SEC v. Panuwat and the Dangers of the SEC’s Novel Shadow Trading Theory

Insider trading is a white-collar crime that fits under the Federal Bureau of Investigation’s “Corporate Fraud” umbrella and has been deemed one of the agency’s highest criminal priorities. The Securities and Exchange Commission (SEC) is responsible for enforcing insider trading rules. In their investigating and prosecuting of alleged instances of insider trading, the SEC operates with the following definition: 

"Insider trading" generally refers to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.

Essentially, a person employed by a firm in any capacity cannot use information that will have a substantial effect on the firm’s stock price to buy or sell the firm’s stock before the information is made public. This definition is expanded to apply to people who may not be employed by the firm but come to know such information by any sort of “tip” from an employee. In such a case, both parties are subject to prosecution. 

In using this definition, the SEC has historically brought insider trading charges against around 50 firms and employees at all different levels and in a variety of industries. Fines imposed on convicted insider traders have reached values as high as $600 million and $92.8 million in cases against SAC Capital and Galleon Hedge Fund respectively. Not only were these firms hit with severe fines, but the individuals deemed responsible in each case received prison sentences of over eight years. These examples highlight the stakes at play for a firm or individual charged with insider trading. While each case is unique in its own right, all past insider trading convictions in the United States share one common denominator: the information that was used to illegally profit from the purchase or sale of a security was directly related to the company whose security was being bought or sold. Such enforcement is well within the purview of the SEC, as the definition of the crime clearly states a link between the material nonpublic information and the security itself. Recently however, the SEC attempted to advance a new theory that would ambiguously widen the traditional interpretation of insider trading. 

Shadow Trading and Its Proving Ground: SEC v. Panuwat

In the recent case SEC v. Panuwat, the SEC is pursuing an insider trading conviction against Mathew Panuwat for illegally using material nonpublic information to buy securities in a company other than the one to which the information was relevant. The theory behind the prosecution has since been labeled “shadow trading” theory. If allowed in this case, the theory looks to significantly expand the range of activities that can be prosecuted as insider trading.

Panuwat was a business development executive at Medivation, a pharmaceutical company that Pfizer acquired. In his role with Medivation, Panuwat gained access to material nonpublic information regarding the sale of the company to Pfizer. Specifically, Panuwat came to know that Medivation was being acquired in an all-cash purchase for a value significantly higher than where its shares had been trading. With this information, Panuwat purchased shares of Incyte, another pharmaceutical company similar in size to Medivation. After the purchase of Medivation went public, Incyte’s stock price increased rather dramatically, and Panuwat made over $100,000 in profit. Since then, Panuwat has been investigated by the SEC and charged with insider trading. Recently, a district court threw out Panuwat’s motion to dismiss the case, marking the first time that a court will actually consider whether shadow trading, which involves the use of material nonpublic information about one firm to buy the stocks of another firm, is illegal. 

Prior to analyzing the viability of “shadow trading” within the SEC’s definition of insider trading, it is worth noting that firms can have their own compliance and insider trading statutes. Policies of this kind make employees liable for activity that may typically fall outside the definition of insider trading. For example, in Panuwat’s case he signed Medivation’s insider trading policy which disallowed him from using confidential information to personally profit from the purchase or sale of shares of Medivation, or any other publicly traded company. As a result of Medivation’s particular policy, Panuwat is more than likely guilty of insider trading. However, this case should not be used to establish a sweeping precedent recognizing “shadow trading” as a type of insider trading without first expanding the definition of insider trading. 

A Bad Example 

The hypothetical case advanced by the theory of  “shadow trading” is not synonymous with that of Matthew Panuwat and Medivation. Rather in order to properly grasp the concept, consider the same case in the absence of Medivation’s insider trading policy. The question remains as to whether the material nonpublic information used by Panuwat constitutes a form of insider trading. Simply put, right now the answer is no. There is no text or past case that a judge could turn to which would render such an action as insider trading. Every word in the definition of insider trading as provided by the SEC hinges on the fact that the illegal activity is performed relative to “the security.” Interpreting the current definition as applying to other securities constitutes an unfounded intellectual leap. 

There is no doubt that Panuwat’s purchase of Incyte shares was dubious, but that is exactly why responsible companies such as Medivation have their own insider trading policies which amend the working industry definition of insider trading. In order for the “shadow trading” theory to be rightfully used by the SEC, it must amend the definition of insider trading. Until such action is taken, prosecutions based on shadow trading theory remain outside the scope of the SEC and create a risky investing environment. 

Consequences

If courts are to one day recognize “shadow trading” as a form of insider trading, the lack of a clear definition of the concept will put investors in jeopardy of unknowingly committing a crime. It needs to be clear exactly which kinds of industry-specific information can be used in buying or selling securities if the use of some of this information is going to be criminalized. 

One particularly vulnerable group which has been identified is those who are considered experts in a given area. Experts are privy to a wealth of knowledge regarding a specific topic, and a recognition of “shadow trading” could work to handcuff the investing options of experts. Thus, the courts should proceed with caution in SEC v. Panuwat and future cases that may deal with the same concepts. A narrow ruling which convicts Matthew Panuwat only due to his violation of Medivation’s policies would serve to allow companies to continue to prevent shady activity in the market on their own while also avoiding a situation in which what counts as insider trading is anyone’s guess. If the SEC feels that it must prevent activity similar to Panuwat’s, a well-defined expansion of the definition of insider trading is required to avoid incredible confusion.