John C. Coffee, Jr. — “Shadow Trading” and the Common Law of White Collar Crime

A fascinating legal soap opera is now underway following a trial just completed in California. The issues are new, novel, and important in one sense, but old, familiar, and important in another. The case – SEC v. Panuwat[1] — is  an SEC civil case that represented the first time the SEC has tested its “shadow trading” theory of insider trading. Nearly all insider trading cases involve a misappropriation of material nonpublic information from the issuer. In such cases, the defendant is alleged to have breached a fiduciary duty to the issuer’s shareholders by the defendant’s use of this information for his own benefit. In a smaller category of cases, known as “misappropriation theory” cases, the defendant is accused of violating a duty to the source of the information. Typically, these cases involve a defendant who is an employee or agent of a company undertaking a takeover, and the defendant buys stock in the target of the takeover, using information that he learned from his client, the prospective bidder. Here, the two companies are linked in a transaction that is probably material to both.

But what happens when there is no such linkage? In Panuwat, the defendant was an employee of Medivation, Inc., a mid-cap oncology firm that was resisting one hostile bidder (Sanofi S.A.) and encouraging another firm (Pfizer) to outbid Sanofi. Pfizer did, but Matthew Panuwat did not seek to profit on that transaction. Rather, he purchased shares in Incyte Corporation, which was a firm arguably occupying the same market space as Medivation. The Medivation/Pfizer transaction had led multiple securities analysts to predict that if Medivation were acquired, the stocks of other firms in the same market would quickly climb because there was a “scarcity” of similar firms. Goldman Sachs in fact published a report prior to Panuwat’s purchases of Incyte’s shares (which he testified he had relied upon) strongly recommending Incyte, largely because it was similarly positioned to Medivation. Still, although many believed that a Medivation acquisition at a premium would cause Incyte’s shares to soar, only Panuwat knew (at the time he traded) that the Pfizer acquisition of Medivation had become relatively certain. Panuwat, a frequent stock trader, made the largest securities purchase of his life (in call options) and profited over $100,000. After a trial in which the defendant took the stand to explain his justifications, a jury has now found him liable.

But did Panuwat truly breach a duty to his own shareholders? In its decision declining to grant summary judgment to the defendant, the district court had ruled that there had to be a “material connection” between the two companies. Although there was no cross-ownership or prior dealings between the two, the court found such a connection, citing analysts’ reports that any acquisition of Medivation would demonstrate the attractiveness of Incyte. Even if the two companies’ fates were linked, there was no injury threatened to the shareholders of Medivation by Panuwat’s purchases of Incyte. This is in sharp contrast to the Supreme Court’s decision in U.S. v. O’Hagan, 521 U.S. 642 (1997), where the defendant traded after inducing associates at his law firm to disclose to him the name of the target firm, even though his own firm was representing the bidder. On these facts, the trading in high volume by defendant O’Hagan did drive up the price of the target to the bidder and also strongly suggested that a transaction was about to be announced (thus costing the bidder the advantages of secrecy and interfering with its desired timing). His firm also suffered injury as he breached a duty to it (as the Court found).

Read this way, O’Hagan implies a limit on “misappropriation theory”: namely, that it applies only when use of the information obtained from the source will likely be harmful to the source’s shareholders or owners. If such a standard of likely harm to the source’s shareholders is not recognized, the reach of this new “shadow trading” doctrine is seemingly uncontainable. Suppose a defendant in Panuwat’s position learns that federal drug regulators have just approved a drug developed by his company that will dominate all existing drugs currently prescribed for the same disease. This information is not clearly material to his own company because the market is small (and the new drug will add less than 1% to its total revenues), but other smaller firms that make the drugs that will become out-of-date will be devastated. The defendant sells short the stock of one of these smaller firms and makes a hefty profit. But he has not injured his own firm, and the loss to the smaller firm’s shareholders was inevitable, given the new discovery.

Sometimes, the information that the defendant learns could affect stock prices across the market. For example, suppose an individual, who is employed by a financial media company that has advance access to the Federal Reserve’s action, learns that the Federal Reserve will shortly reduce interest rates by a half point (a level much higher than most analysts expected). He knows that stock prices will rise across the market, and he buys a broad index of large cap stocks (and profits handsomely). Here, it is difficult to say that there is a “material connection” between his company and most of the market. Although I think the Federal Reserve has been injured by his conduct, a recent, unfortunate Second Circuit decision holds that agencies have no property interest in their anticipated plans and so are not protected by the law of fraud.[2] The only injury to his own company is a potentially reputational injury (and they could lose the Federal Reserve as a client).

At the outset, I declared that the SEC’s “shadow trading” initiative raised several novel issues and one old, familiar issue in a heightened form. The old issue begins with the recognition that the law of white collar crime is largely judge-made and consists of a series of common law crimes whose scope courts keep steadily expanding on a case-by-case basis. This pattern was clearest during the 1980s with the expansion of the mail and wire fraud statutes. For a time, prosecutors were able to indict almost any ethical or political transgression, including any undisclosed conflict of interest, but in the 1980s, the Supreme Court brought this expansion to a screeching halt in its McNallydecision.[3]

The law of insider trading presents an even more extreme example. To be sure, few doubt that insider trading should be prohibited and criminalized. But Congress has never defined what insider trading is. Originally, the SEC defined and justified the prohibition in its 1961 Cady Roberts decision.[4] The Supreme Court substantially modified the SEC’s definition in 1983 in Dirks v. SEC.[5] At other times, the Court has stepped on the gas pedal in decisions such as Basic v. Levinson[6] and U.S. v. O’Hagan,[7] and at other times it has applied the brake in decisions such as Central Bank of Denver v. First Interstate Bank of Denver,[8] Janus Capital Group v. First Derivative Traders,[9] and, of course, Blue Chip Stamps v. Manor Drug Stores.[10]

As a result, the scope of the prohibition has repeatedly changed significantly. But, throughout this process, Congress has stayed on the sidelines and never defined insider trading. There have been efforts to induce Congress to do so, but they all have come to no avail. Of course, Congress has shown its disapproval of insider trading by authorizing treble damages and providing the SEC with other enforcement tools, but it has been unable to complete the initial step of defining the crime.

That brings us to our present juncture. The SEC has just won in its initial test of “shadow trading.” Defendant Panuwat testified, and Skadden Arps, his counsel, explained all the issues in the SEC’s theory, but the jury still held him liable. After a civil victory, the traditional pattern is that regulators next consider the use of criminal penalties.[11]We are thus on the precipice of a possible quantum leap in insider trading law. Under the vague standard expressed in the Panuwat summary judgment decision, it will only be necessary to uphold this conviction to find a “material connection” between the issuer and the other company in whose stock the employee or agent traded. This could chill the law-compliant employee from trading in the stock of any company that was in the same market sector or that was perceived to be a rival or competitor. The benefits from this new regulatory leap seem likely to be modest.

The SEC could, of course, promulgate a tighter rule, but that ignores the most obvious step: namely, legislation. I recognize that Congress has never been more polarized (at least over my fifty-plus year career). But the fate of the securities marketplace does not depend on adopting the SEC’s new theory of “shadow trading.” A carefully tightened SEC definition may well be desirable, but there is no emergency. In short, there is time to give legislation a chance.

To date, our entire and complex body of law on insider trading has been derived from both courts and the SEC attempting to construe six ambiguous words in Section 10(b) of the Securities Exchange Act of 1934: “manipulative or deceptive device or contrivance.” A number of narrow distinctions have been drawn on complex issues, such as whether the tippee has to give some payment or other benefit to the tipper in order for liability to arise. The result is an arcane body of common law, which cannot be adequately supported by this thin, six-word statutory text and which in any event exists in real tension with our constitutional prohibition on common law crimes.[12]

Do not misunderstand me: I want insider trading to be prohibited and have testified to that effect before Congress on multiple occasions. But the SEC is not entitled to expand fundamentally their definition of this crime. Unless a line is drawn in the sand, the SEC (and other administrative agencies) will continue to respond to small crises, promulgate new rules, and steadily push the law outward to cover more and more terrain, while avoiding legislation (because Congress is unpredictable). Worse yet, the SEC may not even adopt rules but only give guidance, deeming each new position to have been earlier resolved by O’Hagan’s claimed adoption of a very broad misappropriation theory.

In this light, the advent of “shadow trading” provides a good opportunity for courts to resist further expansion of insider trading law without greater specification by Congress. “Shadow trading” is not so important that the integrity of the market is threatened. But it does show again that abstract legal principles tend to expand to the limits of their logic – and beyond. Before the SEC pursues its “shadow trading” theory further, distinctions need to be drawn, and possibly some safe harbor created. We can afford the time to think this through more carefully and even invite Congress to join in this process. In the meantime, general counsel and boards should begin to re-examine their own bylaws and insider trading policies to decide just how sweeping they want their current prohibitions to be. Most companies may want to fire an overeager trader, such as Mr. Panuwat, but probably most are less than certain that they want to see him indicted and jailed. Hence, it is time to exercise a measure of caution.


[1] See SEC v. Panuwat, 2023 U.S. Dist. LEXIS 234133 (N.D. Cal. 2023) (denying defendant’s motion for summary judgment).

[2] See United States v. Blaszczak, 56 F.4th 230 (2d Cir. 2022) (finding that a government agency has no property interest in its advance plans and cannot be defrauded by their release).

[3] See McNally v. United States, 483 U.S. 350 (1987).

[4] In the Matter of Cady Roberts, 40 S.E.C. 907 (1961).

[5] 463 U.S. 646 (1983).

[6] 484 U.S. 224 (1988).

[7] 521 U.S. 642 (1997).

[8] 511 U.S. 164 (1994).

[9] 131 S. Ct. 2296 (2011).

[10] 421 U.S. 723 (1975).

[11] Even if there are not criminal prosecutions forthcoming that are based on a “shadow trading” theory, the availability of that theory changes the plea-bargaining dynamic. Prosecutors will now have two arrows to their bow and can argue that even if the defendant can deny liability under traditional theories, the defendant cannot escape a shadow trading theory.

[12] For one of the original cases reading the Constitution to bar common law crimes, see United States v. Coolidge, 14 U.S. (1 Wheat) 415 (1816).

This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.

1 Comment

  1. Stephen J. Crimmins

    Professor Coffee is right that it’s time to define insider trading. As for “shadow trading,” without clear harm to the information source’s shareholders, the theory has no limits. Not what the SEC envisaged in Cady Roberts, nor the Supreme Court in Dirks.

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