Implications of Shadow Trading in Canada
How might a Canadian securities regulator approach so-called “shadow trading”? Shadow trading extends the scope of conventional insider trading to impose liability where a person uses knowledge of undisclosed material information about Company A to trade in securities of another (entirely different) company (Company B) — even though the trader has no undisclosed material information about Company B.
Shadow Trading in SEC v. Panuwat
Earlier this year, a California jury in SEC v. Panuwat found a former executive of Medivation, Inc. liable for insider trading. The executive had purchased short term, out-of-the-money call options for common shares of Incyte Corporation, one of his employer’s “peer companies,” without pre-clearing or discussing his purchases with anyone at Medivation, and within minutes of learning that Medivation would likely be acquired by Pfizer. Days later, when Medivation announced publicly that it had entered into a merger agreement with Pfizer, the secondary market price of Medivation’s common stock predictably increased. Notably, the secondary market price of Incite, a company with no direct connection to the Pfizer transaction, also traded up. Panuwat profited from the exercise of his Incite call options.
The SEC’s case in Panuwat was premised on a couple of related theories. First, the SEC applied “misappropriation theory,” which deems it illegal for a person to misuse confidential information, by breaching a duty of trust and confidence owed to the source of the information, to gain personally. Second, the SEC argued that there was a “market connection” between Medivation and Incite, such that a reasonable investor would anticipate a likely correlation between their trading prices of both companies in response to a significant alteration in the total mix of information available in respect of one of them.
Would Shadow Trading breach securities law in Canada?
Insider trading is prohibited by provincial securities legislation in Canada and by the federal Criminal Code. In general terms, at least outside Quebec, the test for insider trading requires an issuer’s insider to trade while in possession of material non-public information (“MNPI”) “with respect to the issuer”. An insider is someone in a special relationship with the issuer. Special relationship persons include individuals who directly receive MNPI from the issuer or those who indirectly receive MNPI from the issuer and ought reasonably to have known that the information originated from someone in a special relationship with the issuer.
In Canadian common law provinces, the facts in Panuwat would likely not contravene a strict application of the insider trading prohibition. The Medivation executive was not in a special relationship with Incyte and did not learn any MNPI concerning Incite from anyone in a “special relationship” with Incyte. In contrast, the facts in Panuwat would likely have breached section 189.1 of the Securities Act (Québec). Québec prohibits insider trading without requiring the existence of a special relationship. The use of MNPI of one issuer to trade in the securities, options or derivatives of another issuer is prohibited if “their market prices are likely to be influenced by the price fluctuations of the issuer’s securities.”[i]
Could Shadow Trading be Contrary to the Public Interest?
Without offering any express definition of “public interest,” Canadian securities legislation grants provincial securities regulators broad jurisdiction to intervene in the capital markets in order to protect their conception of the public interest. Staff of the securities regulators have in Canada have frequently alleged a breach of the public interest as an alternative to alleged breaches of securities laws (including in insider trading prosecutions). Courts and securities regulators have emphasized that the exercise of the public interest power is motivated by the principle of general deterrence, versus individual deterrence or punishment, in effect to “fill in the blanks” of securities legislation to draw attention to market conduct that, while legal, nonetheless falls short of the expectations of securities regulators and is either abusive of capital markets or offends an animating principle of securities legislation.[ii] The Ontario Capital Markets Tribunal recently emphasized that “[c]onduct that seriously undermines an animating principle [of the Securities Act] may well, in and of itself and by definition, have a harmful effect not just on the particular parties but also on the capital markets generally, including because that conduct, if left unaddressed, would undermine confidence in the capital markets.”[iii]
On facts similar to those in SEC v. Panuwat, shadow trading would almost certainly be alleged to be contrary to the public interest.
The case of Suman, 2012 ONSEC 7, shows that Canadian regulators are willing to use public interest powers to punish conduct like shadow trading. In that case, Mr. Suman, an IT professional, became aware that his employer (a private company) would be acquiring a public US company, prior to any public announcement. Mr. Suman shared this MNPI with his wife and they purchased shares of the US target. However, while this information was material and not generally disclosed, Mr. Suman and his wife were not technically engaged in insider trading under Ontario securities law because neither his employer nor the US target was a reporting issuer under Canadian securities law. Still, the Tribunal used its public interest powers to establish liability. Since the trading bore all the factual indica of insider trading, it did not matter that Mr. Suman and his wife technically did not breach the statute.
A breach of the public interest will likely be easier to ground on similar facts as Panuwat where Medivation’s insider trading policy included an express prohibition against shadow trading, by restricting trading in securities of Medivation “…or the securities of another publicly traded company, including all significant collaborators, customers, partners, suppliers, or competitors…”.
Regulators in common law provinces may also feel more pressure to prosecute shadow trading under their public interest powers since U.S. and Quebec regulators prohibit shadow trading. If left unaddressed, regulators may feel that this legislative gap could undermine the integrity of their capital markets compared to other well-regulated markets.
Takeaways
- Studies suggest that shadow trading is common and widespread.[iv] So, even though SEC v. Panuwat is not binding in Canada — and there are several important differences between the United States’ and Canadian statutory prohibitions against illegal tipping and insider trading — we expect that Canadian securities regulators and law enforcement agencies will not hesitate to enforce credible allegations of shadow trading.
- Registrants and key stakeholders in the capital markets will be held to a higher standard when their conduct is scrutinized. Canadian securities regulators have repeatedly cautioned that capital markets professionals like investment bankers and securities lawyers will be held to a higher standard in insider trading cases.
- Issuers should consider whether it is appropriate to update their internal policies on insider trading to include conduct akin to shadow trading.
[i] See section 189.1 of the Securities Act (Québec): “Nor may the person trade in the securities of another issuer, in options or in other derivatives within the meaning of the Derivatives Act or in future contracts concerning an index, once their market prices are likely to be influenced by the price fluctuations of the issuer's securities.”
[ii] Notably, the OSC’s power to make public interest orders comprised of administrative penalties or disgorgement of ill-gotten profits specifically require a finding by the tribunal that the respondent has not complied with Ontario securities laws – see subclauses 127(1)9 and 10 of the OSA.
[iii] Riot Platforms, Inc v Bitfarms Ltd, 2024 ONCMT 27, at para. 65.
[iv] “Shadow Trading”, M. Mehta, et al, The Accounting Review (July, 2021) <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3689154>; and “Shadow Trading and Macroeconomic Risk”, Y. Lee and A. Romano, Harvard Business Law Review (2023) <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3731719>.