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.
How to Prevent Shadow Trading [3 Tips]
Detect Illegal Shadow Trading With Compliance Technology
What is Shadow Trading?
The US Securities and Exchange Commission (SEC) 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? According to Akin Gump, shadow trading “involves buying or selling the securities of one company while in possession of confidential information of another closely correlated or ‘economically-linked’ company.” This trade would be made based on the “linked” company’s material nonpublic information, or MNPI.
Shadow trading differs from classical insider trading in that it involves trading stocks in a third-party or competing company rather than one’s own company or a pending acquisition or merger.
Shadow trading is challenging to identify, as it requires compliance teams to have:
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 need to tag companies within a sector or establish sector hooks to conduct surveillance and minimize compliance risk.
How to Prevent Shadow Trading [3 Tips]
At the moment, the SEC considers shadow trading a new theory, an entirely novel expansion of insider trading law. 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:
2. Implement Sector Surveillance to Capture Shadow Trading Scenarios
Market-data technologies allow firms to monitor:
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:
3. Update Training to Include Shadow Trading and Other Insider Trading Concerns
As shadow trading is still a novel concept, compliance teams should incorporate real-life and hypothetical situations to educate and train employees. Discuss SEC vs. Panuwat, the SEC case that gave shadow trading its name, as well as other insider trading theories:
Detect Illegal Shadow Trading With Compliance Technology
Shadow trading adds greater complexity to the task of discovering insider trades, but identification is possible. 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 like Star’s Insider Trading Compliance Software can help compliance officers corral, sift through, identify, and make proper sense of large data sets coming from all angles.
The Insider Trading Compliance Solution puts employee trades into context and protects your firm by:
Illegal insider trading happens more often than one might think, perhaps as often as four times more than what regulators catch. Those are daunting odds! Make sure your firm avails itself of every opportunity to beat them.