Shady Days: SEC Secures Another Insider Trading Stat on Shadow Trading Theory

This post in Holland & Knight's SECond Opinions Blog Summer Series comes from Dallas Associate Hunter Bezner, who focuses his practice on a variety of litigation and dispute resolution matters, including internal and regulatory investigations and enforcement actions. Hunter assists companies on a wide range of legal and compliance issues involving financial and lending institutions, employment and healthcare matters, and more.

The U.S. District Court for the Northern District of California on May 30, 2024, approved a settled final judgment against technology company Arista Networks' former chairman and CEO, Andreas "Andy" Bechtolsheim based on allegations of insider trading. The settlement is notable as the second instance of the SEC bringing an enforcement action for insider trading under the so-called "shadow trading" theory.

According to the SEC, shadow trading involves using material nonpublic information (MNPI) learned from one company to engage in a securities transaction involving a different company whose share price is predictably influenced by the disclosure of the MNPI. Though the SEC has called this novel theory "insider trading, plain and simple," it has been challenged as an expansion of existing law. For now, at least, the sun continues to shine on the SEC, as it recently won at trial in its closely watched SEC v. Panuwat action and, as discussed below, secured a settled judgment in its now second shadow trading action.

Case Background

On March 26, 2024, the SEC filed a complaint in the Northern District of California alleging that Bechtolsheim profited from insider knowledge that one technology company was about to purchase another technology company. The complaint alleged that Bechtolsheim learned about the impending acquisition through Arista's relationship with a third-party company that had also considered acquiring the target. After learning this information, Bechtolsheim allegedly purchased put option contracts in the target company through brokerage accounts of a relative and an associate just before the market closed on July 8, 2019. The next day, the acquisition was announced to the public, and the target company's stock price jumped 35.1 percent. Bechtolsheim's trading resulted in $415,726 in total profit.

The SEC alleged that Bechtolsheim's trading on alleged MNPI – material information learned in the course of his employment and applied to trade in securities of a different company – violated Arista's internal insider trading policy and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.

Unlike the first-of-its-kind Panuwat action which was hotly contested through a jury trial, Bechtolsheim agreed to settle the SEC's case and consented to the entry of judgment against him under Section 10(b) and Rule 10b-5 without admitting or denying the agency's allegations, and agreed to pay a civil penalty of $923,740 and be barred from serving as the officer or director of a public company for five years.

Panuwat Redux

The SEC has now filed two enforcement actions under the shadow theory. On April 5, 2024, a jury (sitting, coincidentally no doubt, in the same Northern District of California court where the SEC filed the complaint against Bechtolsheim) found Matthew Panuwat liable for insider trading after a brief deliberation period. Panuwat – an employee of a biopharmaceutical company – learned that his employer was being acquired by an international pharmaceutical company. Evidence at trial showed that Panuwat purchased out-of-the-market, short-term stock options in a different biopharmaceutical company a brief seven minutes after receiving an internal email about the impending acquisition. When that acquisition was announced to the public, Panuwat's trades in the other company earned him $107,066 in profit. For a discussion about the issues in SEC v. Panuwat, see our earlier post.

Under the classical theory of insider trading, a corporate insider violates Section 10(b) and Rule 10b-5-1 by trading in the securities of their own company on the basis of MNPI in breach of a duty owed to that company and its shareholders. On the other hand, the misappropriation theory prohibits a person who is not an insider from trading based on MNPI obtained in breach of a duty owed to the source of the information.

Under the SEC's shadow trading theory, MNPI is used to trade not in the securities of the company to which the person owes a duty of trust and confidence, but in the securities of a different company to which the person does not owe such a duty. Following Bechtolsheim and Panuwat, the question remains: What duty, if any, is being breached for insider trading under the misappropriation theory?

In Bechtolsheim, Arista's insider trading policy prohibited trading while in the possession of MNPI obtained from distributors, vendors, customers and collaborators, among other sources, as well as any other nonpublic information acquired in the course of employment. On the basis of a demonstrated violation of a company policy, the SEC alleged that Bechtolsheim thereby violated a duty owed to the company.

Similarly, in Panuwat, the employer's insider trading policy prohibited trading in other companies while in possession of MNPI and, in addition, Panuwat signed a confidentiality agreement covering the information. The SEC argued that violating his company's insider trading policy and confidentiality agreement satisfied the breach of duty element for misappropriation under Rule 10b-5-1.

The SEC prevailed at trial in Panuwat, and Bechtolsheim consented to a judgment, both based on the premise that a violation of company policy satisfies the duty element for establishing insider trading.

Insider Trading Under an Agency Law Theory

But is a violation of an insider trading (or other applicable) policy necessary to establish the elements of Section 10(b) under "shadow trading" circumstances? The SEC says no. It argued in Panuwat that traditional principles of agency law suffice even without an applicable insider trading policy provision, because such principles prevent employees from using MNPI inappropriately. According to the SEC, because confidential information is traditionally for the exclusive benefit of the corporation, use of that information for personal benefit by an employee could suffice for a Section 10(b) claim. The court in Panuwat accepted this as a viable theory to satisfy the breach of duty or confidence element of a misappropriation claim.

SEC Director of Enforcement Gurbir Grewal has stated that the SEC's shadow trading theory is not novel, and this assertion may bear up, given the second – albeit settled – action filed against Bechtolsheim. We take it as given that Division of Enforcement staff are investigating other potential shadow trading fact patterns (just as companies are reviewing their own insider trading policies). Assuming the SEC continues to file these actions, other district courts and eventually courts of appeals will likely weigh in. Though the SEC has argued for insider trading liability under both a theory of a violated insider trading policy and under agency law, for now, at least, the shadow trading theory seems here to stay – although for now, the SEC has brought enforcement actions only under the theory when an insider trading policy violation is also present.

Key Takeaways

• The SEC likely will continue to raise traditional agency law theories for breach and could in the future bring enforcement actions in the absence of an applicable insider trading policy. Under either theory, the SEC shows no signs of slowing down efforts to bring enforcement actions for shadow trading. As Joseph Sansone, Chief of the SEC's Market Abuse Unit, stated: "We will continue to pursue and prosecute misconduct by trusted insiders at all levels of the corporate hierarchy."
• Companies may wish to review their insider trading policies in light of these cases, if they have not already done so. Companies are best suited to assess the appropriate breadth and coverage of their policies and monitor compliance with them, including assessing whether policies should cover confidential information learned about third-party companies if it seems likely that public disclosure of the confidential information could affect the share price of the other company. Companies may also wish to consider how best to sync up trading policies with existing Rule 10b-5-1 trading plans or blackout periods, particularly when an acquisition may be in the works.
• This is a good time to conduct or redo training to bring this new emphasis on shadow trading enforcement to the attention of employees and review their obligations under the company's insider trading policy. This may prove tricky when considering whether and how to modify preclearance practices and restricted trading lists – a topic we will cover in a future post.
• Might other government regulators decide to jump into the shadow trading arena? Although the U.S. Department of Justice (DOJ) has a higher burden of proof than the SEC in an insider trading case (beyond a reasonable doubt for the DOJ vs. the preponderance of the evidence for the SEC), if "shadow trading" is here to stay, history shows that where facts are deemed particularly egregious, the odds of the DOJ bringing such a case will increase.

The SECond Opinions Blog will continue to monitor insider trading actions and provide updates. If you need additional information on this topic – or any topic related to securities enforcement or investigations – please contact the authors or other members of Holland & Knight's Securities Enforcement Defense Team.