The SEC’s Case For Shadow Trading: A Misguided Expansion of Insider Trading Law?

Dmitriy Smirnov

February 24, 2025

Firm News

The SEC’s Broader Pattern of Overreach

The SEC has taken a significant step in expanding insider trading liability with its “shadow trading” theory, which targets corporate insiders who use material non-public information (MNPI) from their own companies to trade in economically linked firms. This theory was tested for the first time in SEC v. Panuwat, where the Commission successfully persuaded a federal judge and jury that a trader can be liable for using confidential information about their employer to trade in an unaffiliated but comparable company. While the Ninth Circuit has not affirmed the decision on appeal, the case has already set a precedent for the SEC’s far-reaching enforcement approach in this area.

On April 5, 2024, a federal jury in the Northern District of California ruled in favor of the SEC in SEC v. Panuwat. Panuwat, a pharmaceutical executive, learned that his company would soon be acquired by a larger multinational firm. Anticipating sector-wide gains, he used this MNPI to buy securities in a comparable company.

The SEC charged Panuwat under the misappropriation theory of insider trading, arguing he breached a duty to his employer by misusing confidential information. The jury agreed, finding a sufficient “market connection” between the two firms to deem the information material to both. If upheld on appeal, this decision could significantly expand insider trading liability under the shadow trading theory. The United States Department of Justice did not pursue criminal charges alongside the SEC’s civil suit.

The SEC’s expansion of enforcement authority into shadow trading is not an isolated event—it fits a larger pattern of regulatory overreach. The Commission has taken an aggressive stance on crypto and NFTs, asserting jurisdiction over digital assets in ways that courts have increasingly challenged. Recently, the SEC has even dismissed cases and walked back aspects of its approach, acknowledging the legal and practical difficulties of its stance.

Commissioners Hester Peirce and Mark Uyeda have consistently criticized the SEC’s overreach in these areas, warning that the Commission is exceeding its statutory authority and stifling market innovation. The agency’s reliance on administrative proceedings to impose hefty fines—without affording defendants a jury trial—was also called into question by the Supreme Court in Jarkesy v. SEC, which found that such proceedings violate the Seventh Amendment.

This pattern of jurisdictional expansion—first with the cryptocurrency market, NFTs, and now shadow trading—illustrates the SEC’s continued use of aggressive enforcement actions to redefine securities law without clear congressional authorization or, just as importantly, appropriately timed guidance before initiating costly enforcement actions against unsuspecting market participants. While the legal issues in these areas are distinct, the underlying concern remains: the SEC frequently pushes the boundaries of its power, even in the face of internal dissent and judicial skepticism. If the courts continue to push back, it raises serious concerns about the SEC’s ability to regulate by fiat rather than through proper rulemaking and legislative oversight.

Elements of Insider Trading

The SEC’s attempt to regulate shadow trading—where someone trades in a company’s stock based on material nonpublic information (MNPI) about a different but related company—is a dangerous stretch of insider trading law that contradicts the core principles of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.

At its core, insider trading liability under Section 10(b) and Rule 10b-5 hinges on the improper use of MNPI, which must involve:

• A breach of a duty of trust and confidence (Classical Theory): A corporate insider trades on confidential company information for personal gain, violating their duty to shareholders.
• The use of information obtained from another’s breach of duty (Misappropriation Theory): A person receives MNPI from someone else who breached their duty (e.g., a lawyer, banker, or employee tipping off a friend) and then trades on that information.

The Problem with Shadow Trading

Shadow trading does not fit neatly within either theory. In Panuwat, the SEC argued that he learned confidential information about his own employer’s upcoming merger and then bought stock in a competitor. The SEC claimed this was illegal because the competitor’s stock price was likely to move based on the merger. But Panuwat did not trade on MNPI about the company whose stock he bought—he traded based on reasonable market analysis.

The SEC charged Panuwat under the misappropriation theory, yet he neither misappropriated information from the company whose shares he purchased nor traded in the shares of his own employer, from whom he obtained the information. Unlike a traditional misappropriation case, where a trader exploits confidential information from a party to whom they owe a duty by trading in that company’s shares, Panuwat’s trading can be seen as an independent assessment of market conditions rather than an improper use of MNPI. The SEC’s approach is troubling because it expands insider trading liability beyond established boundaries, imposing liability even when a trader has no fiduciary or similar duty to the company whose stock they purchase. 

If shadow trading is insider trading, then what’s next?

• A portfolio manager at a private equity firm learns about an acquisition in one airline and buys stock in another airline?
• A tech executive with internal projections about chip demand buys ETF shares in a semiconductor competitor?

The SEC’s stance blurs the lines between legitimate market research and illegal insider trading. Markets function because traders analyze data, trends, and competitive intelligence to make informed decisions. The SEC now suggests that simply applying MNPI about one company to inform a trade in another company—without any direct insider relationship into the other company—is enough for liability.

Counterpoint: Shadow Trading and Macroeconomic Risk 

In their article entitled, “Shadow Trading and Macroeconomic Risk,” authors Yoon-Ho Alex Lee and Alessandro Romano argue that shadow trading incentivizes corporate insiders to undertake high-risk projects with significant spillover effects, exacerbating macroeconomic instability. Without regulation, they argue, insiders—particularly those at what they call “Central Firms,” may prioritize personal profits over corporate and economic stability. Central Firms, whose activities have outsized economic impacts, are particularly susceptible to shadow trading risks. However, Lee and Romano do not fully consider a more targeted regulatory approach focused just on Central Firms, where systemic risk is most pronounced. This would mitigate the dangers of overregulation while still addressing the most significant risks. But without guidance, which the SEC historically has not provided, it is difficult to tell which firms would fall into the definition of “Central Firms.”

Companies Don’t Restrict Entire Industries—Why Should the SEC?

Most companies already have internal trading policies that prohibit employees from trading stocks in their own company, or that of their partners, or potential acquisition targets when they possess MNPI. That makes sense—these are entities directly linked to the information they receive.

But companies don’t impose blanket bans on entire industries. Employees at a tech company with MNPI about an upcoming merger aren’t suddenly barred from trading every tech stock on the market. An investment banker working on a pharmaceutical deal can’t trade that company’s stock, but they aren’t banned from investing in the healthcare sector altogether. The boundaries are too hard to define.

In his article entitled, “The Solution to Shadow Trading Is Not Found in Current Insider Trading Law: A Proposed Amendment to Rule 10b5-2,” Jamel Gross-Cassel posits a solution. He suggests reforming Rule 10b5-2 to extend the duty of trust and confidence framework, explicitly prohibiting shadow trading when an individual possesses MNPI about one company but trades in the securities of another company that is “closely related.” This expansion aims to close existing legal loopholes and provide regulatory clarity while maintaining market integrity. However, implementing such a prohibition presents challenges, particularly in defining the scope of “closely related” companies with sufficient precision to ensure fair and consistent enforcement. 

In any case, given the SEC’s penchant toward regulation by enforcement in this area, companies have been forced to quickly reassess their MNPI policies to account for potential liability under the shadow trading theory. But expanding internal policies to restrict trading in “closely related” companies or industry competitors will pose significant challenges. Administering these changes will require careful delineation of affected securities, additional compliance resources, and increased monitoring—creating further uncertainty and burdens for market participants. Moreover, because companies will want to avoid liability, their in-house teams will likely adopt an expansive definition of “closely related,” further burdening market participants.

Conclusion: The SEC’s Reliance on Enforcement Creates Uncertainty

While the court’s finding of liability in SEC v. Panuwat and its subsequent affirmation do provide some level of guidance to market participants, relying on enforcement actions as a primary means of regulatory direction is fundamentally inappropriate. The perspectives of former SEC Commissioner Paul Atkins and the Financial Services Institute underscore the argument that clear regulatory frameworks should precede enforcement actions, not follow them.

Instead of shaping insider trading law through litigation, the SEC should have proactively issued guidance or engaged in formal rulemaking to delineate the boundaries of shadow trading liability. Using enforcement as a substitute for clear regulatory direction creates uncertainty, exposes market participants to unexpected legal risk, and raises concerns about fairness in the application of securities laws.

Contact Us for SEC Investigation Help

If you receive a Wells notice, an SEC subpoena for documents or testimony, a FINRA 8210 request, a FINRA on-the-record (OTR) interview request, or a similar inquiry from a state regulator, such as Florida’s Office of Financial Regulation (OFR), act immediately. Contact Fridman Fels & Soto, PLLC to speak with an experienced SEC defense attorney. Prompt action is critical to protect your rights whether you need an attorney skilled in insider trading defense or to respond to a subpoena. 

Alejandro Soto is a former senior official with the SEC. He leads Fridman Fels & Soto, PLLC’s Securities Litigation and SEC Defense Practice Group and is admitted in Florida and Washington, DC.

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¹ SEC v. Panuwat, No. 3:21-cv-6322-WHO (N.D. Cal. Apr. 5, 2024).

² Before the trial, Panuwat’s trial team argued that he lacked notice that the trade was unlawful, which was relevant to (and undermined) scienter for fraud: “At the time he traded, Mr. Panuwat had no notice that anything about his Incyte trade was unlawful. He could not have conceived that anyone would scrutinize his Incyte trade with a suspicion of a federal securities violation because he was not clairvoyant enough to anticipate how the SEC would extend misappropriation liability. This fact is critical for the jury to consider when it decides whether Mr. Panuwat possessed the requisite scienter to have engaged in fraud.” The court permitted Panuwat to testify that he was unaware of similar cases as probative of scienter. It also allowed his expert to corroborate that insider trading cases “typically involve trading stock of the company whose MNPI was learned by the defendant, as that is an accurate reflection of the existing caselaw,” but did not permit the defense or its witnesses to refer to the SEC’s case as “highly unusual, unique, novel, unanticipated, unexpected, or brought without fair notice, as the prejudicial risk of such rhetoric outweighs its probative value.”

³ SEC Rule 10b5-1 prohibits trading while aware of MNPI, with exceptions for pre-arranged plans. Rule 10b5-2 defines when a duty of trust or confidence exists. 17 C.F.R. §§ 240.10b5-1, 240.10b5-2. I discuss 10b5-1 Trading plans here: https://ffslawfirm.com/best-practices-for-corporate-executives-to-avoid-insider-trading-accusations/