FREE ESSAY ON ILLEGAL INSIDER TRADING

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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