Insider trading is a concept that most people are generally familiar with. In its simplest form, it involves a corporate insider trading in securities of his or her corporation on the basis of material nonpublic information (MNPI) about that corporation. “Shadow trading”, on the other hand, involves misappropriation of confidential information about one company to trade in securities of a second company where there is a sufficient “market connection” between the two companies. In 2021, the SEC brought insider trading charges against Matthew Panuwat, a business development executive at a biotech company, Medivation, Inc. The SEC alleged that Panuwat used confidential nonpublic information about a potential acquisition of Medivation by Pfizer to purchase call options in a second biotech company, Incyte Corporation, in the belief that Incyte’s stock price would materially increase following the announcement of the Pfizer deal. The case is scheduled to go to trial on March 25th, and will be keenly watched by practitioners to see how potent a weapon the “shadow trading” theory is likely to be in the SEC’s arsenal against insider trading.
“Shadow trading” is a version of the “misappropriation theory” of insider trading. The misappropriation theory involves trading on the basis of MNPI in breach of a duty, arising from a relationship of trust and confidence, owed to the source of the information. (See, e.g. SEC v. Talbot, 530 F.3d 1085 (9th Cir. 2008)). The SEC alleged that Panuwat received confidential nonpublic deal information of Medivation in an email a few minutes before he purchased options in Incyte. The SEC alleged that the information received from Medivation was material to Incyte, because it would have been viewed by a “reasonable investor as having significantly altered the ‘total mix’ of information made available,” under Basic v. Levinson, 485 U.S. 224, 231-32 (1988). At the summary judgment stage, the court evaluated materiality by considering whether there was sufficient “market connection” between the two companies. The court held that a number of factors provided sufficient support for market connection at the summary judgment stage, including analyst reports and financial news articles reporting that acquisition interest in Medivation showed the attractiveness of Incyte, and discussing the “scarcity of biotech assets” acting as a floor on the stock price of the two companies, evidence that Medivation’s deal bankers viewed the two companies as comparable peer companies, and ultimately that Incyte’s stock price in fact rose 7.7% after the Medivation deal was announced.
The misappropriation theory is not novel, having been adopted by the Supreme Court in 1997 (See United States v. O’Hagan, 521 U.S. 642 (1997)). And insider trading policies of public companies are often drafted to preclude trading not only in the securities of the company issuing the policy, but also in securities of publicly traded customers, vendors and other commercial partners of that company. The novelty of Panuwut is the lack of a commercial connection between the two companies and the fact that the confidential information involved a Medivation transaction in which Incyte was not involved. The connection between the two companies that served as the basis for the SEC’s insider trading charges was that they were both operating in a field where there was a scarcity of viable acquisition candidates, such that the announcement of the Medivation sale was likely to drive up the stock price of Incyte. There is reason to believe that shadow trading is fairly widespread (See 2020 article in The Accounting Review by Mehta, Reeb and Zhao). Officers and directors of publicly traded companies should take note of the Panuwat case and, pending further judicial developments, treat shadow trading as another form of insider trading that they should refrain from engaging in. Issuers should also revisit their insider trading policies, codes of conduct and related compliance programs to mitigate the risk of becoming entangled in “shadow trading” that could cast a dark cloud over their reputations and those of their directors, officers and employees.