What Investment Advisers Need to Know about the SEC's Recent Insider Trading Case Focused on "Shadow Trading"

On August 17, 2021, the U.S. Securities and Exchange Commission (SEC) charged a former employee of Medivation, a biopharmaceutical company, alleging that the individual was privy to confidential information that Medivation would be acquired by Pfizer and misappropriated that information to engage in insider trading. Notably, the SEC does not allege that the individual traded in securities issued by either of the companies involved in the acquisition. Rather, the SEC’s complaint alleges that he profited from the purchase of options on the stock of a third company, Incyte Corporation, on the basis that Incyte Corporation was identified by Medivation’s investment bankers as a comparable company to Medivation and that news of the acquisition of Medivation would likely cause the price of Incyte Corporation’s stock to increase.

Compliance Implications

Insider trading is classically thought of as trading in a security of an issuer on the basis of material nonpublic information (MNPI) that directly pertains to that issuer. This could include, among other things, nonpublic information about the issuer’s business operations, trading in the issuer’s securities by another market participant, or the contents of a sell-side research report or mainstream news report that has yet to be published. In this instance, however, the SEC’s complaint does not allege that the defendant was in possession of any confidential information pertaining to Incyte Corporation, the issuer whose securities he traded. Rather, the defendant is alleged to have engaged in so-called “shadow trading” – i.e., using confidential information about one issuer (Medivation) to trade the securities of another issuer (Incyte Corporation) on the basis that the market price of the two securities is likely to react similarly when the information becomes public. Accordingly, this has profound implications for compliance personnel at most investment advisers whose compliance testing and surveillance programs historically have not focused on this type of activity.

What can advisers do?

Ideally, firms will already have a process in place to surveil for client and employee personal trading in a security ahead of an aberrational price movement and not only scanning against news or events. For ACA’s Market Abuse Surveillance and Employee Compliance clients, there are algorithms and rules to support against the risks identified. The Buyside Front Running algorithm of the Market Abuse Surveillance solution scans for positions opened or increased after an abnormally advantageous price move of the underlying security. The solution leverages historical data and statistical parameters to support in calibrating the “norm”. For clients leveraging the Employee Compliance module, ACA offers a trade rule focused on Employee Trading in Front of Anomalous Price Movement.

In light of this case, firms should consider expanding their investigation process to assess whether the firm and/or relevant employees possess confidential information about another comparable issuer that could be material. Enhancements to the investigation process could include, for example:

• Checking the firm’s restricted list to see if the firm is in possession of MNPI about a comparable issuer.
• Reviewing whether the firm has any non-disclosure or confidentiality agreements in place with respect to a comparable issuer.
• Reviewing whether investment personnel met directly with a comparable issuer or met with a research consultant to discuss a comparable issuer.
• Reviewing firm trading in comparable issuers.

Additionally, firms involved in private markets transactions that intentionally receive confidential information about securities issuers may consider taking additional steps to prevent shadow trading. For example, these firms may consider proactively restricting any public issuers identified as market comps when evaluating a potential transaction.

For more information

ACA believes this action by the SEC warrants a possible enhancement to our market abuse system and we are considering how best to automate some functionality in ComplianceAlpha^®. Please contact us here to set up a meeting to learn more about our products and how ACA can assist your firm.

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