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Insider Trading

Insider trading is a term that most investors have heard and usually associate with illegal conduct. But the term actually includes both legal and illegal conduct. The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC.

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.

By far the most common way in which an insider is caught is through a tip to the SEC from an informant. Even where the informant choses to remain anonymous, the SEC will engage in some preliminary investigation to test its validity. Lawyers and other market professionals who witness some irregularities in the way the business is being handled or who otherwise are faced with blatant violative conduct will frequently contact the Commission for fear that they may in some way be implicated if they do not come forward with the information.

A landmark case in the history of insider trading is about Ivan F. Boesky. Boesky caused securities to be purchased for certain affiliated entities while in possession of material nonpubilc information that was provided to him by Dennis B. Levine, as part of an organized trading scheme. Levine received his information from Robert M. Wilkis, an investment banker at Lazard Freres & Co. and from Ira B. Sokolow, an investment banker at Lehman Brothers Kuhn Loeb Incorporated, Later Shearson/Lehman American Express, and others.

The nonpublic information concerned tender offers, mergers or other business combinations. Boesky at all times knew that such information was confidential and had been obtained through misappropriation or a breach of a fiduciary duty. The nonpublic information included a possible merger of Nabisco Brands, Inc. and R.J. Reynolds, a possible tender offer for Houston Natural Gas Corp. by InterNorth Inc., and a contemplated recapitaliaation of FMC Corporation.

Boesky agreed to pay Levine five percent of his profits that accrued to certain of the entities under his control where Boesky based his decision to purchase the securities on the nonpublic information provided by Levine. A lesser amount, of one percent, was agreed upon if Boesky merely continued to hold or increased his holdings in the security based on such information.

Boesky agreed to pay the equivalent of $100 million in cash and assets, of that amount, $50 million represents disgorqement of his ill-gotten gains and will be placed in escrow for the benefit of investor claims and the remaining $50 million represents a civil penalty that, pursuant to the Insider Trading Sanctions Act of 1984, will be paid to the Treasury of the United States. The $100 million amount is the highest figure ever to be obtained as part of a resolution involving any violation of the federal securities laws. In addition to the disgorgement and civil penalty, Boesky has consented to the entry of a final judgment of permanent injunction restraining and enjoining him from future violations of the Securities Exchange Act of 1934.

Furthermore, in a related public administrative proceeding, Boesky submitted an offer of settlement that the Commission accepted. Subject to a limited stay, the settlement provides that Boesky consented to an administrative order barring him from association with any broker, dealer, investment adviser, investment company or municipal securities dealer. It is clear that with the exception of making his own personal trades through a commissioned broker/dealer, Boesky is out of the U. S. securities business for life.

While the commission is only authorized to impose civil sanctions on its defendants, it often refers cases to the Justice Department or the United States Attorney's Office for criminal proceedings. Obvious ramifications include the possibility of imprisonment for the conduct that gave rise to the Commission's charges. The trading ring began with the once prominent New York investment banker, Dennis B. Levine.

A Fool And His Money

Hang on to your wallet. Money-Grubbing traders will do whatever it takes to rob you blind. Late-'80s-style insider trading (Gordon Gekko and Bud Foxe) is certainly making a comeback. Over the past several months, stock market cops have charged dozens of workers at top Wall Street brokerage houses and hedge funds with using illegal tips to make big bucks. The crooks' alleged total take to date: more than $35 million - and that's likely just the tip of the iceberg. Many of the cases are brazen: Two sons of a former Taro Pharmaceutical Industries exec netted over $4 million by simply setting up a hedge fund to trade on inside into about Taro supplied by their father. Other schemes have even penetrated the legal structure designed to prevent them. Morgan Stanley attorney Randi Collotta leaked news about pending mergers even though her job as a compliance officer was to protect house secrets. Thanks in part to those tips, her 14-person ring (including her husband) is said to have pulled in $15 million.

Doin' the Hustle Insider trading isn't the only way you can be had. False Rumors Scammers plant bogus info about takeovers in the press to make money on the stock spikes that follow. Then the rumored "deal" falls through. Spam Flood Shysters take positions in a penny stock and send e-mails saying it's "ready to explode!" Ignoramuses bite, and the stock jumps. Dial-a-Friend A woman leaves a message for a friend "by rnistake." In it she mentions a tip from "that broker I'm dating." Dupes fall for it and drive up the stock. Price Gouging By law brokers must give clients the best prices. instead, they sometimes buy and sell at prices that favor their firms. Account Hijacking Crooks in Estonia, Latvia, and India have used stolen passwords to hack brokerage accounts and sell their stocks at inflated prices. Options Backdating Execs "backdate" their stock options, cherry-picking grant dates that'll maximize profits when it's time to cash in.

Years of solid growth and low interest rates have pumped a ton of cash into the global economy, which savvy companies and private investment firms have been using to snap up other businesses. The result is a tsunami of takeover deals that generate loads of tips. But old-fashioned arrogance is at play as well. Wall Streeters believe they won't be snagged for insider trading, perhaps because they think the SEC has been preoccupied with accounting fraud and the executive pay excesses that brought down companies like Enron and Tyco. Says one former Morgan Stanley trader, "You'd need an enormous staff to catch everyone, so it's easy to get away with." But Peter Bresnan, deputy director of the SEC's Division of Enforcement, disagrees. "If you think we won't find you," he says, "you might want to check with anyone we filed complaints against recently." In fact, Bresnan and his cohorts have only been aided by the new crooks' overconfidence. According to the SEC, one Credit Suisse banker used his office phone at least five times to tip a banker in Pakistan about a takeover last February. And a Morgan Stanley VP allegedly tried to cover her tracks by setting up an online account for her mother living in China - but then apparently made illegal trades from it using her home computer in New Jersey.

There are additional investigations and indictments on the way, say SEC lawyers and prominent insider trading defense attorneys in New York. Market watchdogs regularly keep an eye out for unusual spikes in the number of shares traded ahead of deals; lately, they have had little trouble spotting the telltale activity. For example, just days before the May 7 news that the aluminum conglomerate Alcoa was planning to buy a smaller company called Alcan, traders purchased a suspiciously large $226,000 worth ofAlcan call options -which gave them the right to buy Alcan stock at a preset price. After news of the deal broke, driving up Alcan stock, the traders' $226,000 investment turned into a cool $6.7 million, according to Jon Najarian of OptionMonster, an online firm that tracks atypical options activity to hunt for trading ideas. "These aren't coincidences," says Najarian. "No one on Wall Street is that lucky." In addition, many insiders say the global nature of business today virtually guarantees continued transgressions. "The playing field is so much bigger, it gives a false sense of security to the people involved in these schemes," says Michael Malloy, a former SEC prosecutor. "They think, Who's going to know if l talk to someone in Hong Kong?"

The average investor really suffers - especially anyone who owns stocks or mutual funds. If you or your fund sold in-the-know insiders shares in companies like Amgen, Caremark Rx, or Macromedia just before their stocks jumped thanks to takeover news, you got screwed. There's also a bigger issue at work: When capital markets function well, they transfer money smoothly from investors to the country's best entrepreneurs, who then use it to create the most jobs and growth. But when top investors begin to mistrust the markets because of insider trading, they start holding back their money - and everybody loses. Eventually, even the little guys become gun-shy. The more average investors learn about scams and scandals, the more hopeless they feel about their potential to reap rewards from the market. The discouraging lesson they take away is that the system is rigged to favor insiders and shut out everyone else.

Michael Brush. Wall Street Bad Boys Are Back! . August 2007.

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