Shadow Trading: When Insider Knowledge Crosses Corporate Boundaries!
Anita Jain
Partner at IC Universal Legal, Asset Management, Investment Funds & Regulatory Pratice
The term "shadow trading" extends beyond the typical concept of insider trading. It refers to the practice of using insider information about one company to trade securities in a related company, either to profit from anticipated market reactions or to avoid potential losses. This can involve buying stock in anticipation of a price increase or selling stock to prevent financial losses due to expected negative market impact.
Example of Shadow Trading
An employee with insider knowledge of a company's upcoming acquisition learns that the deal will boost the stock of a different, related company. The employee buys stock options in the second company, anticipating that the market will react positively once the acquisition is announced. When the stock price of the second company rises, the employee profits. This is an example of shadow trading, where insider information about one company is used to trade in the stock of another company, benefiting from the anticipated market reaction.
Aversion of Loss: A Different Approach
In the first example, the employee uses insider knowledge of an upcoming merger to trade stock in a related company, anticipating a positive market reaction. Here, the goal is to profit. In contrast, consider a scenario where the same employee, armed with insider knowledge, acts to prevent losses by selling stock in the related company before the news breaks to avoid a drop in the stock price. While both scenarios stem from insider knowledge, the key difference lies in the intent: one is driven by potential gain, while the other seeks to avert financial damage.
Key factors to assess in relation to Shadow Trading
When investigating shadow trading, regulators assess several key factors to determine if a violation has occurred:
Industry/Sector: Are the companies involved within the same industry or sector? A strong correlation could indicate that one company's news impacts the other.
Economic Correlation: Is there a significant economic relationship between the two companies that would suggest one’s news can affect the other’s stock price?
Trading Pattern: Does the trading activity appear unusual or align with behaviour that could indicate the trades were driven by access to unpublished information? Alternatively, can it be shown that these trades were part of a pre-established trading plan or strategy?
Public Availability of Information: Is the contested information already available to the public in some form, such as through a news article or other public disclosures, which could explain the trading behaviour?
Global Judicial Precedents
Shadow trading has led to several notable legal cases that highlight its consequences and the regulatory responses across different jurisdictions.
SEC v. Matthew Panuwat (USA)[1]
The most talked-about case in relation to shadow trading is Securities and Exchange Commission v. Matthew Panuwat. The SEC charged a former employee of California-based Medivation, Inc. with insider trading in advance of Medivation's announcement that it would be acquired by pharmaceutical giant Pfizer Inc. According to the SEC’s complaint[2], filed in the U.S. District Court, Matthew Panuwat, the former head of business development at Medivation, allegedly engaged in insider trading by purchasing short-term, out-of-the-money stock options in Incyte Corporation shortly before the announcement of Medivation's acquisition by Pfizer. He made these trades after learning confidential information about the merger and knowing that Medivation's investment bankers had mentioned Incyte as a comparable company. Panuwat anticipated that the acquisition would drive up Incyte's stock price, which rose by 8% after the announcement. His actions violated Medivation’s insider trading policy, and he reportedly made $107,066 in illicit profits.
Court Ruling on Panuwat's Insider Trading
Matthew Panuwat was convicted of insider trading, and the court recognized the seriousness of his actions, even though it was a single incident. The ruling underscored the need for strong deterrents, with Panuwat facing a hefty civil penalty of $321,197, three times the illicit profits he made. While the court opted not to bar him from future executive roles at public companies, the penalty sent a clear message about the gravity of insider trading.
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SEBI order in the matter of insider trading in the scrip of Multi Commodity Exchange of India Limited[3]
In the matter of Insider Trading in the scrip of Multi Commodity Exchange of India Limited, the question arose whether the implications of the Show Cause Notice (SCN) issued by the Department of Company Affairs (DCA) to National Spot Exchange Limited (NSEL), constituted "price-sensitive information" in relation to MCX. To answer this question, it became essential to analyze the contents of the SCN, as well as the context in which the notice was issued. MCX and NSEL were companies under the same holding company, Financial Technologies India Ltd (FTIL). In this regard, SEBI concluded that MCX and NSEL were both subsidiaries of the same holding company, FTIL. Any negative impact on NSEL’s business was likely to have a cascading effect, directly affecting FTIL and indirectly impacting MCX. Given the close relationship between the companies, the challenges faced by NSEL could materially influence the price of MCX's securities if made public. Additionally, this could harm the reputation and credibility of MCX’s promoters and management. Given the nature, timing, and potential impact of the SCN issued to NSEL, SEBI deemed the information to be price-sensitive for MCX.
Further, in the matter, SEBI quoted that when an insider engages in trades or deals in the securities of a listed company, it is presumed that the individual traded based on unpublished price-sensitive information (UPSI) in their possession, unless they can prove otherwise. This presumption is rebuttable, and it is up to the insider to demonstrate that their trading was not based on UPSI, but on some other legitimate basis. To discharge this burden, the insider must provide a reasonable or plausible explanation for their trading decisions. If they fail to provide such an explanation, the charge of insider trading will be deemed to be established.
SEBI had imposed a ban on the Noticee, restraining him from accessing the securities market. The individual was prohibited from buying, selling, or otherwise dealing in securities, either directly or indirectly, or from being associated with the securities market in any capacity for a period of seven (7) years from the date of the order.
Leveraging AI Technology to Enhance Insider Trading Detection by Regulators
As insider trading tactics become more sophisticated, regulators must adapt to stay ahead. Embracing artificial intelligence (AI) could greatly enhance surveillance and detection capabilities. With AI-driven tools, regulators can sift through vast datasets in real-time, quickly identifying suspicious trading patterns. This shift could allow for more proactive market monitoring, enabling authorities to catch insider trading activities earlier and with greater precision. Incorporating such technology could also help regulators stay ahead of emerging trends and complexities in the financial markets. As market practices continue to evolve, the adoption of AI may become an essential tool for regulators to ensure the integrity and transparency of the financial system, fostering greater investor confidence.
Effective Strategies for Companies to prevent Shadow Trading/Insider Trading
Companies should establish clear trading guidelines, implementing robust internal controls, and using surveillance systems to detect suspicious trading. Promoting transparency through timely reporting and creating whistleblowing programs encourages ethical behaviour. Regular training keeps employees informed on legal risks, while strict insider trading policies prevent the misuse of non-public information. Companies should ensure compliance with regulations, enforce penalties for non-compliance, and invite third-party audits to maintain accountability.
Conclusion
The case of SEC v. Matthew Panuwat serves as a reminder of the serious consequences of shadow trading, even when the misconduct involves a single instance of insider trading. Regulatory bodies around the world have reinforced the importance of assessing the relationships between companies and trading patterns when investigating insider trading activities. Additionally, embracing advanced technologies like AI can enhance regulators' ability to detect suspicious activities, ensuring that markets remain fair and transparent. Companies can also play a vital role in reducing shadow trading by adopting strong internal controls, promoting transparency, and ensuring compliance with regulations. In a world of rapidly evolving financial markets, these steps are essential for maintaining the integrity and trust of the investing public.
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