Donald Lai ACG HKACG, Solicitor, CPA, discusses a recent US case in which the shadow trading theory was used for the first time to successfully prosecute an employee for insider trading in another company, and outlines the implications for Hong Kong.

‘There was nothing novel about this matter… this was insider trading, pure and simple.’ So stated the Enforcement Director of the US Securities and Exchange Commission (SEC) on 5 April 2024 in his after-trial statement on the jury’s verdict on the case against Matthew Panuwat (SEC v Panuwat; filed in the District Court for the Northern District of California on 17 August 2021).

However, the shadow trading theory featured in this case was novel – and its successful use has expanded the potential liability of insider dealing. By advancing the shadow trading theory, the SEC obtained a verdict in its favour on insider trading against Mr Panuwat under section 10(b) or Rule 10b-5 of the US Securities Exchange Act (US SEA Provisions), even though Panuwat possessed no inside information on the stock he traded.

Since section 300 of the Securities and Futures Ordinance (SFO) originated from the US SEA Provisions, the shadow trading theory may be relevant to Hong Kong. Company secretaries should be alert to the case details and should undertake action items to mitigate the potential risk of insider dealing.

Background

Mr Panuwat was an employee of Medivation Inc, a US-listed biopharmaceutical company. In 2016, Panuwat learned from an email sent by Medivation’s CEO that Pfizer Inc would acquire Medivation for a premium over Medivation’s market price (Pfizer’s Acquisition). Panuwat anticipated that Pfizer’s Acquisition would boost the share price of Incyte Corporation, another US-listed biopharmaceutical company in a similar field of business to that of Medivation. Seven minutes after Panuwat received the email, he purchased call options for Incyte. When Pfizer’s Acquisition was announced, Incyte’s stock price increased by 7.7%. Panuwat received approximately US$110,000 from his call options in Incyte. At all material times, Panuwat was not connected to Incyte and did not possess any inside information on Incyte.

The SEC took enforcement action against Panuwat. In 2021, the SEC alleged insider trading against Panuwat under the US SEA Provisions. Panuwat’s move to dismiss the SEC’s action failed and, in April 2024, the jury found Panuwat liable for insider dealing.

Shadow trading

The theory of shadow trading predates the Panuwat case. In September 2020, Professors Mehta, Reeb and Zhao published a study on shadow trading. The paper investigates ‘whether corporate insiders attempt to circumvent insider trading restrictions by using their private information to facilitate trading in economically linked firms, a phenomenon we call “shadow trading”’. Using US stock market data from 1997 to 2011 for statistical analysis, the paper found that the returns of economically linked firms were statistically associated, which enabled a profitable shadow trading activity. The paper estimated that the dollar value profit from a single shadow trading event ranges from US$139,400 to US$678,000. The authors assert that while conventional insider trading primarily focuses on insiders who use inside information to trade in ‘their [emphasis added by the authors] firms as opposed to other firms’, the shadow trading theory would close the loopholes to prevent insiders from exploiting their private information to trade in their business partners and competitors.

Shadow trading would not affect ordinary retail investors trading in a company based on public information about its competitors or business partners. The shadow trading theory targets corporate insiders and is premised on the misappropriation theory. Under this theory, the corporate insider commits fraud when he or she dishonestly misuses inside information for gain or avoidance of loss. The fraudulent act is a result of a breach of fiduciary duty. In the Panuwat case, Panuwat owed a fiduciary duty to Medivation by virtue of his employment. He breached his fiduciary duty by violating Medivation’s insider dealing policy and misusing the information obtained from Medivation for his own benefit. Ordinary retail investors who owe no fiduciary duty to a listed company are unlikely to commit insider dealing by shadow trading.

Implications

The Panuwat case may result in unintended consequences for the financial services industry. Active fund managers who employ a pair-trading strategy frequently trade stocks with a high correlation, usually economically linked firms. The information they obtain from analyst meetings or private communication with listed companies may facilitate their trading in other stocks in economically linked sectors. Such a pair-trading strategy may become insider dealing if the fund manager makes investment decisions based on non-public information about economically linked firms. The same logic applies to research analysts making investment recommendations on a firm based on knowledge from analyst meetings of economically linked firms and sector news. The research analyst may commit insider trading by counselling or procuring people to trade a stock based on non-public information about its competitors or business partners. This is undoubtedly detrimental to the research and asset management businesses.

Another hurdle of shadow trading is enforcement. The core concept of shadow trading relates to the identification of economically linked firms. While it may be easy to identify Pepsi as a competitor of Coca-Cola, it may not be straightforward to locate a competitor of a conglomerate that engages in multiple business lines of different natures. Even if firms are in the same sector, they may differ significantly in their business models, target customers, products and services. Moreover, statistically associated firms do not necessarily imply an economically linked relationship. The statistical results may be subject to the sample size, time series, variables or even purely random factors. Even if the economic linkage is established at a point in time, the linkage can change from time to time because of market dynamics. To promptly identify shadow trading, regulators may need to engage market experts to constantly identify economically linked firms, as well as to solicit expert evidence to pursue shadow trading cases. The enforcement costs may be prohibitively expensive.

Shadow trading and insider dealing in Hong Kong

Looking at the shadow trading theory in the Hong Kong context, it may not fall squarely within the definition of insider dealing under Parts 13 and 14 of the SFO. Inside information must be specific information about a corporation, its shareholders, its officers, or its listed securities or derivatives under sections 245 and 285 of the SFO. Assuming Company A and Company B are competitors in the same sector, but are independent and have no common shareholders or officers, then the inside information of Company A is unlikely to be the inside information of Company B. The insider who possesses Company A’s inside information is connected with Company A, not Company B. His or her knowledge of Company A’s inside information is not equivalent to knowledge of Company B’s inside information. When the insider trades Company B’s securities, the insider is not dealing in the listed securities of Company A. The absence of the elements of insider dealing under sections 270 or 291 means that the insider dealing regime under the SFO may not be able to prosecute shadow trading.

However, in the same way that the US SEA Provisions apply to shadow trading in the US, section 300 of the SFO may apply to shadow trading in Hong Kong. In the Lee Kwok Wa case ([2018] HKCFA 45), the Hong Kong Court of Final Appeal (HKCFA) determined that the US SEA Provisions were the origin of section 300 of the SFO and referred to them when considering the particular interpretation of section 300. As Mr Panuwat was prosecuted under the same US SEA Provisions, section 300 may be a possible tool to deal with shadow trading in Hong Kong. That does not mean the Panuwat case can be directly applied to Hong Kong. In the Lee Kwok Wa case, the HKCFA made a distinction between the interpretation of section 300 and that of the US court cases, and ruled that section 300 should be considered in the context of Hong Kong’s legislation and according to Hong Kong’s circumstances. Even with such caution from the court, it would be premature to rule out the possibility of the regulator invoking section 300 to prosecute shadow trading activities in Hong Kong. Therefore, company secretaries should start planning to mitigate the risk of shadow trading by employees and directors.

Action items

Given the real risk of insider dealing, company secretaries are advised to take the following actions to shield directors from potential risks.

Clarify the internal insider dealing policies. Panuwat was held in breach of duty to his employer by breaching the insider trading policy. The policy expansively prohibits trading in all ‘publicly traded companies, including’ certain types of securities. The court held that the plain meaning of ‘including’ merely provides illustrative examples, rather than an exhaustive list of prohibitions. Therefore, the prohibition covers not only the company itself, but also all other publicly traded companies. To reduce the possibility of shadow trading, the company secretary or compliance professional should narrow the scope of the internal insider dealing policy and tailor it to specific trading restrictions.

Revisit the restricted list. The restricted list should be expanded to include competitors and companies in the same sector. The company should install a mechanism to identify ‘economically linked firms’ – for example, employ a third-party database or even consider engaging market experts to assess the linkages with other firms. Relevant surveillance systems and the Chinese Wall system must also be directed to cover the newly expanded restricted list.

Enforce the blackout period – no trade, no risk. Company sectaries should advise directors to strictly observe the blackout period requirements under the Listing Rules. The prohibition should also extend to companies in the same sector where directors hold multiple directorships.

Training on the Panuwat case. The director’s induction and continuing compliance training should include a discussion of the Panuwat case and the shadow trading theory. Directors should also be trained in the consequences and possible insider trading risks of dealing in other companies’ securities.

Donald Lai ACG HKACG

Solicitor, CPA

Donald Lai is a securities law specialist and a member of the Institute’s Qualifications Committee.

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