Are You Guilty of Insider Trading?

March 8, 2004

by Andrew Feinberg

When, exactly, do a few words from a colleague, a relative, a poker buddy or a broker become the stuff of insider trading?

When, exactly, do a few words from a colleague, a relative, a poker buddy or a broker become the stuff of insider trading?

Insider-trading laws are filled with gray areas. "My students love when I talk about insider trading because they find it glamorous and because some of the examples are so counterintuitive," says Theresa Gabaldon, a professor at George Washington University Law School. "If you steal information from your employer, for instance, you're in trouble. But a cat burglar can trade on any information he steals." That's because, under securities laws, a burglar doesn't have any duty to the victims of his crime. (The break-in is another matter. And, of course, an aggressive prosecutor could try to bring insider-trading charges.)

On the other hand, if a friend tells you ever so casually that this might be a good week to sell shares of the company for which he works, you could face charges if you act on his advice. It would all depend on the context, on exactly what was said and on his position at the company.

Insider-trading laws came into being after the crash of 1929. Congress enacted the Securities Act of 1933 and the Securities Exchange Act of 1934 to curb common abuses of the era. The 1934 act specifically addressed insider trading, although "insiders" were defined narrowly as corporate officers, directors and owners of at least 10% of a company's stock. Later court cases and Securities and Exchange Commission regulations broadened the definition to include corporate "outsiders" and people who receive illicit tips.

But the line between legal and illegal trading is still murky. Suppose, while on a plane, you discover a top-secret memo that General Electric CEO Jeffrey Immelt left behind describing an imminent takeover bid for Amersham PLC. Can you trade on this information? Absolutely. What if you overhear two GE executives discussing the deal? Again, trade to your heart's content. Granted, the SEC might call you to question your suspiciously prescient trades. But once it learns the details from you or the lawyer you may feel compelled to hire, you will be exonerated, just as Barry Switzer was.

Switzer led the University of Oklahoma football team to three national titles and then won Super Bowl XXX as the coach of the Dallas Cowboys. While sunbathing at a track meet in 1981, he overheard a CEO tell his wife that he'd just hired Morgan Stanley to advise him on the sale of a subsidiary, part of which traded publicly. Switzer called his broker and some friends, and all bought shares of the subsidiary. They enjoyed a nice payday.

Switzer was acquitted at his 1984 trial because the conversation he overheard was not conducted with "an improper purpose," according to the judge who tried the case. Had the CEO instead given an illicit tip to a friend, and had Switzer overheard that, the legal outcome might have been far different.

Critical triggers

As these examples make clear, it is not simply the use of material, nonpublic information that gets you into hot water. You are guilty of insider trading if you are a corporate insider who trades on such information, or if you misappropriate -- that is, trade on -- information that rightly belongs to someone else, such as an issuer of securities. "Misappropriation" applies to an investment banker who trades in advance of a merger deal, for example, or to a printing-press worker who sells information about an article he sees ahead of its publication (as happened in a case involving Business Week some years ago). Tip recipients -- known as tippees -- will often be found guilty, too.

There is another category of guilt that involves the so-called mosaic theory. If you put together disparate clues -- say, the appearance at your company of officials from an acquisitive rival, or the arrival of six wingtip-wearing investment bankers from Goldman Sachs -- and buy stock in your employer because it may soon receive a takeover bid, you will not be congratulated on your cleverness. The SEC may sue you.

As is often the case, specific facts determine the ultimate outcome. For example, what if your brother-in-law, a biotechnology researcher, tells you about a promising new molecule his company recently discovered. Can you trade? "The answer depends on the context," says Christopher Bebel, a partner with Shepherd Smith & Bebel, in Houston. "For instance, is the information material? Would it change a reasonable investor's opinion of the stock? If the product is in a very early stage of discovery, there is probably no problem. But it also depends on how closely guarded this information is."

Or, suppose at a poker game your buddy, a merger lawyer, lets something slip about a deal. This is dangerous territory because you know he sometimes has access to material, nonpublic information. Your friend is probably guilty if you trade. But you might not be in legal jeopardy unless, according to the law, your relationship is such that you should have known that your friend expected you not to act on the information he disclosed to you. If your friend says "this is very hush-hush," you'd be wise not to trade.

In fact, the insider-trading laws were changed three years ago to make prosecutions easier. Under the new rules, it's now assumed that an insider has a "relationship of confidentiality" with close family members. If you show off knowledge of confidential information to your 18-year-old daughter, and she trades on it, you're both in trouble -- if, that is, she had reason to believe it was truly inside information.

The legal concept in question here is "scienter," doing something with fraudulent intent. If you didn't know the information was tainted, you're okay. "The empty-head defense can work," says Bebel. "But willful blindness is not a defense." Translation: If you sell after learning that the CEO and his relatives were bailing out of a stock the day before a pivotal Food and Drug Administration meeting, your failure to see a connection might not be perceived as credible.

But consider an executive who gets sloshed at a bar and loudly divulges inside information. The next day he remembers nothing of what he said. But other bar patrons do, and many trade profitably on the tip. Well, this was an actual SEC case. The SEC sued the tippler -- er, the tipper -- but left the tippees alone.

Big brother watches

Don't assume you can fool authorities by flying under the radar. The SEC periodically targets small fry precisely to discourage such thinking. Recently, the SEC brought a case against a man whose gains totaled all of $500. The SEC and the exchanges have the power to detect virtually every move you make.

Several kinds of activities are sure to arouse the SEC's suspicion. "Buying on margin, buying options for the first time, buying stock for the first time or making a much larger trade than usual are red flags," says Paul Berger, associate director of the SEC's division of enforcement. Acting too close to the date of a major announcement and "doing anything that is out of the ordinary for you as an investor are also warning signs," adds Nancy Grunberg, a former SEC enforcement official.

Guilty or not, lawyers advise against talking to SEC officials if they contact you about insider trading -- instead, have your lawyer answer their questions. You may not have all the relevant information at your fingertips, and if the SEC catches you in a mistake, you could face charges of making a false statement. In addition, people have a tendency to tell stupid lies to government investigators. "You can turn a civil case into a criminal one by lying your butt off," says Ted Sonde, another former SEC official.

The author, Andrew Feinberg, is a columnist for Kiplinger's Personal Finance.

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