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Regulation and Compliance > Litigation

The SEC Is Bringing Novel Insider-Trading Cases

By Nicolas Morgan

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What You Need to Know

  • Increasingly the SEC has employed insider-trading concepts in novel ways.
  • One case reveals the SEC's intent to move aggressively in areas adjacent to insider trading.
  • Insufficiently wary fund managers and other traders may unwittingly step into the SEC’s crosshairs.

Fund managers and others transacting in the public securities markets generally have little difficulty staying out of harm’s way with the Securities and Exchange Commission when it comes to textbook insider trading situations: If a company insider provides you with material nonpublic information (MNPI) about her company, don’t transact in her company’s securities until the MNPI is public or no longer material.

But increasingly, the SEC has employed insider-trading concepts in novel ways, raising the possibility that insufficiently wary fund managers and other traders will unwittingly step into the SEC’s crosshairs.

So, for example, in 2020 the SEC brought an action against a private equity firm for failing to implement policies and procedures reasonably designed to prevent the misuse of MNPI.

The case was remarkable for what it lacked: any mention of insider trading. By imposing a seven-figure penalty on a PE manager for merely mishandling MNPI rather than trading on MNPI, the SEC signaled an intent to move aggressively in areas adjacent to insider trading.

In that vein, in September of this year, the SEC brought another MNPI case without mentioning insider trading. The case involved a so-called alternative data provider, a company that collected information from companies with mobile apps to assist in improving the performance of those apps.

The alternative data provider sold that data to subscribers for purposes of securities trading, telling the mobile apps companies and the subscribers that the data would be anonymized, aggregated, and run through a statistical model to approximate results.

In this way, the mobile app companies would be assured that their MNPI would not be made publicly available and the subscribers would be assured that they would not be “polluted” with MNPI for purposes of trading.

However, the SEC alleged that the alternative data provider in fact used actual, non-aggregated, non-anonymized data to improve the accuracy of the information provided to subscribers for trading. But the SEC did not (or at least hasn’t yet) charged any of the subscribers with insider trading despite what appears to have been trading while in the possession of MNPI.

The absence of such insider trading charges against the trader/subscribers highlighted the importance for fund managers and others to obtain strong representations from information providers used to inform trading (even if it turns out after the fact that those representations turn out to be false).

Obtaining such representations became commonplace after the flurry of “expert network” insider trading cases a decade ago.

Then in August of this year, the SEC brought another case involving MNPI with a novel twist.

The case alleged what has come to be known as shadow insider trading, a term recently popularized by an academic paper studying “whether corporate insiders attempt to circumvent insider trading restrictions by facilitating trading in competitors and supply chain partners.”

In the case filed in August, the SEC alleged that an insider in company A learned that his company was about to be acquired by a much larger company B.

The insider allegedly used that information to purchase stock in company C, a company of similar size and business model as his own company A.

When company B’s acquisition of company A was announced, company C’s stock price increased by approximately 8%, generating trading profits for the company A insider. In other words, the SEC charged the defendant with insider trading for using MNPI obtained in connection with an M&A transaction between two companies to trade in the securities of a  third company not involved in the M&A transaction in any way.

The defendant in the SEC’s shadow trading case is hotly litigating the case, so it remains to be seen whether the SEC’s legal theory will hold water. Nevertheless, the fact that the SEC brought the case in the first place — whether or not the case has legal merit — raises some challenging issues for fund managers and others.

For example, funds that invest broadly in a particular market sector might routinely come in contact with MNPI about one company in that sector. Often, fund managers will place that company on a restricted, do-not-trade list. Nothing novel about that.

But would the SEC expect the fund manager also to put all competitors and supply chain partners of the company on a restricted list? That is not a direct implication of the SEC’s shadow trading case, but given the SEC’s increasingly aggressive approach toward MNPI in insider trading cases and non-insider trading cases, managers are no doubt considering their options on that point.

Nicolas Morgan

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