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."
Amado, Ralph. "Are You at Risk for Insider Trading Liability?"
University of Pennsylvania Almanac. January 13, 1998. http://www.upenn.edu/almanac/v44/n17/traderisk.html.
Defterios, John. "Insider Trading Persists." CNNfn. October 16, 1996.
Michele. "Insider Trading: To Squelch It, First Define It." Business
Week. May 21, 1990. Meulbroek, L. K. "An Empirical Analysis of Illegal
Insider Trading." Journal of Finance 47, no. 5. 1661-99. New York: Oxford
University. Meulbroek, L. K., and Hart, C. "The Effect of Illegal Insider
Trading on Takeover Premia." European Finance Review, Volume 1, Number 1
1997: 51-80. Perryman, M. Ray. "If an Inside Tip Sounds Too Good To Be
Legal, It's Likely Not." San Antonio Business Journal. December 16, 1996.
http://www.amcity.com/sanantonio/stories/121696/editorial3.html. Pitt, Harvey L.
"Misappropriating Certainty From the Securities Markets: A Practitioner's
Primer on the O'Hagan Decision." Fried, Frank, Harris, Shriver &
Jacobson. August 6, 1997. http://www.ffhsj.com/firmpage/CMEMOS/0111906.htm.
Porter, Jim. "Law Review: Court Rules on Insider Trading." Tahoe
World. July 3, 1997. http://www.tahoe.com/worldarchive3.97/opinion/porte03Jul5681.html.
Securities Exchange Act of 1934. Section 21A. Civil Penalties for Insider
Trading. http://www.law.uc.edu/CCL/34Act/sec21A.html Smith, Anne Kates.
"Betrayers of Trust." U.S. News. November 19, 1998.
http://www4.usnews.com/usnews/issue/970707/7insi.htm. Springsteel, Ian. "Shhhhh!"
CFO Magazine. October 1996. http://www.cfopub.com/html/Articles/CFO/1996/96Ocwall.html.
Staff. "Regulators Move to Catch New Wave of Insiders." Baltimore
Business Journal. 1998. http://search.amcity.com/baltimore/stories/010598/smallb3.html.
The-Advisor.com. "What Exactly is Insider Trading?" November 2, 1999.
http://www.1800adviser.com/Money/what.htm. Walker, John. "Insiders and Rule
16(b)." http://www.fourmilab.ch/autofile/www/section2_34_5.html. Wells,
Rob. "Decade Passed Since Boesky Squealed to Feds." The Standard
Times. November 15, 1996. http://www.s-t.com/daily/11-96/11-15-96/a06bu037.htm.