow trading” has captured the attention of registered investment advisers who are grappling with the compliance implications of this new theory. The SEC has effectively put advisory firms on notice that they should enhance compliance policies and procedures to police potential “shadow trading,” but many advisers feel they have been left in the dark about the SEC’s expectations, including whether they should design and implement appropriate new policies and procedures – and, if necessary, what those new policies and procedures should look like.
Given the lack of certainty about how far the SEC is willing to test its “shadow trading” theory outside of Panuwat, firms’ response to these developments will depend in large part on individual risk appetites. Although we can only speculate on how the SEC’s “shadow trading” theory might play out in contexts distinct from Panuwat, firms considering a proactive response to Panuwat would be well advised to scrutinize their compliance policies and procedures in three broad areas:
- Compliance Policy Language. In Panuwat, the SEC relied heavily on the specific language of the MNPI policy at issue – and the Court in Panuwat endorsed that reliance. Compliance professionals should review their MNPI policies to ensure the wording cannot be interpreted more broadly than is intended, and that the policy is not vague about its obligations. Compliance professionals should similarly review the policies to ensure they aren’t creating any additional monitoring or enforcement obligations that similarly are unintended. Compliance professionals in industry sectors where stock prices tend to move together are likely to face heightened scrutiny and should think critically about how the policy language could be mis-interpreted.
- Non-Disclosure Agreements. Relatedly, given that the duty in Panuwat flowed entirely from the plain language of the MNPI policy at issue, compliance professionals considering whether a trader has received MNPI should scrutinize whether other contractual agreements – such as any NDAs governing the traders’ receipt of the potential MNPI – create duties not to trade that are independent of those in the firms’ compliance policies.
- Day-to-Day Monitoring of Potential MNPI. Although the ultimate viability of the SEC’s theories in Panuwat remains to be seen, compliance professionals who are approached by a trader with potential MNPI should consider whether there are new, post-Panuwat questions they should be asking that trader. Especially given the emphasis in Ares on compliance professionals’ need to probe whether the potential MNPI at issue is in fact material, compliance professionals would do well to both consider some of the specific factors at play in Panuwat and potentially document their firm’s consideration of same.
The reach and implications of the SEC’s approach in Panuwat remain uncertain, especially given the lack of guidance at the motion to dismiss phase from the Court in Panuwat. The extent to which the SEC’s focus on “shadow trading” will require firms to reconsider their compliance policies remains to be seen. But firms that are concerned about Panuwat need neither sit on their hands nor completely revise their compliance policies. The steps outlined above should provide adequate safeguards. In many cases, firms will simply continue to following existing practices when a supervised person receives potential MNPI, but expand their analysis to consider whether the MNPI covers economically-linked companies or industries.
Frequently Asked Questions on “Shadow Trading”
In conversations with clients and industry contacts, we frequently field questions about the potential reach of the SEC’s “shadow trading” theory, and the appropriate compliance response. Following are our responses to several frequently asked questions. (These responses, of course, are not legal advice. Firms may wish to pursue different paths depending on a number of firm-specific factors.)
Q: We are concerned about how the SEC’s “shadow trading” theory of insider trading may impact our compliance obligations. What is the first thing we should do?
A: Begin by revisiting your firm’s policies and procedures. How do they define “material nonpublic information,” and what do they instruct employees to do if/when they receive it? Consider whether policies might be enhanced to encourage traders, analysts, and the like to report the receipt of potential MNPI to appropriate members of the compliance or legal teams.
Q: If a trader/analyst comes to us with a question about her/his receipt of potential MNPI, does this raise Panuwat issues?
A: It depends. The compliance or legal team will need to ask some questions: How did the trader/analyst receive the information? And from whom? Is there a formal or informal expectation that the trader/analyst will not use the information for certain purposes? Critically, does the trader/analyst plan to use the MNPI for a trade in a similar company or industry?
Q: If the trader/analyst is considering a trade/strategy in a similar company or industry, what should I do?
A: First, ask if there’s an NDA (or similar agreement) that purports to restrict the use of the MNPI. If so, what limitations apply (e.g., “only for purposes of fulfilling the contract / further the relationship”)?
Second, if you are comfortable that there is not an agreement (e.g., a provision in an NDA) that restricts trading in a similar industry, you might still consider a few additional factors before clearing the trade. For example, you might consider whether there are independent reasons for the investment decision/strategy and how similar the industries or companies are (e.g., ask questions designed to ascertain the size of the industry/segment, how specific the information is to a particular company, or how broadly applicable the information may be). For example, information about a potential merger or acquisition in a tight industry (the situation in Panuwat) may require different treatment than information about supply chain issues in a massive global manufacturing industry.
Q: Should we prophylactically place names on the restricted list?
A: There is no simple answer to this question, but over-designation creates its own set of issues. The decision to place names on the firm’s restricted list requires an analysis of all the relevant facts. You should consider the source of the information, restrictions on use, plans (or no plans) to use the information to trade, and whether the firm/fund already has positions in economically-linked companies, among other factors. The decision to wall-off supervised persons, or place names on a restricted list, should be largely the same analysis you have been conducting all along; now, you are simply considering additional factors that might suggest a prophylactic response is appropriate.
Q: If we determine that is safe to trade, what next?
A: Document the vetting process in the usual way (the same log/software you use to record MNPI questions in the ordinary course). Consider whether to note that compliance/legal personnel considered the size of the industry, broad applicability of the information, or other relevant factors in clearing the trade.
Q: If we determine that the trader/analyst should not trade in a similar entity, what should we do?
A: Again, you should document the process in the usual way. You will also need to determine what restrictions may be appropriate. This should be similar to the usual analysis: Do you need to place similar entities on a restricted list? Do you need to temporarily prohibit trading in an entire industry/segment? Can you safely wall off one or more employees that are aware of the potential MNPI?
Q: What else should we be doing?
A: This is an excellent time to conduct remedial training sessions or exercises, to make sure your team is attuned to “shadow trading” issues and the circumstances that should cause them to call compliance.