By Steve Brown, Managing Director, Head of Business Development at StarCompliance
This article first appeared as Compliance in Focus on Markets Media.
Compliance in Focus is a content series, produced in collaboration with Eventus, about regulatory topics for financial markets and the challenges compliance officers face in addressing surveillance and monitoring.
In this article, guest author Steve Brown, Managing Director, Head of Business Development at StarCompliance, writes about how capital markets firms can prevent ‘shadow trading’ by having the right teams and technology in place.
Steve Brown, StarCompliance
Where there are markets, there have always been bad actors trying to take advantage of access to material, non-public information (MNPI) for their own interests – and catching them has never been simple. Regulators have continued to crack down on market abuse and cases of insider trading through legislation and market surveillance activities. They have also introduced robust processes for tips and complaints, and incentives and protection for whistleblowers. But with each intervention, bad actors have persisted in uncovering new opportunities and evolving their practices to be even more elusive.
First came the classical theory of insider trading. In the US, this is where an insider violates section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 by trading in the securities of their own company on the basis of MNPI. A typical case would follow a company executive, board member, or agent trading in the company’s securities or in the securities of a potential target prior to the release of news concerning a significant event (e.g. a merger and/or acquisition etc.).
Next, the misappropriation theory, where an outsider comes across MNPI and uses the information to trade because they owe a fiduciary duty to the source of the information. This became widely known after United States v. O’Hagan, in which Mr O’Hagen purchased stock and options in the Pillsbury Company after overhearing MNPI regarding a possible takeover by Grand Met.
Then there was the tipper/tippee theory, where a tipper gives MNPI to another person – the tippee. The tippee then trades on that information and the tipper receives some benefit (which does not have to be monetary).
As these methods have been around for a while, firms and compliance officers are more accustomed to detecting instances of them. This is achieved by deploying various systems and processes that collect and organize deal information flows to ensure they can easily manage and monitor their employees’ trading activities. However, bad actors are increasingly stepping into the dark, creating a new challenge for the world of compliance: Shadow trading.
This form of insider trading is where a person uses confidential information about one company to trade in the securities of an economically linked company (for example, those of a competitor or sector peer). It was brought to light after the SEC filed a complaint against a former corporate executive, Matthew Panuwa, on August 17, 2021. In the filing, the SEC cited that moments after learning his company was being acquired, Panuwat purchased the securities of a competing company based on the belief that the competitor’s stock price would rise following the public announcement of the merger. This was the first time the SEC had brought a case like this, and has implications for the way the SEC might pursue insider trading enforcement.
Since then, academics have concluded that its prevalence may be far wider than previously feared and can touch industries far beyond the financial services sector. They estimated that shadowing trading through ETFs may have accounted for at least $2.75 billion – or $212 million on average per annum – from 2009 to 2021. The study delved into how individuals would trade “in ETFs that contain the target stock, rather than trading the underlying company shares.”
As the name suggests, shadow trading is incredibly challenging to identify. Firms and compliance teams need to have access to a broad range of data identifying securities linked to business entities, industries, and economic activity types at their disposal. It also requires firms to analyze these dimensions against employee trades, MNPI, and watch restricted or blackout lists. Sifting through all this takes a lot of time, and sometimes compliance teams can be at a complete loss in trying to piece together hidden trades and transactions that breach trading violations. Without the aid of technology, compliance teams are unable to stop these issues from happening, or have the means to investigate them.
The good news is that automation in the industry is continuing to accelerate, with the adoption of monitoring and surveillance software – diminishing the use of manual processes. This is enabling compliance teams to quickly analyze broad sets of potentially unrelated and unorganized data points that may indicate an instance of this new form of insider trading. Nevertheless, the industry is still awaiting more clarity from the SEC (and other global regulators) or courts on shadow trading, and compliance professionals must stay vigilant.
This requires them to continually review their employee trading policies; restrict sector trading by bankers, traders, and research analysts; implement sector surveillance to capture shadow trading scenarios; and update training to include shadow trading concerns.
By putting in place the right teams and technology, this growing form of insider trading can be stopped at its source, negating the need for complex and almost impossible investigations. It will also make it easier for staff to follow the right procedures – without fear or inconvenience – while removing the headache of ensuring insider trading hasn’t occurred when information needs to be sent to the regulators. All these measures will cast further light on shadow trading, and make chasing shadows a thing of the past.
