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Insider trading

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."

Bibliography:

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.

http://europe.cnnfn.com/markets/9610/16/insidertrading_pkg/index.htm

Galen,

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.

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