Legal Sidebar

SEC’s First “Shadow Trading” Case Slated for
Trial
February 28, 2024
Corporate insiders commit securities fraud when they trade their firms’ shares on the basis of material
nonpublic information (MNPI). A pending Securities and Exchange Commission (SEC) enforcement
action raises a related but novel issue: is it unlawful for corporate insiders to use MNPI derived from their
employment to trade the securities of similar companies? One recent study concludes that this practice—
dubbed “shadow trading”—is widespread, meaning the case may have important implications for insider
trading law and corporate compliance departments. The litigation may also be of interest to Congress in
its oversight of the enforcement of the securities laws.
This Legal Sidebar provides an overview of insider trading doctrine, the SEC’s enforcement action, and
considerations for Congress.
Insider Trading: Doctrinal Background
Insider trading is governed by several distinct legal schemes. For purposes of this Sidebar, the relevant
provisions of federal law are Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5,
which prohibit specified forms of securities fraud.
Neither provision explicitly mentions transactions by corporate insiders. The modern prohibition of
insider trading that has emerged from Section 10(b) and Rule 10b-5 is instead the product of common-law
decisionmaking by courts and the SEC. The scope of the prohibition has fluctuated over the years as
competing theories—one grounded in the value of equal access to information, the other in fiduciary
duty—have vied for supremacy.
Origins: The Equal Access Approach
The SEC deployed Rule 10b-5 to target open-market insider trading for the first time in 1961. In an
administrative enforcement action—In re Cady, Roberts & Co.—the SEC concluded that a
brokerage-firm partner violated Rule 10b-5 by selling shares of the Curtiss-Wright Corporation after
learning of an impending dividend cut from one of the corporation’s directors, but before the cut was
announced to the public. In its opinion, the SEC articulated what came to be known as the “disclose or
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abstain” rule, which provides that persons with access to MNPI must either disclose such information
prior to trading a corporation’s securities or abstain from trading. This duty, the SEC reasoned, rested on
“two principal elements”:
(1) “the existence of a relationship giving access, directly or indirectly, to information intended to be
available only for a corporate purpose and not for the personal benefit of anyone”; and
(2) “the inherent unfairness involved where a party takes advantage of such information knowing it is
unavailable to those with whom he is dealing.”
Cady, Roberts represented a notable expansion of Rule 10b-5, but it was only an administrative decision.
Judicial confirmation of the SEC’s position came seven years later with the Second Circuit’s decision in
SEC v. Texas Gulf Sulphur Co. The case involved insiders at a mining company who had purchased the
company’s shares and options to acquire its shares after the firm discovered promising mineral deposits,
but before the discovery was announced to the public. The Second Circuit agreed with the SEC that this
conduct violated Rule 10b-5. Citing Cady, Roberts, the court announced a broad rule under which
“anyone” in possession of MNPI regarding a company’s securities must either disclose it or abstain from
trading. The court explained that this rule was grounded in the principle that “all investors should have
equal access to the rewards of participation in securities transactions.”
The Modern Prohibition: Fraudulent Breaches of Duty
The SEC continued to press this “equal access” gloss on Rule 10b-5 through the 1970s. In 1980, however,
the Supreme Court rejected the theory in Chiarella v. United States. Chiarella involved criminal charges
against an employee of a financial printer that prepared tender offer documents. Based on those
documents, the employee identified companies that were being targeted for takeovers. He then purchased
target company shares before bids were announced and later sold those shares for a significant profit. The
employee thus traded on the basis of MNPI. He was not, however, an insider of the targeted firms, nor did
his employer—which served bidders—have any special relationship with the targets. Despite the absence
of such a relationship, the Second Circuit affirmed the employee’s conviction for violating Rule 10b-5
based on the equal access theory from Texas Gulf Sulphur.
The Supreme Court reversed. In repudiating the equal access theory, the Court reasoned that the
nondisclosure of MNPI qualifies as fraud under Rule 10b-5 only when a defendant has an affirmative
duty of disclosure. While the Court recognized that the fiduciary relationship between corporate insiders
and shareholders triggers such a duty, it concluded that the defendant in Chiarella did not have a
disclosure duty to sellers of the target company securities with whom he had no previous dealings. The
Court accordingly reversed the Second Circuit’s decision affirming the defendant’s conviction.
Chiarella thus did two things. First, it rejected the proposition that Rule 10b-5 creates an expansive
parity-of-information regime for securities trading. Second, in endorsing a narrower framework
predicated on fiduciary duty and fraud, Chiarella effectively ratified what became known as the
“classical” theory of insider trading, which is based on an insider’s breach of a duty to a counterparty
(i.e., persons buying or selling the corporation’s shares).
Chiarella also left an important question unresolved. While the decision acknowledged that insiders owe
disclosure duties to corporate shareholders, the majority declined to consider whether a corporate outsider
could violate Rule 10b-5 by breaching duties to the source of the relevant information (in Chiarella, the
defendant’s employer and the bidders that had retained it). This alternative basis for Rule 10b-5 liability
later came to be called the “misappropriation” theory of insider trading.
In the years following Chiarella, lower federal courts split on the validity of the misappropriation theory.
The Supreme Court resolved that split in 1997 when it endorsed the misappropriation theory in United
States v. O’Hagan. In O’Hagan, a partner at a law firm representing a takeover bidder bought shares and

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options to acquire shares of the target before the bid was announced to the public. Like the defendant in
Chiarella, the partner could not be held liable under the classical theory of insider trading because he did
not owe disclosure duties to the target’s shareholders. However, in reversing the lower court’s rejection of
the misappropriation theory, the Supreme Court held that the partner could be liable under Rule 10b-5 for
breaching duties of loyalty and confidentiality to his law firm and its client. Those duties, the Court
reasoned, precluded the partner from depriving his firm and its client of the exclusive use of their
confidential information, which represented a type of property. In the Court’s view, the undisclosed
misappropriation of that property constituted a form of fraud akin to embezzlement.
Chiarella and O’Hagan thus mark the two branches of Rule 10b-5 liability for insider trading. Under the
classical theory, corporate insiders violate Rule 10b-5 by trading on the basis of MNPI because such
trading breaches a duty of disclosure to their counterparties. Under the misappropriation theory, trading
on the basis of MNPI violates Rule 10b-5 if such trading breaches duties to the source of the MNPI.
SEC v. Panuwat: The First “Shadow Trading” Case
The SEC’s first shadow trading enforcement action—SEC v. Panuwat—concerns the scope of the
misappropriation theory of insider trading. The case involves a former employee of Medivation, an
oncology-focused biopharmaceutical company. The SEC alleges that, after the employee learned
confidential information about a pending acquisition of Medivation, he purchased call options for the
stock of another oncology-focused firm, Incyte. After the announcement of Medivation’s acquisition,
Incyte’s stock price increased by roughly 8%, ultimately netting the employee more than $100,000 in
profit. The SEC contends that this conduct violated Rule 10b-5 under the misappropriation theory,
because Medivation’s insider trading policy prohibited employees from using confidential information
derived from their employment to trade the securities of other public companies.
In January 2022, a federal district court denied the defendant’s motion to dismiss the case. The court
concluded that the SEC had adequately alleged that information regarding the acquisition of Medivation
was material to Incyte’s stock price; that the defendant had breached a duty of confidentiality to
Medivation by trading on that information; and that the defendant acted with the requisite mental state.
The court also rejected the defendant’s argument that the SEC’s theory of liability violated the Fifth
Amendment’s Due Process Clause by failing to give him sufficient notice that his conduct was illegal.
While the court acknowledged that no previous cases involved the type of shadow trading at issue in
Panuwat, it determined that the alleged conduct fell within the established parameters of the
misappropriation theory. As a result, the court held that the defendant had adequate notice that the charged
conduct was unlawful.
In November 2023, the district court likewise denied the defendant’s motion for summary judgment,
concluding that the SEC had established genuine disputes of material fact concerning the defendant’s
receipt of confidential information; the materiality of the information to Incyte’s stock; whether the
defendant breached a duty to Medivation; and whether the defendant acted with the necessary mental
state. A trial is scheduled for March 25, 2024.
Considerations for Congress
Panuwat’s implications remain to be determined. The case involves a broadly worded corporate insider
trading policy barring the use of confidential information to trade the securities of any public company.
Moreover, the SEC alleges that the defendant told Medivation’s investment bankers that Incyte was an
economically similar firm. Without such details, it may be more difficult to prove breach of a duty and
that one company’s information is material to another company’s stock price, which may dissuade the
SEC from pushing the misappropriation theory significantly beyond Panuwat’s facts.

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On the other hand, in denying the defendant’s motion for summary judgment, the district court concluded
that the SEC had adequately alleged breach of a duty under three independent theories. Two of those
theories involve Medivation policies, but the third is rooted in traditional agency principles. The court’s
decision thus suggests that shadow trading may be unlawful even in the absence of an explicit corporate
policy prohibiting it.
Several commentators have argued that this conclusion stretches Rule 10b-5 closer to the type of
parity-of-information regime that the Supreme Court rejected in Chiarella, especially in cases where the
defendant’s trading does not appear to harm the source of the relevant MNPI.
This ambiguity may also create challenges for corporate compliance departments. SEC regulations
require public companies to disclose whether they have adopted policies and procedures that are
“reasonably designed” to promote compliance with insider trading laws. Panuwat may have ramifications
for this disclosure obligation. If liability for shadow trading turns on the content of a corporation’s
internal policies, then it appears that such policies can be “reasonably designed” to promote legal
compliance even if they do not address shadow trading; silence on the issue would effectively preclude a
Rule 10b-5 violation. If, however, shadow trading can violate Rule 10b-5 even without a corporate policy
prohibiting it, then public companies may need to prohibit shadow trading explicitly before claiming that
they have policies and procedures that are “reasonably designed” to promote compliance with insider
trading laws. (Affirmative corporate authorization of shadow trading is another possibility; in theory, an
employee does not misappropriate his employer’s property by using it with permission. That option,
however, may not be attractive to image-conscious compliance departments.)
Congress has the power to define the elements of insider trading. Bills in past Congresses aimed to
expand and clarify the offense. In the 114th Congress, for example, S. 702, the Stop Illegal Insider Trading
Act, would have replaced the current fraud-based system with an equal access regime. Alternatively,
Congress could pursue more limited legislation clarifying the legality of shadow trading. Congress also
has the option to chart a deregulatory course and leave the regulation of insider trading to private
ordering.

Author Information

Jay B. Sykes

Legislative Attorney




Disclaimer
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