The SEC’s Latest Insider-Trading Theory

Securities and Exchange Commission Chairman Gary Gensler
Securities and Exchange Commission Chairman Gary Gensler

Summary

The agency rewrites the law to invent a new offense: ‘shadow trading.’

Congress has never clearly defined insider trading in stocks, but that hasn’t stopped the Securities and Exchange Commission and prosecutors from finding the meaning in statutory penumbras. Chairman Gary Gensler’s SEC is at it again in a civil trial next month that will try to extend its reach to punish trading in the shares of another company about which the defendant had no insider information.

Federal law doesn’t explicitly ban trading on confidential information. But courts have said that insiders defraud companies by “misappropriating" private information for personal gain. In a classic case, an insider trades in his company’s stock based on proprietary information or tips off someone else who then trades and cashes in. While courts have circumscribed insider-trading liability, regulators keep inventing new theories.

In 2021 the SEC charged Matthew Panuwat, an employee at the biopharmaceutical firm Medivation, with insider trading for a timely and lucrative options trade on another pharmaceutical company’s stock. Having developed a highly effective prostate-cancer drug, Medivation was shopping itself to large drug companies in 2016.

The SEC alleges that Mr. Panuwat started purchasing call options for a different company, Incyte, soon after Medivation’s CEO sent an internal email announcing an imminent deal to be acquired by Pfizer. While Incyte and Medivation didn’t directly compete, the SEC alleges that their stock prices were correlated, and that Mr. Panuwat knew this.

After news of Medivation’s acquisition broke, the share prices of Incyte and several mid-sized pharmaceutical companies popped. Mr. Panuwat sold his Incyte options for a roughly $107,000 profit. The SEC says Mr. Panuwat committed insider trading by allegedly using confidential Medivation information to bet on Incyte’s stock. Medivation had a company policy that forbade such trades, but violating a company policy isn’t the same as violating a federal statute.

In his defense, Mr. Panuwat says it was publicly known that Medivation was on the sale block, so information about its potential acquisition wasn’t private. He also claims he bet on Incyte because he believed the company was undervalued by the market.

Disagreement over facts aside, the major problem with the SEC case is that it writes new insider-trading law by enforcement with no limiting principle. An executive could be charged with investing in the shares of any stock in his industry group. Yet everyone knows stocks in the same industry often move up or down based on the news of a single firm.

A Nvidia employee who knew his company had a strong earnings quarter and bought stock in tech companies, or even a tech-focused ETF, could be charged under this SEC theory. A 2021 academic study dubbed this practice “shadow trading" and “an undocumented and widespread mechanism that insiders use to avoid regulatory scrutiny."

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The SEC seems determined to prosecute Mr. Panuwat as a way to send a message across the market that such shadow trading is banned. But it’s an abuse of the law to punish someone after the fact for acts that he didn’t know at the time to be illegal.

In 2014 Justice Antonin Scalia, joined by Justice Clarence Thomas, lambasted the SEC’s penchant for defining insider trading however it wants (in denying a cert petition in Whitman v. U.S.). “Only the legislature may define crimes and fix punishments. Congress cannot, through ambiguity, effectively leave that function to the courts—much less to the administrative bureaucracy," Justice Scalia wrote.

“When King James I tried to create new crimes by royal command, the judges responded that ‘the King cannot create any offence by his prohibition or proclamation, which was not an offence before,’" Justice Scalia wrote. “James I, however, did not have the benefit of Chevron deference." Mr. Gensler may not have Chevron for long either. The High Court in January heard a challenge to the court-made Chevron doctrine, which requires judges to defer to regulators’ statutory interpretation when the law itself is ambiguous.

The SEC’s shadow insider-trading theory looks like another example of how regulators exploit vague laws to expand their power and undermine legal due process. If Congress wants to ban the practice, it can. But Mr. Gensler isn’t King James I, even if he sometimes acts as if he is.

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