Key Takeaways
- In a novel case of Shadow Trading, California District Court held that MNPI about one company could count as MNPI for another company if they are economically linked
- What is Shadow Trading? What is the concept of economically linked entities? How is international jurisprudence developing on Shadow Trading?
- US law differs from Indian law on grounds of knowledge, materiality and intention – to that extent Indian law, arguably, maybe more equipped to deal with these situations
- PE funds with multiple verticals or EFMs, and listco boards should consider revising UPSI/ MNPI policies to factor-in economically-linked companies
Key Takeaways
- In a novel case of Shadow Trading, California District Court held that MNPI about one company could count as MNPI for another company if they are economically linked
- What is Shadow Trading? What is the concept of economically linked entities? How is international jurisprudence developing on Shadow Trading?
- US law differs from Indian law on grounds of knowledge, materiality and intention – to that extent Indian law, arguably, maybe more equipped to deal with these situations
- PE funds with multiple verticals or EFMs, and listco boards should consider revising UPSI/ MNPI policies to factor-in economically-linked companies
Introduction
Consider a situation where a company CEO trades in a listed competitor’s securities based on his material nonpublic information (“MNPI”) such as his company’s unpublished financial results. A recent US ruling1 held such trading to be violative of US insider trading regulations. Journalistic pieces call this a novel case of “Shadow Trading”2 . While SEC had to jump through many hoops, the question is if the test remains the same in the Indian context as well? Arguably, SEBI (owing to the broader scope of Insider Trading Regs) may be able to successfully prosecute an individual in a similar set of facts
What is Shadow Trading?
Insider trading is generally understood as trading in securities while in possession of unpublished price sensitive information (“UPSI”) relating to the security. However, using UPSI to trade in securities of another economically linked firm is referred to as “Shadow Trading” 3 . In a globalized world, economically linked firms can include direct competitors, business partners, suppliers, customers and any other company which may be affected by changes in the main company.4 Research reports suggest that Shadow Trading is seldom prosecuted for a variety of reasons, but the menace is much bigger than conventional cases of insider trading.5 “The premise of Shadow Trading is straightforward: private information held by insiders can also be relevant for economically linked firms and exploited to facilitate profitable trading in those firms. The legality of Shadow Trading appears to be relatively untested due to the lack of a clear breach of fiduciary responsibility by insiders who use private information to facilitate trading in other firms. Indeed, in the U.S., prosecutions for Shadow Trading are virtually non-existent.”6
Panuwat Case – Brief facts
In the case of SEC vs. Mathew Panuwat (“Panuwat Case”), the SEC prosecuted former Medivation employee Mathew Panuwat for engaging in insider trading prior to the public announcement of Medivation‘s acquisition by Pfizer. Panuwat was accused of trading not in the securities of Medivation or Pfizer, but rather in the securities of another similar company, Incyte. This occurred shortly after Medivation‘s CEO had emailed Panuwat and others, stating that Pfizer was eager to finalize the deal over the weekend. Panuwat purchased Incyte options in August 2016, and sold them, yielding a profit of $107,066.
SEC’s arguments?
This case is the first instance in which the SEC successfully argued that (i) a company’s MNPI may be material to another company if both companies have a “market connection” or are “economically linked”; and (ii) trading a company’s securities while having MNPI of a different market-connected or economically linked company (even if MNPI does not relate to the traded company’s securities) can violate federal securities laws.
To successfully prosecute Mr. Panuwat, SEC established a three-pronged misappropriation theory test7, summarily, that Mr. Panuwat knowingly misappropriated information, the information in question was indeed material and nonpublic, and doing so was a breach of duty arising from a relationship of trust and confidence.
Can SEBI prosecute individuals for Shadow Trading?
Yes. Unlike US, the SEBI (Prohibition of Insider Trading) Regulations, 2015 (“Insider Trading Regs”) do not necessarily require all the above tests to be fulfilled and knowledge and awareness of the price sensitivity is presumed.
For context, as a precursor to the Insider Trading Regs, a committee was constituted under the chairmanship of Mr. N.K. Sodhi to examine the framework of insider trading to be adopted. As part of this report, the following charging provision was suggested: “No insider shall trade in securities that are listed on a stock exchange when in possession of unpublished price sensitive information relating to such securities.” This language seems to indicate that Shadow Trading was not prohibited since the UPSI has to relate to the securities in question.
However, the fine print of the Insider Trading Regulations interestingly omitted the words “relating to such securities”, which seems to allow for shadow trades to be brought under the ambit of Insider Trading Regs.
Section 4(1) of the Insider Trading Regs provides that “No insider shall trade in securities that are listed or proposed to be listed on a stock exchange when in possession of unpublished price sensitive information. Explanation - When a person who has traded in securities has been in possession of unpublished price sensitive information, his trades would be presumed to have been motivated by the knowledge and awareness of such information in his possession.”
Effectively, if SEBI can establish that UPSI of one company is also material (and effectively UPSI) in relation to another security or company, whether by reason of economic linkage or otherwise, it may be able to establish a case of ‘Shadow Trading’.
Does insider trading hinge on ‘intention’ to be established?
US law requires intent to be established, which wasn’t entirely the case under Indian law. The Insider Trading Regulations changed the benchmark from ‘on the basis of’ to ‘when in possession of’ UPSI clarifying that mens rea or intent as such may not be of relevance to establish a case of insider trading. Several case laws support that line of thinking. The Supreme Court in a recent case of Abhijeet Ranjan vs SEBI8 held that an insider’s profit motive is essential to establish insider trading, which convoluted the understanding. The jury is still out on the necessity of ‘intent’ to be established, even if trading happened when in possession of UPSI. Of course, the Insider Trading Regs allow for innocence to be established if one can prove that the trades were not ‘motivated’ by knowledge and awareness of the UPSI, which might be quite challenging since the law would presume otherwise.
Conclusion
The ruling in Panuwat Case has highlighted cross-market implications of insider trading and provided clarity on something market players could possibly be prosecuted for. The principle is simple. If a trade is driven by MNPI/ UPSI, it is illegal. Irrespective of where UPSI originates from, if the information is ‘unpublished’ and ‘price sensitive’ for a certain set of securities, then trading in such securities is prohibited (with limited exceptions). Finally, since Insider Trading Regs presumes trades made by those in possession of UPSI are motivated by that very UPSI, listco boards should, as part of their insider trading policies, consider prohibiting trades in economically linked firms to avoid inadvertent Shadow Trading. PE funds with multiple verticals and EFMs would also do well to consider revised policies to this effect.
1 Securities and Exchange Commission v. Panuwat, Case No. 21-cv-06322-WHO.
2 Kershen, K., 2022. SEC v. Panuwat: The Federal Pursuit of Shadow Trading. Brook. J. Corp. Fin. & Com. L., 17, p.151.
3 Lee, Y.H.A., Liu, L. and Romano, A., 2022. Shadow Trading and Corporate Investments. Journal of Law, Finance, and Accounting (Forthcoming), Bocconi Legal Studies Research Paper, (4307455), pp.23-15.
4 Kershen, K., 2022. SEC v. Panuwat: The Federal Pursuit of Shadow Trading. Brook. J. Corp. Fin. & Com. L., 17, p.151.
5 Mehta, M.N., Reeb, D.M. and Zhao, W., 2021. Shadow Trading. The Accounting Review, 96(4), pp.367-404.
6 Id.
7 Note. Under the classical theory of insider trading, a corporate insider violates the anti-fraud provisions by trading in the securities of their own company on the basis of UPSI in breach of a duty owed to that company and its shareholders. By contrast, the misappropriation theory extends liability one step further – to a person who is not an insider at a company (i.e., a corporate outsider, who is not an employee, officer or director) - and prohibits these corporate outsiders from trading based on UPSI obtained in breach of a duty owed to the source of the information.
8 2022 SCC OnLine SC 1241.
Introduction
Consider a situation where a company CEO trades in a listed competitor’s securities based on his material nonpublic information (“MNPI”) such as his company’s unpublished financial results. A recent US ruling1 held such trading to be violative of US insider trading regulations. Journalistic pieces call this a novel case of “Shadow Trading”2 . While SEC had to jump through many hoops, the question is if the test remains the same in the Indian context as well? Arguably, SEBI (owing to the broader scope of Insider Trading Regs) may be able to successfully prosecute an individual in a similar set of facts
What is Shadow Trading?
Insider trading is generally understood as trading in securities while in possession of unpublished price sensitive information (“UPSI”) relating to the security. However, using UPSI to trade in securities of another economically linked firm is referred to as “Shadow Trading” 3 . In a globalized world, economically linked firms can include direct competitors, business partners, suppliers, customers and any other company which may be affected by changes in the main company.4 Research reports suggest that Shadow Trading is seldom prosecuted for a variety of reasons, but the menace is much bigger than conventional cases of insider trading.5 “The premise of Shadow Trading is straightforward: private information held by insiders can also be relevant for economically linked firms and exploited to facilitate profitable trading in those firms. The legality of Shadow Trading appears to be relatively untested due to the lack of a clear breach of fiduciary responsibility by insiders who use private information to facilitate trading in other firms. Indeed, in the U.S., prosecutions for Shadow Trading are virtually non-existent.”6
Panuwat Case – Brief facts
In the case of SEC vs. Mathew Panuwat (“Panuwat Case”), the SEC prosecuted former Medivation employee Mathew Panuwat for engaging in insider trading prior to the public announcement of Medivation‘s acquisition by Pfizer. Panuwat was accused of trading not in the securities of Medivation or Pfizer, but rather in the securities of another similar company, Incyte. This occurred shortly after Medivation‘s CEO had emailed Panuwat and others, stating that Pfizer was eager to finalize the deal over the weekend. Panuwat purchased Incyte options in August 2016, and sold them, yielding a profit of $107,066.
SEC’s arguments?
This case is the first instance in which the SEC successfully argued that (i) a company’s MNPI may be material to another company if both companies have a “market connection” or are “economically linked”; and (ii) trading a company’s securities while having MNPI of a different market-connected or economically linked company (even if MNPI does not relate to the traded company’s securities) can violate federal securities laws.
To successfully prosecute Mr. Panuwat, SEC established a three-pronged misappropriation theory test7, summarily, that Mr. Panuwat knowingly misappropriated information, the information in question was indeed material and nonpublic, and doing so was a breach of duty arising from a relationship of trust and confidence.
Can SEBI prosecute individuals for Shadow Trading?
Yes. Unlike US, the SEBI (Prohibition of Insider Trading) Regulations, 2015 (“Insider Trading Regs”) do not necessarily require all the above tests to be fulfilled and knowledge and awareness of the price sensitivity is presumed.
For context, as a precursor to the Insider Trading Regs, a committee was constituted under the chairmanship of Mr. N.K. Sodhi to examine the framework of insider trading to be adopted. As part of this report, the following charging provision was suggested: “No insider shall trade in securities that are listed on a stock exchange when in possession of unpublished price sensitive information relating to such securities.” This language seems to indicate that Shadow Trading was not prohibited since the UPSI has to relate to the securities in question.
However, the fine print of the Insider Trading Regulations interestingly omitted the words “relating to such securities”, which seems to allow for shadow trades to be brought under the ambit of Insider Trading Regs.
Section 4(1) of the Insider Trading Regs provides that “No insider shall trade in securities that are listed or proposed to be listed on a stock exchange when in possession of unpublished price sensitive information. Explanation - When a person who has traded in securities has been in possession of unpublished price sensitive information, his trades would be presumed to have been motivated by the knowledge and awareness of such information in his possession.”
Effectively, if SEBI can establish that UPSI of one company is also material (and effectively UPSI) in relation to another security or company, whether by reason of economic linkage or otherwise, it may be able to establish a case of ‘Shadow Trading’.
Does insider trading hinge on ‘intention’ to be established?
US law requires intent to be established, which wasn’t entirely the case under Indian law. The Insider Trading Regulations changed the benchmark from ‘on the basis of’ to ‘when in possession of’ UPSI clarifying that mens rea or intent as such may not be of relevance to establish a case of insider trading. Several case laws support that line of thinking. The Supreme Court in a recent case of Abhijeet Ranjan vs SEBI8 held that an insider’s profit motive is essential to establish insider trading, which convoluted the understanding. The jury is still out on the necessity of ‘intent’ to be established, even if trading happened when in possession of UPSI. Of course, the Insider Trading Regs allow for innocence to be established if one can prove that the trades were not ‘motivated’ by knowledge and awareness of the UPSI, which might be quite challenging since the law would presume otherwise.
Conclusion
The ruling in Panuwat Case has highlighted cross-market implications of insider trading and provided clarity on something market players could possibly be prosecuted for. The principle is simple. If a trade is driven by MNPI/ UPSI, it is illegal. Irrespective of where UPSI originates from, if the information is ‘unpublished’ and ‘price sensitive’ for a certain set of securities, then trading in such securities is prohibited (with limited exceptions). Finally, since Insider Trading Regs presumes trades made by those in possession of UPSI are motivated by that very UPSI, listco boards should, as part of their insider trading policies, consider prohibiting trades in economically linked firms to avoid inadvertent Shadow Trading. PE funds with multiple verticals and EFMs would also do well to consider revised policies to this effect.
1 Securities and Exchange Commission v. Panuwat, Case No. 21-cv-06322-WHO.
2 Kershen, K., 2022. SEC v. Panuwat: The Federal Pursuit of Shadow Trading. Brook. J. Corp. Fin. & Com. L., 17, p.151.
3 Lee, Y.H.A., Liu, L. and Romano, A., 2022. Shadow Trading and Corporate Investments. Journal of Law, Finance, and Accounting (Forthcoming), Bocconi Legal Studies Research Paper, (4307455), pp.23-15.
4 Kershen, K., 2022. SEC v. Panuwat: The Federal Pursuit of Shadow Trading. Brook. J. Corp. Fin. & Com. L., 17, p.151.
5 Mehta, M.N., Reeb, D.M. and Zhao, W., 2021. Shadow Trading. The Accounting Review, 96(4), pp.367-404.
6 Id.
7 Note. Under the classical theory of insider trading, a corporate insider violates the anti-fraud provisions by trading in the securities of their own company on the basis of UPSI in breach of a duty owed to that company and its shareholders. By contrast, the misappropriation theory extends liability one step further – to a person who is not an insider at a company (i.e., a corporate outsider, who is not an employee, officer or director) - and prohibits these corporate outsiders from trading based on UPSI obtained in breach of a duty owed to the source of the information.
8 2022 SCC OnLine SC 1241.
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