Insider Trade Ethics on Wall Street
It is a little known fact that there two types of insider trading — legal and illegal. Usually, when we think of insider trading, we think of only the illegal, unethical acts of individuals trying to make their millions in a shady, underhanded way. Not necessarily true. Legal insider trading is merely the act of a “corporate insider” like an officer or director of a company buying and selling stock within their own corporation and reporting it to the Securities Exchange Commission (SEC).
The illegal form of insider trading involves an individual, whether inside or outside the company, utilizing information about a particular stock that is not known by the public. And there are three aspects to illegal insider trading. “Tipping” involves the person who transfers this type of information to a second party who uses it to trade securities. Next is the actual trading of the stock by the individual who has been tipped. Finally, illegal insider trading involves the person who both misappropriates the non-public information and then uses it himself to trade (SEC).
Because illegal insider trading has long marred the face of the stock market, and upset the American public’s confidence in Wall Street and in the integrity of those who occupy positions of trust, the SEC takes infractions very seriously. Penalties are severe for the slightest misuse of this public trust and the SEC’s vigilance over the past decade has increased significantly. Its enforcement of this one particular aspect of the securities market has become its top priority. Despite that, insider trading continues as the following examples demonstrate.
Members of the U.S. Senate and justices of the U.S. Supreme Court can trade stocks based on non-public information and not be held legally liable for illegal insider trading. There are approximately a thousand federal departments in the U.S. government. These are the only two that have absolutely no rules against illegal trading.
The House of Representatives at least, has a rule in its ethics manual that gives a “slap on the hand” to Congresspersons and says that they should “never use any information coming confidentially to them in the performance of their governmental duties as a means to make a private profit.” It is not at all surprising to know that this rule is not legally binding (ProCon.org).
Does this offer these government officials an unfair advantage based on information the public does not have? Georgia State University accomplished a study in 2004 that showed that stock trades by U.S. Senators outperformed the market average by 12.3%. Trades by corporate insiders performed 7.4% better than the market average. Trades by the average American investor underperformed the market by 1.5%. According to the U.S. Securities Exchange Commission, insider trading is in part “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” (ProCon.org).
There are those who will argue that these individuals are not “insiders” so the SEC rules can not apply. There are those who will say that they are insiders because they have inside information that no one else has due to their positions on committees, etc. that deal with these financial matters and they have many people they know who are insiders.
It is this type of unethical behavior by those with inside information that places a black mark against the equities market, and against “insiders” who feel they are above the law.
A friend of Martha Stewart, Sam Waksal, who was CEO of ImClone, a biotechnology company, received information that the Federal Drug Administration (FDA) was about to decline ImClone’s application for approval of its cancer drug, Erbitux. Having this information, Waksal called his stock broker, Peter Bacanovic. Bacanovic was on vacation, so he talked to Doug Faneuil, Bacanovic’s assistant, and advised him to sell Waksal’s stock in ImClone. Faneuil advised Bacanovic of the situation by phone. Bacanovic told Faneuil to advise Martha Stewart of the ImClone stock situation. Faneuil called Stewart and told her that the ImClone price would drop due to Waksal’s cash out. Stewart sold all her shares one day before the announcement of the drug’s rejection by the FDA, avoiding a $45,673 loss (Hoffman).
There is no question in anyone’s mind but Martha Stewart that this clearly met the definition of illegal insider trading based on “tipping” of information from an insider. After that trade, Merrill Lynch and the SEC investigated Stewart’s trade which also led to talking with Bacanovic and Faneuil. Unfortunately, in her first interview with the SEC, and under the advice of her attorney, Stewart lied, and in collusion with Bacanovic and Faneuil fabricated a story about the “coincidental” sale of her stock at just the right time but without insider information, based on a previously agreed to sell price with her broker. However, her assistant witnessed Stewart erasing from the computer, the message from Bacanovic discussing the pending ImClone price decline
Clearly, this was illegal insider trading, and, in a further “stupid” move, Stewart lied to the SEC. The amounts involved were so small, had Stewart not lied, the matter probably would have been dropped or a minimal, non-prison sentence involved as punishment. And the ultimate irony for Stewart was that the amount of money she would have lost would equal about .006% of her total wealth — in other words, nothing.
Again, it is the unethical deceit and “above-the-law” attitude that originates with insiders and rich, corporate executives which gives the stock market a black eye and the American taxpayer a much-jaded view of the entire equities trading process and of corporate America.
Corporate insider trading is illegal, so those who do it should be prosecuted. But why is it such a vilified crime? There is a simple answer. It’s personal. Those who do it are held in such strong contempt because officers of corporate America who illegally and unethically use non-public information for their own greedy purposes, can impact the price of the stock millions of Americans have spent their hard-earned dollars purchasing. And when stocks take a hit because of the illegal insider trading, the American economy suffers. People lose significant portions of their life savings, their jobs at companies affected by the cheating, and their spending decreases. In some cases, their children can’t go to college because that money, invested in 401K funds of the company, can be reduced or wiped out. Multiplying the effect is that the leadership of the company is lost and band-aids need to be applied to hold things together. More layoffs follow and the company’s performance, at least short-term, flounders, and, at worst, fails.
When Enron imploded, the cost to its 4,000 employees was their jobs and most of their life savings. Of course, millions of investors also lost billions of dollars. Was that all caused by insider trading? No, but Jeffrey Skilling, ex-CEO of Enron, was found guilty of several counts of illegal insider trading for selling his personal shares when he knew the company was going down. And he did this while telling his employees that Enron was in good shape and they should hang on to their own shares which they ultimately lost completely.
And the impact of the Enron scandal still lingers in investors’ minds today as a classic example of corporate mismanagement, illegal insider trading, and loss of business ethics and human morals. It still shades the perspective of the market and stock investments. Potential investors in corporate America have become much more astute and knowledgeable today than they were a decade ago because of corporate scandals like Enron.
Recent Illegal Insider Trading
Though one might believe that, with all the bad publicity and the public already up in arms, illegal insider trading would subside. But, just a few months ago, the SEC charged eleven people in two different cases (Krantz):
Liberty Mutual Insurance acquired Safeco in 2008. Anthony Perez, who worked for Goldman Sachs, knew about the deal and “tipped” his brother, Ian, in time for Ian to buy and then sell call options. He made a $152,000 profit. Peter Talbot, a former Hartford Financial analyst, told his nephew he had heard that Safeco was a target in the above case. Both of them bought call options for six days and earned over $600,000 in profit. At the same time, though independently, a woman who worked for Safeco with knowledge of the deal, “tipped” her husband, who made a $118,000 profit.
Odyssey Investment Partners’ acquired Neff in 2005. Advance information was utilized by six individuals to profit using insider knowledge of the acquisition. The wife of Neff’s CEO told her father. He made 14 separate purchases of the stock and ended up with an $84,000 profit. Meanwhile, in an unrelated incident, Thomas Borell, an attorney, learned from the brother of Neff’s CEO of the acquisition, and ended up with a profit of almost $1 million (Krantz).
And in separate cases, in November of this year, the SEC charged that Zvi Goffer, a Manhattan stock trader, was tipped by an insider about Bain Capital’s then-pending acquisition of 3 Com in 2007. Goffer made over $300,000 from the illegal deal. As the case expanded, 13 others were also charged. Altogether, they had acquired approximately $40 million or more in profit during the years 2006-2009 (Krantz). And the list could go on and on.
Conclusion – How Does Illegal Insider Trading Affect the Market and Economy?
Unfair advantage. Violation of transparency. Disruptive of a properly functioning market. Investors no longer invest. It begins with the first one and ends with the last. Trading in the market, whether by a professional or an amateur is based on skill and luck. One investor can perform better in the market because he or she learns how to acquire more skill in analyzing equities. But, if one person has an advantage such as inside corporate information no one else has, and he uses it to trade, he now has an unfair advantage (Heakal).
Transparency is now violated in the market. Transparency means that the same information is distributed so that all purchasers of stock receive it at about the same time. So that’s where skill and luck enter the picture in how an individual stock trader chooses to use the information. But now the unfair advantage of the illegal trader violates that transparency and disrupts the natural flow of the market. The other investors lose confidence that they can compete and stop investing.
Illegal insider trading does affect both the market and the economy as a whole. To what extent it affects the economy is a matter of debate and it is also dependent on the magnitude of the losses experienced by the insider trading. It affects the labor market mostly for more senior managers of corporations and it impacts the quality of management decisions that are made.
When corporate insiders are allowed to trade on inside information they make decisions that might affect them personally rather than keep the well-being of the corporation and its employees in mind. It also makes the insider more reluctant to distribute what might perhaps be crucial corporate information to others in lieu of keeping it to himself knowing that he might profit from it. The result of that is managers and directors of the company who would normally receive that information in order to more effectively operate the company are uninformed and their decisions are based on less than adequate knowledge. The company suffers. Shareholders may not have full knowledge either since the insider is keeping valuable information to himself.
The insider may also choose projects for the company to invest in that maximize his own profit and advantage rather than that of the shareholders.
What happens because of all of this is that the company, the investors, the market, and the economy are all affected because of the results of these activities and the resultant decrease in the quality of the company, its stock, and in its investors’ confidence in continuing to invest not only in the company but in the market as a whole. Once massive investor confidence is lost, the economy of a city, area, state or the country can be negatively impacted. A snowball effect occurs and negative leads to more negative, much like the recent “depression” the country is still suffering from. This is not to imply that this recent economic downturn is caused solely by insider trading, because it definitely was not. But the devastating, lasting effects can be the same.
Heakal, R. “Defining Illegal Insider Trading.” n.d. Forbes Investopedia . 18 December 2009 .
Hoffman, D. “Martha Stewart’s Insider Trading Case.” 1 July 2007. allbusiness.com. 18 December 2009 .
Krantz, M. “On warpath, SEC charges 11 with illegal insider trading.” 15 July 2009. usatoday.com. 18 December 2009 .
ProCon.org. “Should Insider Trading by Congress be Allowed?” 11 August 2009. ProCon.org. 18 December 2009 .
SEC. “Insider Trading.” 19 April 2001. Securities and Exchange Commission (SEC). 18 December 2009 .
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