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The Brief

Fall 2024 | Shipowners' Limitation of Liability

Shadow Trading in the Spotlight

Hunter Bezner, Jessica Magee, and Allison Kernisky

Summary

  • Insider trading includes shadow trading, using material nonpublic information (MNPI) from one company to engage in a securities transaction involving another company whose share price is predictably influenced by the MNPI disclosure.
  • As a form of misappropriation-based insider trading, shadow trading requires a breach of a duty of trust.
  • While early cases found this breach from internal policies and confidentiality agreements, the SEC has argued that agency law could form the requisite duty.
  • Companies should review their internal insider trading policies and confidentiality agreements to evaluate whether they could form a duty and create insider trading liability.
Shadow Trading in the Spotlight
Kevin Trimmer via Getty Images

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In Hollywood movies, evil often lurks in the shadows. Although “shadow trading,” the U.S. Securities and Exchange Commission’s (SEC’s) newest theory of insider trading enforcement, may not have the makings of a box office smash horror film, it has led to some amount of fright and uncertainty among corporate management and governance professionals who are watching closely to see what comes next as shadow trading steps into the agency’s enforcement spotlight.

The SEC has long enforced the prohibition against illegal insider trading. While shadow trading is but the newest flavor of insider trading, reviewing the historical underpinnings of the historically prohibited practices helps highlight the idea behind this new rendition.

“Insider trading”—the commonly prosecuted and disdained practice—technically has no statutory definition. Yet, the body of common law developed by courts around the country over time has led to what most people understand to be the prohibited practice: buying or selling securities while in possession of material information not known to the public. Though a few types—or “theories”—of insider trading have taken shape over time, the traditional fact pattern involves a corporate insider (such as an employee, officer, or director) trading in their employer’s securities based on material, nonpublic information (MNPI) gained at and about their employer.

In recent months, the SEC—with some success in courts to date—has clarified (or expanded, perhaps, depending on one’s perspective) what constitutes insider trading. Specifically, according to the SEC, unlawful conduct can also take the form of “shadow trading,” using MNPI learned from one company to engage in a securities transaction involving a different company whose share price is predictably influenced by the MNPI’s disclosure.

Shadow Trading: Coming to a Courtroom Near You?

As an example, consider an officer of a pharmaceutical company, Company A, who is involved in confidential negotiations for Company A to be purchased by Buyer. On a Friday, the officer learns that Buyer has agreed to purchase Company A and that the sale will be announced the following Monday. After learning this, but before it is publicly announced, the officer buys options for Company B, which she knows is a competitor pharmaceutical company in a similar market position as Company A—even though Company A has a policy forbidding sales in any company’s securities while in possession of MNPI. When Company A’s sale is announced, Company B’s stock price enjoys its own boost, and Company A’s officer profits as a result. According to the SEC—which recently secured a jury win in a first-of-its-kind case on similar facts—Company A’s officer engaged in unlawful insider trading of a new sort now commonly referred to as “shadow trading.”

What the exact reach of the SEC’s new shadow insider trading theory will be is not yet clear. In the example above, Company A notably had an internal policy forbidding officers from using MNPI, such as the impending sale, to trade in any company’s securities. Thus, when the officer bought options of Company B, she violated her employer’s policy and, it turns out, gave the SEC a plausible hook on which to hang a claim that she also breached a duty of trust and confidence she owed to her employer—an essential element to any insider trading case. The SEC has gone even beyond this application, however, and argued that the existence of such an internal policy is not required. The SEC’s most recently stated position is that general common law fiduciary duty to one’s own company could serve as the basis for a breach to support insider trading charges.

Further, Company B was in a similar market position to Company A, making the knowledge of Company A’s sale arguably material to Company B securities. In simple terms, because of their market similarities, Company A’s officer reasoned that if Company A was being purchased, so too might Company B be an attractive target and hence Company B’s stock price might rise on news of Company A’s deal. But just how attenuated the relationship between two companies can be is not clear. This and other open questions should be front of mind when considering internal compliance practices, drafting policy language (handbooks, insider trading policies, confidentiality agreements, and the like), and counseling colleagues and clients because, for now anyway, the SEC’s interpretation of insider trading encompasses shadow trading, and the prohibition against it appears here to stay.

The Classics: Insider Trading as We’ve Always Known It

Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) makes it “unlawful for any person, directly or indirectly,” to use “any manipulative or deceptive device” in connection with the trade of securities. Exchange Act Rule 10b-5 makes it unlawful to “engage in any act, practice, or course of business” that would constitute fraud or deceit on another in connection with the trade of securities. Under these rules, the traditional or “classical” form of insider trading occurs when someone inside Company A, who owes a duty of trust and confidence to the corporation, trades in Company A’s securities on the basis of MNPI. The theory underpinning classical insider trading is that an officer, director, employee, or other insider has a special relationship with the company and its shareholders, preventing the officer, director, employee, or other insider from taking advantage of that relationship by using MNPI to their unique advantage.

Another established type of insider trading covers certain corporate “outsiders.” The “misappropriation” theory applies when a person uses confidential information obtained from a corporate insider for one’s own benefit to trade in that company’s securities. In this scenario, the trader owes a duty not to the company itself or its shareholders but to the owner of the MNPI, and breaches that duty by trading on the information. Accordingly, this theory is not about protecting specific shareholders of Company A but, instead, protecting the integrity of the securities market against abuses by outsiders. For example, were a managing director of the investment bank advising Company A in its sale to trade in Company A’s securities before news of the sale was publicly disclosed, they would be at risk for misappropriation theory–based insider trading charges. Thus, to state a misappropriation claim, the SEC must show that the trader “knowingly misappropriated [MNPI] for securities trading purposes, in breach of a duty arising from a relationship of trust and confidence owed to the source of the information.”

Yet another traditional theory of insider trading involves tipper-tippee liability—which has its own storied body of case law but, generally, is just as it sounds: one party with MNPI “tips” another party who trades or themself “tips” another who trades. In these cases, the tippee assumes the tipper’s breach of duty, preventing the tippee and the tipper from escaping liability by merely moving the information to a party without a duty to not trade on the information.

This brings us to the SEC’s latest permutation of insider trading: shadow trading. Though the SEC has called this novel theory “insider trading, pure and simple,” it has been received by most as an expansion of existing law.

These criticisms notwithstanding, for now, at least, the SEC’s shadow trading theory continues to shine under the spotlight, as it won at trial recently in the closely watched SEC v. Panuwat action and, separately, secured a settlement, subsequently approved by the court, in SEC v. Bechtolsheim. Nevertheless, the full extent of shadow trading enforcement remains an open question.

The SEC Premieres a Novel Theory: Panuwat

To date, the SEC has filed two enforcement actions under the shadow trading theory. The first to make it to judgment was SEC v. Panuwat. On April 5, 2024, after an eight-day evidentiary trial followed by a brief deliberation period, a jury in the Northern District of California found Matthew Panuwat liable for insider trading. Panuwat—an employee of the biopharmaceutical company Medivation—learned that Medivation was being acquired by an international pharmaceutical company (Pfizer). Evidence at trial showed that Panuwat purchased out-of-the-market, short-term stock options in a different biopharmaceutical company (Incyte) seven minutes after receiving an internal email about the impending acquisition and that Panuwat was subject to an insider trading policy and confidentiality agreement prohibiting use of insider information for one’s own benefit. When the acquisition was announced to the public, Panuwat’s trades in Incyte earned him $107,066 in profit.

The SEC’s complaint charged Panuwat with scienter-based fraud in violation of Exchange Act section 10(b) and Rule 10b-5 thereunder. Panuwat lodged numerous legal challenges to the SEC’s claims, including a motion to dismiss and later a motion for summary judgment, both of which were denied. Some of the issues raised are worth discussion.

First, the shadow trading theory necessarily expands what information is considered material for MNPI. At first blush, the fact that Medivation was being purchased by Pfizer would not obviously be material to Incyte—a company with no part in the transaction. But, the court found, because a “market connection” existed between Medivation and Incyte, Panuwat’s knowledge of the impending sale was also material as to Incyte.

In Panuwat, the SEC presented evidence that included analyst reports and articles linking the two companies. For example, one article reported that talks about Medivation’s sale made Incyte shares look very appealing. Further, the two companies were similar—both mid-sized, cancer-related drug companies in a unique yet similar position—suggesting that the purchase of Medivation could mean that Incyte would be purchased at some point in the future. Finally, the fact that Incyte’s stock did in fact jump when Medivation’s sale was announced supported the inference that the two companies were connected. Given this connection, the court found that the material information for Medivation could reasonably be material to Incyte as well.

Notwithstanding the specific facts at play in Panuwat, query whether “market connection” is an objective factor regardless of the individual’s actual knowledge; that is, an open question exists about whether an individual who happened to place a poorly timed trade without any knowledge of a market connection between companies at the time (and assuming they could so demonstrate) would pass post hocSEC scrutiny.

Second, the shadow trading theory, as a subset of the misappropriation theory, requires that the trader breach some fiduciary, contractual, or similar duty. For Panuwat, the SEC asserted three possible sources for this obligation: internal insider trading policies, confidentiality agreements, and agency law. Helpfully for future SEC investigations and those no doubt already underway, the court held that all three were viable paths to establishing a breach.

Though the trial lasted eight days, the jury found Panuwat civilly liable for insider trading after only a few hours of deliberations. In August 2024, the court denied Panuwat’s post-trial motions for a directed verdict and new trial. Specifically, the court rejected Panuwat’s evidentiary and instruction objections, reaffirming its reasoning for denying dismissal and summary judgment. Interestingly, the court denied the SEC’s request to bar Panuwat from serving as an officer or director of any public company in the future, and it imposed the maximum civil penalty of $321,197.40 and enjoined him from further violations of the federal securities laws. On November 8, 2024, Panuwat appealed the district court’s final judgment and denial of his post-trial motions to the Ninth Circuit, meaning we may soon have the appellate decision on this theory.

The Cerberus of Panuwat: Duties

Proceeding from the positive outcome in Panuwat, it can be concluded that the SEC has three paths to establish a breach for the shadow trading theory. Even though all three of the mythical dog heads could establish liability, one of them—here, agency law—could have a sharper bite.

Internal policies can create a duty of trust. Medivation’s insider trading policy prohibited trading on “not yet publicly disseminated” information about the company. Importantly, the policy also specifically prohibited using the information to trade in securities of “another publicly-traded company.” Incyte, a publicly traded company, fell within the prohibition. Following from the court’s endorsement of this theory is that such internal policies that address other companies’ securities can explicitly create a duty of trust that, if violated, can subject employees to insider trading charges.

Confidentiality agreements can create a duty of trust. Separately, Panuwat signed a confidentiality agreement with Medivation that required him to hold in the strictest confidence financial information or other subject matter about the company. Further, the agreement prohibited Panuwat from using confidential information other than for the company’s own benefit. By agreeing, Panuwat established a duty that the court found sufficient to support misappropriation theory liability when he used confidential information for his own benefit.

Agency law can create a duty of trust. Perhaps most interesting is the SEC’s argument that background common law principles create a duty of trust even in the absence of insider trading policies or confidentiality agreements. According to the SEC, because confidential information is traditionally for the exclusive benefit of the corporation, use of that information for personal benefit by an employee could suffice for a section 10(b) claim under an agency law theory. At least for summary judgment purposes, the court permitted this theory to proceed to trial. As discussed below, this broader theory will be one to watch as it applies to all employees without the plain notice that an explicit insider trading policy would provide.

Following a successful premiere of shadow trading as a concept, and three paths to liability available, the SEC was ready for its next feature, Bechtolsheim.

Bechtolsheim: The SEC’s Shadow Trading Sequel

No doubt bullish following its win in Panuwat, the SEC’s Division of Enforcement likely has any number of nonpublic, fact-finding investigations ongoing to identify other instances of potential shadow trading. But even before racking up its first win in Panuwat, at least one other such investigation was playing out at the SEC and resulted in the second concluded shadow trading case to be reported in the SEC’s 2024 fiscal year. A walk through recent history sheds light on the agency’s commitment to prosecuting shadow trading cases and why Panuwat is unlikely to be an outlier.

The SEC filed Panuwat in August 2021. The court in that case denied Panuwat’s motion to dismiss in January 2022. In November 2023, the court denied Panuwat’s motion for summary judgment. Finally, the jury trial began in Panuwat on March 25, 2024—nearly three years after the case was first filed. The next day, March 26, 2024, the SEC filed its second shadow trading case—this time a fully settled action alleging that technology company Arista Networks’ former chair and CEO, Andreas “Andy” Bechtolsheim, profited from trading on insider knowledge that a different technology company was about to purchase Acacia Communications Inc. Concluding a nonpublic investigation of unknown duration, rather than litigate—and perhaps bearing witness to the challenges Panuwat’s own case had faced—Bechtolsheim agreed to settle the action without admitting or denying the SEC’s allegations.

In this second-of-its-kind case, the SEC’s complaint alleged that Bechtolsheim learned about an impending acquisition of Acacia through Arista’s relationship with a third-party tech company. That third-party company had previously considered acquiring Acacia. When the third-party company learned that a different company placed an offer to purchase Acacia, it reached out to Bechtolsheim to discuss the competing bid. After learning about the separate bid information, Bechtolsheim allegedly purchased put option contracts for Acacia through brokerage accounts of a relative and an associate just before the market closed on July 8, 2019. The acquisition was publicly announced the next day, and Acacia’s stock price jumped 35.1%, resulting in $415,726 in total profit for Bechtolsheim.

The SEC alleged that Bechtolsheim’s trading on alleged MNPI—material information learned in the course of his employment and applied to trade in securities of a different company—violated Arista’s internal insider trading policy and Exchange Act section 10(b) and Rule 10b-5 thereunder. There are notable differences between Panuwat and Bechtolsheim, however, highlighting that the SEC’s use of the shadow trading theory can vary.

Unlike in Panuwat, the information used by Bechtolsheim was specifically about the company he traded in. As alleged, Bechtolsheim learned that Acacia was being acquired and proceeded to trade in Acacia securities. On the other hand, Panuwat allegedly learned that Medivation was being acquired and traded in Incyte stock. Because the allegation in Panuwat did not involve trading in the stock of the company about which the MNPI pertained, the SEC was required to show that the two companies were somehow connected for the information to be deemed material. Conversely, in Bechtolsheim, the information was about Acacia, and Bechtolsheim traded in Acacia, making materiality clearer.

But the critical similarity between these cases is the existence of internal policies or agreements restricting each defendant’s use of confidential information. Bechtolsheim was first subject to Arista’s insider trading policy prohibiting the misuse of MNPI from other companies with which Arista worked. The internal policy further required that any MNPI acquired through employment could only be used for legitimate business purposes. This internal policy likely would establish the necessary breach of trust with the company.

Separately, though similarly to Panuwat, Arista also had a nondisclosure agreement (NDA) in place with the tech company. Under the agreement, Bechtolsheim was required to maintain confidentiality of information shared by the tech company with Arista. Accordingly, when Bechtolsheim utilized the confidential information about the sale of Acacia for his own benefit, he allegedly breached the NDA—and the attendant duty it created—as well.

On May 30, 2024, the court approved and entered a settled final judgment against Bechtolsheim based on allegations of insider trading. The settlement is notable as the second instance of the SEC bringing an enforcement action for insider trading under the shadow trading theory. Unlike the first-of-its-kind Panuwat action, which was hotly contested all the way through a jury trial, Bechtolsheim agreed to settle the case in lieu of litigation and without admitting or denying the SEC’s allegations. In settling, he consented to the entry of a judgment enjoining him from violating section 10(b) and Rule 10b-5, agreed to pay a civil penalty of $923,740, and agreed to suspension from serving as an officer or director of a public company for five years.

The Possible Monster Under the Bed: Agency Law Redux

The central question unanswered by these cases is this: Is a violation of an insider trading (or other applicable) policy or agreement necessary to establish the elements of section 10(b) for shadow trading liability? The SEC says no. It argued in Panuwat that traditional principles of agency law suffice even without an applicable insider trading policy provision, because such principles prevent employees from using MNPI inappropriately.

According to the SEC, because confidential information is traditionally for the exclusive benefit of the corporation, use of that information for personal benefit by an employee, alone, could suffice for a section 10(b) claim. In denying summary judgment, the court in Panuwat accepted this as a viable theory to satisfy the breach of duty or confidence element of a misappropriation claim. With a win in that case and the settled action under its belt in Bechtolsheim, the SEC may be more willing to nudge its shadow trading enforcement efforts closer to center stage by hanging a case entirely (or at least more meaningfully) on a pure agency law theory. Such a strategy would not be without risk, of course, and these authors would expect any such case to include favorable enforcement facts suggesting that a defendant clearly intended to trade based on the MNPI at issue.

To be sure, not all trades by insiders are illegal. For example, employees and other insiders can trade in securities when they do not have MNPI, when they have sought and secured “preclearance” from their compliance departments, or if transactions occur in compliance with 10b5-1 trading plans. Instead, for insider trading liability to attach, some specific duty must prohibit the use of the MNPI in the securities transaction. To get around this, the SEC seems to argue, agency law could create a background duty of trust. Under this theory, an agent is subject to a duty to the principal not to use confidential information for the agent’s own benefit.

This concept has been applied in run-of-the-mill misappropriation cases. For example, in SEC v. Talbot, the Ninth Circuit held that the employee’s position resulted in him being entrusted with confidential information. Applying agency principles, and no written agreement or policy, the court held that the employee owed a duty to the company that he breached by trading on MNPI from the company.

The application of agency law can support the underlying purpose of the misappropriation theory. The classical theory of the prohibition against insider trading—where one trades in the securities of their own company—is that this prohibition protects shareholders of the company. On the other hand, the misappropriation theory protects the market itself from abuse. Prohibiting shadow trading, as a subset of the misappropriation theory, also would have the broad goal of protecting the market, making agency law a possibly reasonable path to restricting trading that might be viewed as fraud on the market.

But applying agency law does present potential problems.

First, would agency law expand the scenarios when trading on MNPI is prohibited beyond what the U.S. Supreme Court has permitted? Trading is fraudulent only when the MNPI is secured through an abuse of position, violation of trust, or betrayal of confidence. Drawing on agency law would seem to be limitless, or at least create a difficult line-drawing problem, for which employees could fall within the agency rule prohibiting use of MNPI.

Second, and more broadly, while one of the purposes of the misappropriation theory is to protect the market, insider trading should not overly chill price discovery. The SEC has recognized the importance of allowing information to spread to reach market efficient pricing. A broad application of the shadow trading theory creates significant risks for those who would want to trade in companies within their industry or sector. The Supreme Court recognizes how imprecise line drawing can result in uncertainty and reduce entirely permissible behavior. Without a clearer background principle, investors would be left to guess whether using certain information might breach some common law duty.

Third, notions implicit in prosecuting shadow trading theories go beyond historical goals of rooting out insider trading. Even though one of the SEC’s stated purposes has been to protect the integrity of the market, the legal basis still is that the information is owned by the principal and the trader’s use of the information would be deception on the principal who provided them the information. But, particularly in Bechtolsheim, the idea that Bechtolsheim’s employer—Arista—or the tech company that gave him the information had an ownership interest in the knowledge that Acacia was being purchased by a separate party extends ownership of that knowledge well away from the initial possessor. While Bechtolsheim’s position within Arista may be how he learned the information, one could argue that Arista did not really have an interest in the knowledge of Acacia’s impending merger.

The SEC has been careful in how it has applied shadow trading in its earliest cases. The case against Panuwat premised liability on his violation of the company’s insider trading policy and contractual agreements, along with the broader common law theory. As the agency conducts ongoing and new investigations with the backstop of these early wins, however, it remains to be seen whether future cases will chart even newer territory.

In March 2024—before the Panuwat jury returned a favorable verdict—former SEC Director of Enforcement Gurbir Grewal stated that the agency’s shadow trading theory is not novel, and this assertion may bear up, given the second—albeit settled—action the SEC filed against Bechtolsheim. As noted above, enforcement staff are almost certainly investigating other potential shadow trading fact patterns (just as companies are reviewing their own insider trading policies). Assuming the SEC continues to file similar actions, other district courts and eventually courts of appeal likely will have an opportunity to weigh in. The SEC has argued for insider trading liability both under a theory of a violated insider trading policy and under agency law, and the shadow trading theory seems here to stay—although for now, the SEC has brought enforcement actions only under the theory when an insider trading policy violation is also present.

For Materiality, Like Cinema, Storytelling Is Key

Another difficult line-drawing problem will be the “market connection” test utilized in Panuwat. A fact is material if there is a substantial likelihood that its disclosure “would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” In Panuwat, the district court rejected the argument that information about a merger would be material only to the two merging entities. Panuwat argued that expanding materiality to other companies would result in information being material to an entire field. Similar to the breach of duty discussion, the shadow trading theory creates a heightened risk for individuals who trade in not only their own company but also another company in its same industry. Still, it remains to be seen how the SEC will seek to establish “market connection” between entities in future actions. In Panuwat, the SEC introduced evidence of news articles and analysts in the weeks before Panuwat traded, highlighting that if Medivation were acquired, Incyte would be the next major target in the industry. The SEC presented a story about a subsection of the biopharmaceutical industry with Medivation and Incyte as the two uniquely placed in the center.

The SEC could continue searching for new stories to tell. Some stories might focus on businesses that sell the same product, target the same buyers, operate in the same industries, or have a supplier-purchaser relationship. Businesses have numerous competitors, suppliers, and partners, all of which in turn have numerous connections. The ripple effect of news for one business is often incalculable. The ability to connect news from one entity to another may only be limited by the SEC’s imagination.

Strict enforcement of shadow trading and broad interpretations of when two companies are connected for materiality purposes could chill activity in the market and may result in unnatural pricing due to fear of SEC activity. To be sure, the information used must still be “nonpublic,” limiting some of the risk of inadvertent insider trading. Still, investors should be extremely wary of trading on any MNPI learned in connection with their position in a given industry.

This issue will not arise in every case, however. In Bechtolsheim, the information learned was about Acacia, and the securities were also of Acacia. The market connection test is not necessary where there is sameness in the MNPI and the company traded. Once again, this highlights the breadth of the concept and the potential for novel fact patterns under a shadow trading theory.

Previews: Strategies to Avoid Shadow Trading

Time will tell if other government regulators decide to jump into the shadow trading arena. Although the U.S. Department of Justice (DOJ) has a higher burden of proof than the SEC in an insider trading case (beyond a reasonable doubt for the DOJ vs. the preponderance of the evidence for the SEC), if shadow trading cases propagate, history shows that where facts are deemed particularly egregious, the odds of the DOJ bringing such a case increase.

So what should companies be considering in response to the SEC’s recent use of shadow trading as a tool in its enforcement toolbox? The following steps are suggested:

  • Companies may choose to review and consider whether or how to amend insider trading policies. Practitioners should think critically about what information, and from whom, companies should categorize as confidential for their internal policies. While companies should protect their confidential information, they may not want to place officers at an undue risk of violating securities laws.
  • Companies may want to review their agreements with employees and partners to evaluate whether they could be the basis for a breach of duty, similar to the confidentiality and nondisclosure agreements from Panuwat and Bechtolsheim, respectively.
  • Companies may also wish to consider how best to sync up trading policies with existing Rule 10b5-1 trading plans or blackout periods, particularly when an acquisition may be in the works.
  • Companies, and practitioners for their corporate clients, may want to revamp and conduct employee (and board) training to bring this new emphasis on shadow trading enforcement to stakeholders’ attention and review their respective obligations and prohibitions under a company’s insider trading policy, employee handbook, code of conduct, confidentiality agreement, or elsewhere. But note that this may prove tricky when considering whether and how to modify preclearance practices and restricted trading lists.
  • Practitioners should continue to monitor for new SEC enforcement actions based on the shadow trading theory, especially if any exclusively allege a breach under agency law. The implications of an agency-law-only action might be difficult to contemplate at this stage. But companies should begin to consider how such an action could result in more employees being at risk of violating securities law than before and what impact that could have on the company, including through control person liability in an SEC enforcement action and reputational harm.

Fin

Given the SEC’s success in pursuing shadow trading enforcement actions to date, and the SEC’s professed belief that this is not a “new, expanded” concept of insider trading, it seems certain that such actions are likely to increase. The SEC likely will continue to raise agency law theories and could in the future bring enforcement actions even in the absence of an existing company policy or agreement, the violation of which satisfies the breach of duty element for an insider trading charge. Under either theory, the SEC shows no signs of slowing down efforts to bring enforcement actions for shadow trading. As Joseph Sansone, chief of the SEC’s Market Abuse Unit, stated: “We will continue to pursue and prosecute misconduct by trusted insiders at all levels of the corporate hierarchy.” Thus, while questions remain, what we know for sure is that the SEC is watching—even in the shadows.

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