Shadow Trading

Transcript

Stephen:
Hi, I'm Stephen Thau. I'm a partner in the Technology Companies Group here at Orrick.

Paul:
And I'm Paul Rugani. I'm the head of the Securities Litigation Practice at Orrick.

Stephen:
And we're here today to talk about shadow trading, which is a new theory of insider trading that the SEC is pursuing. Paul, what is shadow trading?

Paul:
So shadow trading has been in the news lately, as you said, because of a recent successful SEC enforcement action. The traditional species of insider trading is somebody is an insider at a company. They get information that is material and nonpublic, that may signal a price move for that company, whether up or down. And they go and they decide to trade on that information. So shadow trading is different. And it's unique because instead of learning information about your own company and trading in your own company's stock, it's taking information that you learn and then using that to go and trade in the stock of a different company. And Stephen, maybe you can describe the specific facts that happened here that led to this particular enforcement action.

Stephen:
Yeah. Yeah. No, Paul, this is really fascinating because, as you said, the traditional insider trading case is you learn something about your own company or maybe it's about a company that your company deals with. So you're a supplier or you run a clinical trial for a company and you learn something about that other company. In this case, the individual who was charged and convicted for shadow trading was an executive at one biotech company that was acquired by Pfizer. And he received an email from his boss, the CEO, saying, hey, we're going to sign our deal with Pfizer. And per the trial transcript, seven minutes later, he bought stock in another biotech company on the assumption that the announcement of the deal involving his own company was going to cause the stock price of that other company to increase. And that's what led to the action.

Paul:
Right. Which turned out at least initially to be a pretty good bet on his part. It was a six-figure profit that he made initially on the trade, but also I think something that got the attention of the SEC and led to the enforcement action. And this was a risk for the SEC to take as far as the market is aware. It's the first of its kind for the SEC to take a shadow trading case and actually bring enforcement action, take it all the way through trial. And, you know, they got a jury verdict very quickly. The jury was only out for about two hours before coming back and agreeing with the SEC that this was improper activity, that it was prohibited insider trading. And I think it's going to embolden the SEC to look for more and more of these opportunities and look for ways where it can engage in sort of its market policing role against things that it perceives to be unfair conduct.

Stephen:
Right. But then where do you draw the line? Right. If it's not about your own company or some company that you have a contractual dealing with, but it's just about the industry at large. Right. How do you know what's a safe trade or not?

Paul:
Yeah. So I think it is particularly hard to draw the line. And I think it does introduce a level of unpredictability and uncertainty into how people can go about and engaging in trading activities. And, you know, that's difficult both for the individuals, but also for the companies who have these folks as their employees, as they want to try to set guidance and set policy for them. And I think, you know, the best starting point is from a sense of fundamental fairness. Right. If you have information that you only have by virtue of your position as an insider at a company that isn’t more broadly known to the public, this sends a message that the SEC is saying you shouldn’t be taking advantage of that to your own personal benefit. And so I think the starting point for people to understand is what kind of information do I have? Is it confidential? Is it something the market knows about? Is it something that is likely to be viewed as having a strong impact on the value of my company, of other companies, etc.? And if it feels like, hey, this is information that gives me a leg up because I know it and nobody else does, that’s probably not information that you want to be trading on because that will put you at risk of some enforcement action coming from the SEC.

Stephen:
And I'm sure a lot of people are wondering, like, how does the SEC even figure these things out? Like, if you, you know, work at company A and you buy stock in company D, right, how do they make those connections?

Paul:
Well, so the SEC has trading access to everything that happens on NASDAQ and the New York Stock Exchange. And they also have very sophisticated models that they can run across those trading activity to look for unusual patterns. So this may have been a circumstance where there was an unusual spike in activity in the trading in this other company's stock on that day. And so they found out who was involved in the trading and they went and they sent information requests and went to go and look into it. But any trading that you do in a security that's traded on one of the public markets, like, the SEC can see that and can find out about it. And it's just a choice of where they direct their resources in terms of saying, oh, if I identify this unusual activity here or this unusual activity there, let's follow up and find out more.

Stephen:
Yeah. So what can companies do to try to protect their employees and should they do anything? Right. This is a new area of law probably going to evolve. There might be an appeal in this case. There would probably be future enforcement actions by the SEC that will try to put some more contours over the law. So while we're in this period of development, you know, should companies take action? What should they do? What are things they can think about?

Paul:
Right. So a lot of companies already have insider trading policies. And on one sense, you might ask, well, why do you have an insider trading policy if there are laws that already prohibit insider trading? And one of the reasons that companies do it is A, to provide good guidance to their employees, to help their employees be able to comply and ensure that they don't run afoul of the law, because it's easier for employees to receive a discrete set of company policies to know what is and isn't prohibited than to be familiar with the entire U.S. code. But the other reason that companies have these policies and can lay out ground rules about what you should and shouldn't do is a way to help conserve company resources. You know, anytime the SEC takes enforcement action, even though here it was against an individual, almost certainly the company had to get lawyers involved. Co-workers of the individuals were witnesses who testified at trial and had to participate, you know, in the investigative process already. This one individual, certainly his job at the company was disrupted, which causes cost, causes time. It's all sorts of burdens that are imposed on the company for this. And so, you know, I think companies are faced with a choice, right? On the one hand, if you say any kind of information that you get, just don't trade on it at all, that could become off as an overly conservative position. It could unduly restrict people's ability to go and fairly trade on the market. And it could, you know, put companies in a position of agreeing with a scope of enforcement that they don't necessarily agree with, right? If they think the SEC is overreaching here, designing their policies to match what the SEC is doing undercuts that argument a little bit. But giving clear guidance also just helps people follow the boundaries. And in this area in particular, there are incentives both for individuals and for companies not just to do the bare minimum of what the law requires, but to put some cushion between what the company will allow and what the law allows to provide a little bit of extra comfort and extra benefit to ensure that you steer clear of these kinds of enforcement actions.

Stephen:
Yeah. Yeah. And it's easy to imagine lots of examples of companies' stock behavior that is likely to correlate. So in sort of life sciences, for example, if two companies are pursuing clinical trials for drugs in the same biological pathway, right? Information, one set of trials is likely to create expectations about the other companies' trials, those types of things, or pursuing the same disease area, even. So, you know, it's possible, I think, for companies to try to design policies that, as you say, are not over-restrictive, like don't trade anything or only buy mutual funds. But that are sort of properly contoured to the risks of these enforcement actions as they come about and try to keep people able to focus on their jobs.

Paul:
Right. Yeah. And I think there is an element of sort of fundamental fairness concepts that is underlying all of this. And I think it's one of the reasons in this case that the jury did come back so quickly is that there's a perception that what the person was doing was taking advantage of something that didn't really belong to him. And turning it into personal financial gain. And from a corporate policy perspective, I think that's a perfectly fair place to start with the lens of how you think about your insider trading policies. Right. You want to encourage your people not to be taking unfair advantage of information that they come into possession of just by virtue of their job. You want to encourage them to be, you know, conducting themselves fairly and even-handedly when they're out in the market trading. And to be fair stewards of information that they get as employees of the company.

Stephen:
I think that's very good advice. And, you know, we'll have to see how the law evolves in this area. But for now, I think that's a good place to start.

Paul:
Yeah.

Stephen:
Thank you.