Illegal Insider Trading
Consider this: "Imagine a boardroom of
corporate executives, along with
their lawyers, accountants, and investment
bankers, plotting to take over a
public company. The date is set; an
announcement is due within weeks. Meeting
adjourned, many of them phone their
brokers and load up on the stock of the
target company. When the takeover is
announced, the share price zooms up and the
lucky 'investors' dump their
holdings for millions in profits." First
things first - insider trading is
perfectly legal. Officers and directors who
owe a fiduciary duty to
stockholders have just as much right to trade a security
as the next
investor. But the crucial distinction between legal and illegal
insider
trading lies in intent. What this paper plans to investigate is the
illegal
aspects of insider trading. What is insider trading? According to
Section
10(b) of the Securities Exchange Act of 1934, it is "any
manipulative or
deceptive device in connection with the purchase or sale of any
security."
This ruling served as a deterrent for the early part of this
century before
the stock market became such a vital part of our lives. But as
the 1960's
arrived and illegal insider activity began to pick up, courts were
handcuffed
by this vague definition. So judicial members were forced to
interpret "on
the fly" since Congress never gave a concrete
definition. As a result, two
theories of insider trading liability have evolved
over the past three
decades through judicial and administrative interpretation:
the classical
theory and the misappropriation theory. The classical theory is
the type of
illegal activity one usually thinks of when the words "insider
trading" are
mentioned. The theory's framework emerged from the 1961 SEC
administrative
case of Cady Roberts. This was the SEC's first attempt to
regulate securities
trading by corporate insiders. The ruling paved the way for
the traditional
way we define insider trading - "trading of a firm's stock
or derivatives
assets by its officers, directors and other key employees on the
basis of
information not available to the public." The Supreme Court
officially
recognized the classical theory in the 1980 case U.S. v. Chiarella.
U.S.
v. Chiarella was the first criminal case of insider trading.
Vincent
Chiarella was a printer who put together the coded packets used
by companies
preparing to launch a tender offer for other firms. Chiarella
broke the code and
bought shares of the target companies based on his
knowledge of the takeover
bid. He was eventually caught, and his case
clarified the terms of what has come
to be known as the classical theory of
insider trading. However, the Supreme
Court reversed his conviction on
the grounds that the existing insider trading
law only applied to people who
owed a fiduciary responsibility to those involved
in the transaction. This
sent the SEC scrambling to find a way to hold these
"outsiders" equally
accountable. As a result, the misappropriation
theory evolved over the last
two decades. It attempted to include these
"outsiders" under the broad
classifications of insider trading. An
outsider is a "person not within or
affiliated with the corporation whose
stock is traded." Before this theory
came into existence, only people who
worked for or had a direct legal
relationship with a company could be held
liable. Now casual investors in
possession of sensitive information who were not
involved with the company
could be held to the same standards as CEOs and
directors. This theory
stemmed from a 1983 case, Dirks v. SEC, but the existence
of the
misappropriation theory had not been truly recognized until U.S.
v.
O'Hagan in 1995. The case - U.S. v. O'Hagan - involved an attorney at
a
Minneapolis law firm. He learned that a client of his firm (Grand Met)
was about
to launch a takeover bid for Pillsbury, even though he wasn't
directly involved
in the deal. The lawyer then bought a very sizable amount
of Pillsbury stock
options at a price of $39. After Grand Met announced its
tender offer, the price
of Pillsbury stock rose to nearly $60 a share. When
the smoke finally cleared,
O'Hagan had made a profit of more than $4.3
million. He was initially convicted,
but the verdict was overturned. The case
bounced around in the Court of Appeals
for several years before it made its
way to the Supreme Court. It is there the
Supreme Court held that O'Hagan
could be prosecuted for using inside
information, even if he did not work for
Pillsbury or owe any legal duty to the
company. In a 6-3 ruling, the court
indicted O'Hagan and, in doing so, upheld
the foundation of the
misappropriation theory. I believe that the SEC is correct
in its efforts to
punish this white-collar activity, but there is still much
work to be done.
According to Rule 16(b), "if an insider buys and sells a
security in any
six-month period leading up to or following a significant
company event, he
must hand over his profit to the company." Suppose a
board member buys some
stock, and four months later Microsoft comes along and
buys his company. The
profits are taken back from that transaction and the
executive is left with
nothing to show for his investment. You can see the
one-sidedness of this
rule. Executives must take the losses, but the company
takes back the gains.
However, in order to secure confidence in our markets, it
is essential that
there be some type of governing backbone to protect our
investments. Going
back to the O'Hagan case, consider yourself a small
shareholder in Grand Met
before the tender offer is announced. You have no idea
of the takeover bid
because it is material, nonpublic information. Naturally,
Pillsbury wants
its shareholders to receive a premium on the deal. O'Hagan comes
along and
buys millions of dollars worth of Pillsbury stock. At the time
of
negotiations, the price of the stock was $39. But due to O'Hagan's heavy
buying,
Pillsbury's market price jumps to $47 on circulating rumors of a
possible
takeover. In order for Grand Met to follow through on the
acquisition, they must
now pay a premium over the $47 market price, instead
of the $39. The acquiring
company's shareholders are now penalized and must
pay more for Pillsbury,
possibly affecting their own stock. Now consider a
hypothetical situation
opposite of the previous scenario. You are a
shareholder in Grand Met and
approaching retirement. Grand Met is currently
trading at $39 a share. O'Hagan
is a major shareholder and receives a tip
about Grand Met possibly going
bankrupt. He goes out and quietly sells his
shares, while you continue to hold
onto yours. The announcement is made a
week later that Grand Met is indeed
filing for bankruptcy. By this time, you
have reacted too slowly and the market
price dives to $5 a share. Is this
what you had in mind heading into retirement?
Scenarios like this become
reality on a regular basis. One of the most famous
insider trading scandals
in history involved a man named Ivan Boesky. He
illegally obtained secrets
about impending mergers to buy and sell stock before
the mergers became
public knowledge. Mr. Boesky made a "$200 million
fortune by profiting off
stock price volatility as corporate mergers came
together and fell apart."
His case brought national exposure to illegal
insider trading in the 1980s
and helped pave the way for other big-shot
criminals such as Dennis Levine,
Martin Siegal, and Michael Milken to pay the
price. Boesky cooperated with
officials and had to pay $100 million in fines and
received 26 months in
prison. But that still leaves $100 million in change left
over from his
illegal activities. So, in other words, as long as you cooperate,
you'll only
lose half on your trade-in. Is that the kind of
"hard-core" message we want
to send to these white-collar criminals?
So why risk lawsuits or even
prison? The answer is obvious - greed. The
potential of making millions of
dollars in a single week greatly outweighs the
risk of getting caught in many
people's eyes. In the recent Duracell
International takeover of Gillette
Co., the SEC found that 18 people netted more
than $1 million in trading
securities of the two companies in a two-day period
before the acquisition
became public. The SEC currently has suits pending on
those trades. According
to William McLucas, director of enforcement at the SEC,
about forty-five
insider trading cases are pursued every year. Ironically, that
number is the
same as the amount of cases pursued in the "go-go
1980s," when legendary
insider trading scandals were continually making
headlines. In 1997, the New
York Stock Exchange referred forty-eight insider
trading investigations to
the SEC, while the NASDAQ referred 121.
"Regulators say the brisk pace of
mergers and acquisitions is behind a lot
of insider trading now." But for the
most part, most of the cases today
have that "next-door neighbor" feeling.
Relatives and friends of
employees pocketing a quick $5,000 after buying
shares of a company's stock
before a merger has replaced the high profile
cases of the 1980s. This has
placed greater pressure on enforcement There is
always going to be a "gray
zone." "If all the information was public
property, there would be no
incentive for share analysts and others to seek
it. For markets to work, there
have to be private rights to valuable
information." And that is where the
line is drawn in the sand. When does
private turn into public information?
"There's always going to be a moment
when information passes from being
confidential business information that the
company has guarded to being market
gossip." It is unrealistic to expect our
courts to pinpoint the exact time
when a company's secrets become the
street's common news. But steps can be taken
to control sensitive information
from getting out in the public. First,
"close the loop." The less exposure
there is to investment bankers and
advisers, the less potential of
information leaking to the public. Secondly,
"speed it up." Try not to
stretch out the process of negotiations too
long. Thirdly, "think like a
spy." Avoid the use of facsimile
machines, cellular phones, and e-mail as
much as possible. And finally,
"lay it on the line." Make it clear to both
parties involved in the
deal that leaks will not be tolerated. In 1980, one
out of seventeen U.S.
households had money in stocks and bonds. Today, it's
one out of three. The
expansion of mutual funds and 401(k) plans in the 1980s
dumped huge amounts of
money into the market. Greed follows opportunity, and
as money continues to pour
into the market, illegal insider trading will
continue to grow. In conclusion,
knowledge is power in today's business
world. And where power goes, manipulation
can't be far behind. Not a day goes
by without talk of a new merger,
acquisition, or IPO - that is why illegal
insider trading has become an ongoing
problem. Just remember one thing. When
faced with a situation where you may be
exposed to illegal insider trading,
use the golden rule - "If a lead sounds
too good to be true, it probably
is."
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