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 Keeping on the Right Side of Insider Trading Laws

A friend or broker calls you with a hot stock tip. Should you follow it? You overhear an executive talking in the gym about company plans. Can you act on that information? One of your psychiatric patients discloses a major corporate deal in a therapy session. Can you rush out and buy stock? With marquee cases such as ImClone (and the related Martha Stewart prosecution) offering cautionary tales about the perils of insider trading, how can individual investors and brokers keep from crossing the line?

Insider trading is such an important and complicated topic that Bill Tyson, Wharton Associate Professor of Legal Studies, Accounting, and Management and Associate Professor of Law at the University of Pennsylvania Law School, uses it to open the NASD Institute at Wharton Certificate Program, a program for financial services industry professionals and regulators. Tyson and Co-Academic director Eric Orts, Wharton Professor of Legal Studies and Management, recently explored some of the complex challenges of understanding and following insider trading regulations.

Murky Legislation

The concept of insider trading is fairly clear. Senior executives and others privy to material information about future company moves should not be able to take advantage of that information for personal gain at the expense of other shareholders. But the laws are fairly murky and don't even mention the term "insider trading," which means that much of insider trading law has been left to the courts to sort out after the fact. "Everyone knows when you see this conduct, you shouldn't be allowed to do it," said Tyson. "It is like stealing information and profiting from it."

The laws that govern insider trading today were formulated after the stock market crash of 1929, with the passage of the core securities and exchange acts of 1933 and 1934, and the creation of the Securities and Exchange Commission (SEC) to enforce them. By forcing the disclosure of insider holdings and allowing the company and investors to recover damages from improper trading, the legislation sought to discourage executives from engaging in short-swing transactions from which they would reap gains.

Since the courts were left to sort out what was meant, a "legislative acorn grew into a judicial oak," Tyson said (citing the Supreme Court's description). In particular, three cases that have come to the U.S. Supreme Court have shaped the interpretation of the law:

  • Although the government lost the Chiarella v. United States case in 1980, involving a printer who benefited from an advance look at documents his company printed for corporate takeover bids, the case emphasized the fiduciary responsibility of insiders to either disclose material, nonpublic information or not trade at all.

  • The 1983 Dirks v. SEC case involved an analyst at a broker-dealer firm who received inside information about company malfeasance and passed it along to clients who traded on it before it became public. Because the inside tipper revealed the information as a whistle-blower, rather than for personal gain, the government lost its case. But the court affirmed that a person receiving a tip (tipee) who knows it was the result of a breach of the insider's fiduciary duty also violates the statute. The loss of this case, however, troubled the SEC; and nearly 2 decades later, it attempted to tighten regulations through Regulation FD (Fair Disclosure) in 2000. "Before FD, because of the Dirks case, brokers could get material, nonpublic information and give it out selectively to clients," Tyson said. Instead of going after this issue directly, the SEC attacked it through requiring more complete disclosure of all material information.

  • The third case, O'Hagan, brought against an attorney working at a law firm that represented a bidder in a planned tender offer, brought forward the concept of misappropriation. Without publicly disclosing his knowledge of the tender offer, the attorney bought securities in the target company and then sold the securities at a substantial profit after the public announcement. Although the lawyer did not have direct fiduciary responsibility to the target company, he was held responsible for misappropriating this inside information for his own benefit.

Tyson said that while laws are sometimes deliberately left vague to make it harder for people to find loopholes, he advocates more clarity. "While I think all this behavior is wrong, criminal laws are supposed to spell out in vivid detail what wrongful conduct is," he said. "O'Hagan went to jail based on a Supreme Court decision that defined the law after the fact. The law should tell you what you are supposed to do."

Staying on the Right Side

Given these uncertainties, what should investors do to avoid ending up on the wrong side of insider trading laws? Tyson and Orts recommend:

  • For "hot tips," consider the source: If you receive a stock tip, you need to consider the source. "If you have reason to know that your broker or friend has access to inside information, then you are potentially liable," Orts said. "Especially if the information involves a pending takeover, the law is quite strict. If you know for sure that a tip involves inside information, then you are almost certainly liable under current insider trading rules and should not trade." On the other hand, if the advice is based on the broker's own analytical skills, you could trade on it, Tyson said. "Analysts sometimes get immaterial information from corporate insiders, but they put it together using their own analytical skills to form something that is material. You have to be careful because you never know whether they got the whole tip from the insider. As an investor, I'd err in the direction of caution."

  • Don't ever lie to cover up: This is one of the lessons of the Martha Stewart case and the recent conviction of Credit Suisse First Boston trader Frank Quattrone. They were both convicted of obstruction of justice. Stewart might have made a better case admitting that she received the information and leaving it to the government to prove that she knew the information was not public. "You should never lie or try to cover up," Orts said. "Prosecutors hate lies perhaps more than anything else. Try not to do anything wrong; but if you make a mistake, it's much worse to lie about it. Disclose the problem, retain good counsel, and do the right thing going forward."

Laws continue to be strengthened. For example, the SEC is considering a recent NASD-proposed rule that would require Chief Compliance Officers (CCOs) to meet annually with CEOs to certify compliance procedures for registered broker-dealers, modeled after Sarbanes-Oxley principles. "The consequences could be quite significant," said Orts, "with greater organizational importance and perhaps appreciation of compliance professionals, but perhaps greater risks of legal liability as well." While the United States still has the most robust insider trading and disclosure laws, regulators in Europe, Japan and other parts of the world have been implementing new insider trading directives.

Postscript

And the questions at the start of the article? While there are no easy answers, there are some cases that have addressed similar challenges. On the issue of overhearing conversations, an Oklahoma football coach found himself in court when he overheard executives on the sidelines of a game discussing the planned liquidation of a company. The coach bought shares before the news was public and sold them afterwards, for a gain of $98,000. He also told friends about the stock tip. But while the executives were careless with their conversation, there was no indication that they tipped for personal gain, and the government lost its case.

The psychiatrist acting on information from a patient faces a more serious situation. In 1986, psychiatrist Robert Willis traded on information he received from his patient, the wife of Citigroup CEO Sanford Weill, that her husband was trying to become chairman of Bank of America and the company would receive financial backing if he was successful. While Weill never made the move, the doctor made more than $27,000 after the plans were disclosed. Willis pled guilty to insider trading and was sentenced to 5 years of probation and a $150,000 fine.

   

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