Shadow Trading – An Indian Perspective

[Mihir Deshmukh is an Associate at Finsec Law Advisors, Mumbai and Bhavya Solanki is a 4^th-year student at Maharashtra National Law University, Mumbai.]

Coined by Mehta, Reeb, and Zhao, shadow trading is a theory of insider trading, which postulates that confidential information of a company could also be relevant for other economically-linked companies, and insiders could profit from trading in the economically-linked scrip to circumvent regulatory scrutiny. The term also finds reference in a 2001 research by Ayres and Bankman which labels it as ‘trading in stock substitutes’. However, it had remained untested in the United States of America until August, 2021, when the Securities and Exchange Commission (“SEC”) brought a complaint against Matthew Panuwat. This post provides an analysis of the case, and also examines the theory’s legal and practical viability from an Indian standpoint.

SEC v. Matthew Panuwat

Matthew Panuwat was a business development executive at Medivation, a mid-cap oncology-focused biopharmaceutical company. In 2016, during the course of his employment, he received confidential, non-public information that Medivation would be acquired by Pfizer. Within minutes of receiving such information, he purchased out-of-the-money, short-term call options in Incyte, another company in the oncology-focused biopharmaceutical company sector, expecting its value would rise when the news relating to Medivation’s acquisition goes public. Surely enough, on the day the information relating to Medivation’s acquisition was announced, the price of Medivation’s shares rose by approximately 20%, and the price of Incyte’s scrip rose by approximately 8 percent. Consequently, the value of Panuwat’s Incyte stock options almost doubled, and Panuwat made a profit of $107,066. The SEC filed a complaint against him alleging insider trading violations.

The complaint has been noted to be a first of its kind, and has also struck many as overstepping the bounds of established insider trading laws. The notion of shadow trading is an extension of the misappropriation theory of insider trading which means that a corporate outsider trades in breach of duty of trust or confidentiality that they owed to the source of their information. Had Panuwat, an outsider vis-à-vis Pfizer, traded in the stock of Pfizer, a strong case would have been made against him under this theory as firstly, Medivation had a direct business relationship with Pfizer, and secondly, Panuwat owed fiduciary duty to Medivation as it was the source of his information. However, there are no business arrangements between the employer and the linked company in the present facts, and hence, establishing a duty owed to the employer becomes difficult.  Extending the misappropriation theory, the SEC opined that the fiduciary duty owed to the employer extends not just to misappropriating material non-public information (“MNP”) to trade in the securities of the employer company, or the acquirer company, but also a similarly situated company, as long as it can be shown that the information was material to that third company’s securities as well.

Therefore, the main issues center on, firstly, (a) whether the confidential information about Medivation and Pfizer can be considered as material to Incyte? and secondly, (b) whether Panuwat owed a duty to Medivation to not use its confidential information to trade in the securities of another company?

With regard to the first issue, SEC alleges that Panuwat knew or was reckless in not knowing that the information was material not just to Medivation, but also Incyte as it made the latter a more attractive target. With regard to the second issue, it is the SEC’s case that Panuwat owed Medivation a duty of trust firstly as an employee and agent of the company; and secondly, as a signatory of the confidentiality and insider trading policies of the company which explicitly provide that making financial profits from the confidential information received during the course of employment, by 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” was illegal. It remains to be seen whether an employee or agent’s fiduciary duty could extend to not misappropriating information by profiting from trading in the securities of a linked company. If it does not, the subsequent question becomes: whether a company’s internal policies could create such a duty?

Analysis from an Indian Standpoint

As the matter is sub judice, the outcome of the first shadow trading case remains unclear. Nevertheless, the fact that the SEC has brought such a complaint is something to take note of in India.

The 2013 N.K. Sodhi report has defined insider trading as trading in securities with the advantage of having asymmetrical access to unpublished price sensitive information (“UPSI”). Unlike in the USA, the Indian Insider Trading regulations do not require establishing a fiduciary duty, which makes it easier to bring such cases.

Notably, UPSI and MNP connote the same meaning. Regulation 2(1)(n) of SEBI (Prohibition of Insider Trading) Regulations, 2015 (“PIT Regulations”) defines UPSI. As per this definition, firstly, the information must directly or indirectly “relate” to a company or its securities, and secondly, upon becoming generally available, it should be “likely” to materially affect the price of the securities.  The fact that the information on acquisition did not directly relate to Incyte can be the first stumbling block, but it may perhaps be interpreted as an indirect relation. This is because as per the facts of the Panuwat case, in 2016, large-caps were looking to acquire mid-caps but there were only a few targets left, including Medivation and Incyte. So, information about each acquisition was relevant for the remaining potential targets as it made them more attractive. 

Secondly, the price of securities should be ‘likely’ to get affected on the information becoming generally available. As discussed above, each acquisition was material to the other remaining targets and it positively impacted their stock prices. Moreover, SEC has stated in its complaint that a similar announcement of acquisition of another company made in 2015 had materially increased the stock prices of both Medivation and Incyte. These facts indicate a likelihood of impact on the price of Incyte’s scrip. Further, the fact that Incyte’s stock price did move when the information became generally available supports the assertion that the information was price-sensitive in nature.  

However, in other cases of shadow trading, anticipating a price movement in linked-stocks may require a bigger leap of logic, expertise and market assessment. This may substantially decrease the likelihood of impact because, when the information becomes generally available, a reasonable investor may not consider it significant in making an investment decision. It further raises the question: should such a market analysis conducted by the shadow trader be penalized, or celebrated as skilled logical deduction?

Further, shadow traders base their trades on riskier or less precise information because they are not privy to the linked company’s own confidential plans that could directly affect the price of their scrips. This could also go against the anticipated magnitude of impact on the price of linked-stocks. 

Assuming that the information is held to be UPSI for the scrips of Incyte, the next point of enquiry would be whether Panuwat was an insider for Incyte under Indian law. As per regulation 2(1)(g) of the PIT Regulations, an insider does not necessarily have to be a connected person, and it is enough for him to just have possession of or access to UPSI. Therefore, Panuwat can easily be considered an insider under regulation 2(1)(g)(ii).

So, if SEBI decides to follow the SEC, it may be able to successfully bring such claims in India. The moot question then becomes: is such an expansion of insider trading laws desirable?

It is argued by Deuskar, Khatri, and Sunder that stricter insider trading laws are encouraging insiders to put their superior information to its next best use i.e. trading in peer stocks. This is undermining the objectives of PIT Regulations which is to restrict trading with an unfair advantage. A shadow trader definitely has an edge over other traders by being privy to information he obtained solely by virtue of his connection with the source-firm, irrespective of the analysis or market assessment he subsequently adds to it.

That being said, we need to look at what we are essentially outlawing: the gall of a shadow trader to brazenly exploit UPSI and reap profits, or just insiders from making sound investment decisions based on their superior knowledge. Panuwat’s case is perfectly cut out for a shadow trading allegation because of his work background, and his prompt purchase in suspicious instruments. Other cases may not be as overtly underhanded. Generally, persons with specialized insider knowledge do use it to make smart investment decisions in other companies. So, should they not be able to base their investment decisions on the information at all?

SEBI has observed that the charge of insider trading is one of the most serious charges in relation to the securities market. It bears huge implications on the business and reputation of an accused. If the net is cast too wide, it could become a specter of harassment for traders. Even in the instant case, Panuwat profited off of a mere 8% rise, and now risks losing his entire career over it.

Finally, if SEBI does get inspired to bring such claims, Indian firms will have to alter their insider trading policies. Ayres and Bankman have identified four potential “stock substitutes”: a firm’s competitors, suppliers, customers, or manufacturers of complementary products. However, identifying a set of companies that serve as stock substitutes beforehand could prove to be a difficult task. Medivation’s insider trading policy itself seems too vague. So, while shadow trading does seem to impede the objectives of maintaining a fair marketplace, it may not be desirable to introduce it in India.

– Mihir Deshmukh & Bhavya Solanki