What is shadow trading and what can compliance teams do about it? Star's Head of Business Development and veteran compliance officer Steve Brown recommends firms take these precautionary steps to minimize risk
The US Securities and Exchange Commission prosecutes roughly 50 insider trading cases each year. Until 2021, each case was much like the last, involving insider transactions that could easily be categorized as classical insider trading, misappropriation of information, or tipper/tippee liability. That all changed with a recent SEC filing against a former pharmaceutical company executive for what has now been dubbed shadow trading.
What is shadow trading? As the theory goes, shadow trading occurs when a corporate insider trades shares of economically linked stocks, as would be the case of a similarly situated competitor, based on his or her company’s material nonpublic information, or MNPI. Needless to say, shadow trading is more challenging to identify, as it requires compliance teams to not only have a broad range of data identifying securities linked to business entities, industries, and economic activity types at their disposal, but also the means and technology to analyze these dimensions against employee trades, MNPI, and watch, restricted, or blackout lists.
Compliance needs to be able to take a broad set of potentially unrelated and unorganized data points and find the signals within the noise that indicate this new type of insider trading. To do this, firms will need to tag companies within a sector or establish sector hooks to conduct surveillance and minimize compliance risk.
DETECTING ILLEGAL INSIDER TRADING WITH COMPLIANCE TECHNOLOGY
Until the SEC or the courts offer more clarity on shadow trading, StarCompliance recommends firms take certain precautionary steps:
1. REVIEW EMPLOYEE TRADING POLICIES
In light of the new regulatory focus on shadow trading, greater scrutiny is needed to determine whether employee trading policies achieve the desired risk tolerance for your firm. Assess the degree of available MNPI for employees specializing in an industry sector. If you find that MNPI is readily accessible, determine whether current employee trading policies are restrictive enough to address potential conflicts of interest and insider trading of any kind. It may be beneficial to restrict sector-specific trading for individuals most likely to obtain MNPI regarding industry movements, such as bankers, traders, and research analysts.
2. IMPLEMENT SECTOR SURVEILLANCE TO CAPTURE SHADOW TRADING SCENARIOS
Market-data technologies allow firms to monitor individual issuer securities, derivative securities, and sector-specific/non-diversified/non-broad-based funds that are both sector and employee-specific. Consider using security identifiers—such as business entities, individual securities, industry sectors, and economic activities—as data points or hooks to facilitate employee trade surveillance for shadow trading; all are widely accepted data protocols for tagging companies.
Some of the most common security identifiers include:
- Global Industry Classification Standard: An industry taxonomy for use by the global financial community. The GICS structure comprises the 11 sectors, 24 industry groups, 69 industries, and 158 sub-industries into which S&P has categorized all major public companies.
- Data Universal Numbering System: A unique nine-digit numeric identifier assigned to a single business entity.
- Committee On Uniform Securities Identification Procedures: A unique nine-digit numeric or nine-character alphanumeric code to identify a North American financial security.
- International Securities Identification Number: An International Securities Identification Number to uniquely identify a security.
- Standard Industrial Classification: A four-digit code used by government agencies to classify industries and industry areas.
- North American Industry Classification System: A classification of business establishments by type of economic activity used by governments and businesses in Canada, Mexico, and the US.
- Financial Instrument Global Identifier: An open standard, unique identifier of financial instruments assigned to common stock, options, derivatives, futures, corporate and government bonds, municipals, currencies, and mortgage products.
- Legal Entity Identifier: A unique global identifier for legal entities participating in financial transactions for identification through a globally accessible database.
As shadow trading is still a novel concept, compliance teams should incorporate real-life and hypothetical situations to educate and train employees. Discuss the SEC case that gave shadow trading its name, as well as other insider trading theories. The classical theory is the most well-known of these insider trading theories. It involves executives, board members, or agents trading on their company’s MNPI before the release of news about a significant event. Misappropriation theory also involves trading on MNPI, but from an outsider with a fiduciary duty to the information source. Tipper/tippee theory involves an insider receiving a personal benefit after providing an outsider MNPI that is later used for trading purposes.
Shadow trading adds greater complexity to the task of discovering insider trades, but it can be done. Additional due diligence on the part of compliance teams is required, and compliance tech can and really must be a part of that enhanced due diligence process. Automated software platforms that help compliance officers corral, sift through, identify, and make proper sense of large data sets coming from all angles cannot be understated in their ability to aid in this critical firm risk-reduction effort. Illegal insider trading happens more often than one might think, perhaps as often as four times more than what regulators catch. Daunting odds. Make sure your firm avails itself of every opportunity to beat them.