Consider this: "Imagine a boardroom of corporate executives, along with
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
or deceptive device in connection with the purchase or sale of any
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
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.
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
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
As a result, the misappropriation theory evolved over the last two decades. It
attempted to include these "outsiders" under the broad classifications
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),
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
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
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
mergers and acquisitions is behind a lot of insider trading now." But for
most part, most of the cases today have that "next-door neighbor"
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
line is drawn in the sand. When does private turn into public
information? "There's always going to be a moment when information passes
being confidential business information that the company has guarded to being
market gossip." It is unrealistic to expect our courts to pinpoint the
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
advisers, the less potential of information leaking to the public.
Secondly, "speed it up." Try not to stretch out the process of
long. Thirdly, "think like a spy." Avoid the use of facsimile
cellular phones, and e-mail as much as possible. And finally, "lay it on
line." Make it clear to both parties involved in the deal that leaks will
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
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