What We Do in the Shadows: Corporate Policy and the Regulation of Shadow TradingPosted on Apr 3, 2023
Nikolos G. Schillaci
Suppose Otis is working in research and development at Apple, specifically on the next iPhone. At the most recent project meeting, Otis learns from the product manager that Apple is in contract talks with its current supplier Bananaz—a publicly traded tech company—to have Bananaz supply its hardware exclusively to Apple for use in the new iPhone. If the deal goes through, Otis knows that the next iPhone incorporating Bananaz tech will be one of the biggest Apple releases in years and the stock price of both Apple and Bananaz will go up. A month later, through status updates, Otis determines that Apple’s contract with Bananaz will be completed any day now. Otis wants to see if he can trade off this knowledge, so he consults Apple’s Business Conduct Policy and finds the following language describing insider trading: “Never buy or sell Apple securities, including Apple stock, if you are aware of information that has not been publicly announced and that could have a material effect on the value of the securities.” After reviewing the relevant information, Otis determines he cannot conduct any trading on his Apple employee shares. He remains unsure as to whether he can purchase Bananaz stock. However, Otis knows that there are only a handful of other start-ups in Silicon Valley who produce hardware similar to Bananaz, one of which is Cantelope. Bananaz competitor Cantelope is one of the only companies with technology comparable to Bananaz, and Otis anticipates that when the exclusive contract becomes public, Cantelope stock will increase in value as other companies seek to identify an alternative supplier. Therefore, Otis purchases call options on Cantelope before the deal is announced.
The Securities and Exchange Commission (“SEC”) had not regulated this type of informed trading in economically connected firms, termed “shadow trading,” until August of 2021, when the SEC brought SEC v. Panuwat. In the ongoing case, the SEC charged Matthew Panuwat, a senior director of business development at the biopharmaceutical company Medivation, with violations of SEC Rule 10b-5 under the “shadow trading” theory. When Panuwat began working at Medivation in 2014, he signed the company’s broad insider trading policy. The policy stated:
During the course of your employment . . . you may receive important information that is not yet publicly disseminated . . . about the Company. . . . Because of your access to this information, you may be in a position to profit financially by buying or selling or in some other way dealing in the Company's securities . . . or the securities of another publicly traded company, including all significant collaborators, customers, partners, suppliers, or competitors of the Company. . . . For anyone to use such information to gain personal benefit . . . is illegal.
In his role, Panuwat had access to confidential information about Medivation’s potential mergers and acquisitions, including analyses furnished by investment banks to company executives about peer companies. Specifically, Panuwat had access to information about Incyte, “another ‘valuable, mid-cap, oncology-focused [company] with a profitable FDA-approved (commercial stage) drug on the U.S. market.’” In 2016, within minutes after receiving internal emails suggesting the acquisition of Medivation by Pfizer, Panuwat purchased options in Incyte. When Medivation and Pfizer announced the acquisition, the share prices of Incyte and similarly situated companies rose. Panuwat realized $107,066 in profit on the Incyte options.
Panuwat moved to dismiss the charges against him, but the motion was denied. Among Panuwat’s failed arguments, he contended that he did not breach his duty to Medivation because the firm’s insider trading policy did not cover his trades in Incyte securities. In contradicting this assertion, the court looked to Medivation’s insider trading policy and found that “[t]he plain language of the policy covers ‘the securities of another publicly traded company, including’” the categories of “a significant collaborator, customer, partner, supplier, or competitor.” The court concluded that “[b]ecause Incyte is a publicly traded company, it is covered by Medivation's insider trading policy”—a reading of the word “including” that saved the court from parsing whether Incyte was a “significant…competitor.” That Medivation’s insider trading policy covers “the securities of another public traded company” is central to the government’s case because it establishes that Panuwat breached his duty of confidentiality to Medivation by trading in Incyte securities. The logic of the ruling suggests that the SEC would not be able to establish liability under Rule 10b-5 without key language in Medivation’s insider trading policy.
Prosecuting “shadow trading” based only on a defendant’s violation of their company’s insider trading policy will limit the SEC’s regulatory scope. For example, an employee at a company like Apple could avoid prosecution for shadow trading as long as the language of the company’s insider trading policy is limited to prohibitions of dealing in a company’s own securities or those of a business partner when an employee possesses material non-public information (“MNPI”).
In their seminal paper, Shadow Trading, Mihir N. Mehta, David M. Reeb and Wanli Zhao employ a binary classification to analyze corporate trading policies: a policy “either prohibits insiders from (1) trading in or sharing information about the firm and its business partners or competitors, or (2) restricts conventional own-firm trading.” However, as the authors acknowledge, this binary classification does not distinguish firm policies that may go beyond own-firm informed trading but do not capture all informed trading in economically-linked firms. This nuance in policy language is important to recognize because “prohibitions against using private information to trade in business partners may direct insiders to trade in competitors,” the type of trade which is the subject of SEC v. Panuwat. Here, I analyzed the insider trading policies of a set of 124 “central firms” consisting of the S&P 100 and Dow Jones constituent firms and the Financial Stability Board’s list of Globally Systemic Important Financial Institutions (“G-SIFIs”) to determine whether their policies prohibit shadow trading. In this sample, thirty-six firms did not have corporate policy language that prohibited trading in economically-linked firms while in possession of MNPI, representing over a quarter of the firms sampled.
In December of 2022, the SEC adopted new rules concerning Rule 10b5-1 plans and other securities transactions. Among other rule changes, “[t]he amendments also create new disclosure requirements that include: … [a]nnual disclosure of a registrant’s insider trading policies and procedures.” The language of the rule appears only to require policies that cover a registrant’s own securities: “registrants will be required to disclose whether they have adopted insider trading policies and procedures governing the purchase, sale, and other dispositions of their securities.” The new rule fails to provide the SEC with an enforcement mechanism for compelling firms to expand their insider trading policies beyond their own securities. Firms may willingly adopt broad insider trading policies to encourage focus and loyalty among employees, strengthen relationships with business partners, and increase the confidence of shareholders. But companies also know “that you will attract more talented and motivated executives if you allow them to profit personally from their industry expertise.” The rule will perpetuate this perverse incentive for firms to narrow insider trading policies to allow employees to evade enforcement surrounding shadow trading. To avoid limiting the shadow trading theory alleged in SEC v. Panuwat to its facts, the SEC should promulgate a rule extending insider trading policy requirements beyond the securities of the registrant.
 Hypothetical based on those presented in Matt Levine, Watch Out for Shadow Trading, Bloomberg (Jan. 26, 2022), https://www.bloomberg.com/opinion/articles/2022-01-26/watch-out-for-shadow-trading.
 Business Conduct Policy, Apple 12 (Oct. 2022), https://www.apple.com/compliance/pdfs/Business-Conduct-Policy.pdf.
 Apple’s policy furthers states: “It is illegal and against Apple policy to give anyone, including friends and family, tips on when to buy or sell securities when aware of material nonpublic information concerning that security. This applies to decisions to buy or sell Apple stock or the stock of an Apple supplier, manufacturer, vendor, or customer, such as cellular network carriers or other channel partners.” Id. The language of the policy suggests that Apple prohibits tipping others to trade in the stocks of a supplier but does not forbid direct trading in the shares of a supplier like Bananaz. As one article notes, “[t]o the best of our knowledge, all the existing case law concerned with trades on the stocks of the suppliers involved cases in which the insider had violated explicit contractual prohibitions between the trader and her firm.” Yoon-Ho Alex Lee and Alessandro Romano, Insider Trading and Macroeconomic Risk, SSRN 13 (Jan. 5, 2021), https://ssrn.com/abstract=3731719. See also Ian Ayres & Joe Bankman, Substitutes for Insider Trading, 54 Stan. L. Rev. 235, 257 n. 63 (2001).
 Mihir N. Mehta, David M. Reeb & Wanli Zhao, Shadow Trading, 96 The Accounting Rev. 367 (2021).
 Complaint, SEC v. Panuwat, No. 21-cv-06322 (N.D. Cal. Jan. 14, 2022).
 SEC v. Panuwat, No. 21-cv-06322-WHO, 2022 U.S. Dist. LEXIS 39584, at *5 (N.D. Cal. Jan. 14, 2022).
 Id. at *2–3.
 Id. at *3–4.
 Id. at *3.
 Id. at *5.
 Id. at *1–2. Judge Orrick, presiding over the case in the Northern District of California, ruled that “the SEC has adequately shown that the information about Medivation's acquisition was nonpublic, confidential, and material to Incyte, that Panuwat breached his duty to Medivation by using that information to purchase Incyte stock options, and that he acted with the requisite scienter.” Id. at *18–19.
 Id. at *15.
 Id. at *15–16.
 Id. at *16.
 SEC’s shadow trading case survives motion to dismiss, DavisPolk (Jan. 25, 2022), https://www.davispolk.com/insights/client-update/secs-shadow-trading-case-survives-motion-dismiss.
 Apple, supra note 2.
 Mehta, Reeb & Zhao, supra note 4, at 393.
 Id. The authors acknowledge this limitation, noting that coefficients “indicate mixed effects of prohibitions for shadow trading in source firm competitors.” The paper offers that “[o]ne explanation for this finding is that firms may impose express prohibitions against trading in business partners (as opposed to competitors).” Id.
 Id.; Panuwat, 2022 U.S. Dist. LEXIS 39584, at *2–5 (N.D. Cal. Jan. 14, 2022).
 Lee and Romano’s research on informed trading in linked firms, or what they referred to as “network trades,” concludes that “[a] subset of firms in our economy can create macroeconomic risk and the prospect of network trades gives incentives to take on more risk exactly to the insiders of these firms.” Lee and Romano, supra note 3 at 4. They characterized this subset of firms as central firms, including systemically important financial institutions (“SIFIs”). Id. at 27–28. Their article noted that there is a legally defined list of SIFIs published annually by the Financial Stability Board known as Globally Systemic Important Financial Institutions (“G-SIFIs”). Id. at 7. Lee and Romano observed that, unlike for SIFIs, there is no established definition of non-financial central firms. Id. Here, we define central firms beyond SIFIs as the companies which make up the overlapping S&P 100 Index and Dow Jones Industrial Average.
 iShares S&P 100 ETF, BlackRock, (Mar. 1, 2023), https://www.ishares.com/us/products/239723/ishares-sp-100-etf#/.
 Dow Jones Industrial Average: Index Constituents, Financial Times, (Jan. 11, 2023), https://markets.ft.com/data/indices/tearsheet/constituents?s=DJI:DJI.
 2022 List of Global Systemically Important Banks (G-SIBs), Financial Stability Board, (Nov. 21, 2022), https://www.fsb.org/wp-content/uploads/P211122.pdf.
 These central firms without shadow trading prohibitions make up a quarter of the S&P 100 constituents, seven of the thirty Dow Jones listed companies, and twelve of the thirty G-SIFIs. Among these firms are the five largest banks in the world by assets. The world’s 100 largest banks, S&P Global (Apr. 11, 2022), https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/the-world-s-100-largest-banks-2022-69651785 (the five largest banks by assets are Industrial & Commercial Bank of China, China Construction Bank, Agricultural Bank of China, Bank of China, and JP Morgan Chase).
 Insider Trading Arrangements and Related Disclosures, Exchange Act Release Nos. 33-11138,34-9642, 87 FR 80362-01 (Feb. 27, 2023). SEC adopts major changes for insider transactions, Davis Polk (Dec. 19, 2022), https://www.davispolk.com/insights/client-update/sec-adopts-major-changes-insider-transactions.
 FACT SHEET Rule 10b5-1: Insider Trading Arrangements and Related Disclosure EC adopts major changes for insider transactions, SEC 2 (Last visited Jan. 22, 2023), https://www.sec.gov/files/33-11138-fact-sheet.pdf. In its release concerning the rule change, the SEC stated: “Under the final rule, registrants will be required to disclose whether they have adopted insider trading policies and procedures governing the purchase, sale, and other dispositions of their securities by directors, officers, and employees, or the registrant itself that are reasonably designed to promote compliance with insider trading laws, rules, and regulations, and any listing standards applicable to the registrant. If a registrant has not adopted such insider trading policies and procedures, it must explain why it has not done so.” Insider Trading Arrangements and Related Disclosures, supra note 28, at 84.
 Insider Trading Arrangements and Related Disclosures, supra note 28, at 84 (emphasis added).
 Matt Levine, supra note 1.
 A revision to the new rule could be as simple as striking the word “their.” To avoid misinterpretation, the rule could apply to “any security” or could mirror the language in Panuwat. Narrower variations of this language could also be used to reach consensus on the Commission and could require firms to define specific relationships that would capture a Panuwat-type of informed trade.