First it was Martha Stewart. The imbroglio began last December, when ImClone Systems Incorporated (NasdaqNM: IMCL) was unable to obtain a U.S. Food and Drug Administration (FDA) review of its application to sell its newly developed treatment for colon cancer, Erbitux.
The FDA appears to have first given the news of its denial to the brother of ImClone CEO Samuel Waksal on December 25. The bad news initiated a $19 million selloff of stock by employees and associates of ImClone beginning on December 26. (ImClone’s share price had hovered around $30 in March of 2001 before increasing about 133 percent, to $70, by December.)
On December 27, two of Waksal’s daughters, his father and sister, and his ex-girlfriend, Martha Stewart, all sold their ImClone stock. Stewart successfully sold 3,928 shares; Waksal himself attempted to sell about 80,000 but was prevented from doing so by two different brokerages. Waksal was arrested by the FBI on June 12; he was released after posting $10 million bail.
Stewart moved off the federal radar in April, when she told the FBI that she had an oral “stop-loss” agreement with her Merrill Lynch broker (and former ImClone employee), Peter Bacanovic. Bacanovic backed up Stewart’s story that there was an unwritten stop-loss agreement in place to execute sales of Stewart’s ImClone holdings should ImClone’s share price dip below $60.
This all changed on June 21 when Bacanovic’s assistant, Douglas Faneuil, denied the existence of even an oral stop-loss agreement between Stewart and Bacanovic. Federal investigators now have their sights set on Stewart for possibly lying to the FBI. “We’re going to keep dogging her,” one investigator told Newsweek, even as Stewart will continue to muster evidence of the existence of such oral orders.
Waksal and Stewart might come to regret that they didn’t have the savvy of some executives at Apple Computer. It turns out that six Apple executives, led by Apple CFO Fred Anderson, sold almost 2 million shares of Apple stock worth about $49 million between April 22 and May 31 of this year. The last of these sales came almost three weeks before Apple’s June 18 warning that its second-quarter revenue would not meet expectations.
After the revenue news, Apple’s share price fell from roughly $24 to $17. Not surprisingly, this wasn’t the first time such questionable sales took place at Apple. Three of the same executives who participated in this year’s selloff (along with the senior vice president of hardware engineering) sold about 370,000 shares for more than $21 million back in August 2000.
This selloff conveniently took place before a Sept. 28, 2000, earnings warning. The stock’s price fell from $53.50 to $25.75 after the Sept. 28 warning. What likely saved the Apple executives from a lot of grief is that they were careful not to push the envelope too far. No obvious selloff occurred before a December 5, 2000, earnings warning. During all of 2001, relatively few sales took place.
Appearing on Fox News Channel’s “O’Reilly Factor” on June 24, Wall Street Journal editorial-page editor William McGurn downplayed the seriousness of the investigation of Stewart conducted by the U.S. attorney for the Southern District of New York, the Securities and Exchange Commission (SEC), and a House Commerce & Energy subcommittee. McGurn’s argument was that Martha wasn’t an employee of ImClone, therefore she couldn’t be guilty of insider trading.
This, of course, is nonsense under the current judicial interpretation of securities laws. It is correct under an archaic and narrow interpretation of securities laws known to some commentators as the classical theory of insider trading.
According to this theory, individuals who purchase or sell shares of Firm A’s stock on the basis of material, nonpublic information while not directly employed by Firm A are not guilty of trading on inside information. Such “quasi-insiders” (e.g., Stewart and members of the Waksal family not directly employed at ImClone at the time of their stock sales) are not “true insiders” and can’t be penalized for making economic gains through access to inside information.
This theory first congealed in the wake of SEC v. Cady, Roberts and Company (1961), where a broker was notified by a company director that his company was cutting its stock dividend. The broker sold shares in discretionary accounts he controlled, reaping abnormally high gains for some of his clients. Such abnormally high gains constituted de facto price discrimination in an era of fixed commissions.
Fixed commissions had been in place on the NYSE since its founding, but by the time of Cady, they were seriously eroded by institutional investors bargaining for lower commissions on large trades. Fixed commissions were ended by Congress in 1975, having been effectively eradicated by the same market processes that had so undermined them by the time of Cady.
At the time, the Cady indiscretion--if it can be called that--normally would have been handled inside the boundaries of disciplinary action against the broker by his/her employer. Instead, the SEC took action against Cady on the basis of its broad Rule 10b-5 (in turn based on the vague Section 10[b] of the Securities Exchange Act of 1934) and oddly framed its case as a broad strike against inside trading. The hardly coincidental effect was the renewed bolstering of the brokerage cartel’s fixed-minimum commission system (more on that later).
The Supreme Court gave its approbation to the narrow classical theory in Chiarella v. United States (1980), where Vincent Chiarella, while working for a firm that printed documents for companies engaged in takeovers, earned more than $60,000 (in 1991 purchasing power; see Haddock) from 1975 to 1976 by trading on inside information. The Supreme Court reversed Chiarella’s conviction by a lower court because he held no fiduciary position within the companies whose shares were traded.
The SEC (at least outwardly) didn’t seem to care for this opinion--which restricted its ability to go on fishing expeditions like that surrounding ImClone--so it sought to establish a regulatory precedent against quasi-insiders. The hoped-for precedent was SEC v. Dirks (1983). Dirks was an insurance-company analyst who was informed of accounting irregularities at Equity Funding of America (EFA) by a company insider. Dirks pushed the story to a Wall Street Journal reporter, who showed no interest. Dirks then successfully persuaded some of his firm’s clients to sell EFA’s shares.
When the Journal finally decided to pursue the story, Dirks’s intermediation was brought to light, and he was indicted by the SEC for insider trading. Luckily for Dirks, the Supreme Court came to the rescue and exonerated him, declaring that insider trading didn’t occur because Dirks didn’t receive the information from an insider who had benefited as a result of providing it. Since the tipper wasn’t guilty of insider trading, neither were Dirks and his multiple tippees.
The implication of Dirks was that corporate managers could offer inside information to analysts and brokers who could benefit from it as long as the managers providing the information didn’t appear to benefit. The court went so far as to assert that such disclosures promoted the public interest by serving as a means for bringing information to the market.
By some accounts, the SEC begged to differ, viewing selective disclosure (and its accompanying selective benefits) as “unfair,” and spent close to two decades trying to eradicate it. The supposed culmination of this process was the SEC’s August 2000 adoption of Regulation FD (fair disclosure), which requires corporations to disclose to the public all information given to analysts, brokers, and select small or institutional investors through press releases or SEC filings.
The Supreme Court gave its approval to the ostensive SEC campaign against quasi-insiders in U.S. v. O’Hagan (1995). O’Hagan was an attorney in Minneapolis who learned that one of his firm’s clients, Grand Met, planned to take over Pillsbury. O’Hagan purchased a large quantity of Pillsbury options with a strike price of $39. When the share price of Pillsbury rose to almost $60, O’Hagan earned more than $4 million.
The Supreme Court ruled on June 25, 1997, that O’Hagan could be prosecuted for insider trading even if he held no fiduciary position with respect to Pillsbury. Thus, the second legal theory of insider trading, the so-called misappropriation theory, was recognized and upheld.
Some commentators (McGurn included) have speculated that Martha Stewart, either because of her fame, wealth, and/or connections to the Democratic establishment, will in the end not be indicted or imprisoned for insider trading or other offenses associated with her ImClone stock sale. If this turns out to be correct, it should then be quite obvious (not that it isn’t to some of us already) that the SEC and the rest of the federal government is only interested in selective application of its regulatory precedents.
Whose interests does the SEC favor? Recall that at the time of Cady (1961), the brokerage cartel’s system of fixed commissions was under assault, and inside information was being used to effectively lower commissions to certain clients (through the earning of abnormally-high market returns in discretionary accounts). Seven years later, in SEC v. Texas Gulf Sulphur (1968), the SEC took aim at “true insiders” and curiously declared its mission to make material nonpublic information equally available to all investors.
Keep in mind, this was 30 years before the broad spread of 24-hour cable news channels and widespread use of the Internet. With all corporate insiders now out of the way, who was next in line to reap the greatest benefits? Analysts and brokers were the next in line on the information totem pole.
While the outward trappings of Dirks might seem to argue against the cartel-enforcement theory, another view is that the SEC knew it could (and history will show it did) overlook selective disclosures to analysts. Regulation FD (requiring concomitant disclosure of material non-public information to analysts and the public) came 39 years after Cady and after information dissemination had become much more efficient in the age of CNBC and the Internet.
In other words, the cartel returns from selective disclosure became dissipated away, and the SEC’s inaction (highlighted by outparty market professionals and some small investors) became too conspicuous and costly for the agency to maintain.
Regardless of whether one accepts this story, some commentators seem convinced that the SEC’s level-information playing field has been achieved by cable news channels and the Internet. Even if this were so, the two mediums still wouldn’t be effective arguments for restrictions on insider trading. The usual arguments about the fairness of arbitrary circumstances as a source of economic gains outside the world of equity markets would apply here.
Also noted (by others) are the economic gains from inside information via abstention of trading. Empirically, the disparate treatments of Apple and ImClone seem to show (at least so far) that enforcement depends on the discretion of insiders in their sales, among other factors. The other side of this situation is the ominous case of the executive who truly is ignorant of certain material nonpublic information, who buys/sells shares, and then the following day, material information is disclosed, sending share price rocketing up or down.
For those who take the SEC at its word, if insider trading was a major factor behind the fall in the Dow average in October 1929, why did the SEC wait 27 years to launch its war on insider trading and then wait an additional 39 years to bring about fair disclosure?
Here are some other angles: If equality of information is a peculiar right to investors (as opposed to equal rates of interest between varieties of spendthrifts), why isn’t equal access to the market? Why has the government attempted to ensure equality in dispersion of information but not in its use? Surely differential net gains exist in use every bit as much as they exist in transmission. (Juxtapose a wealthy broker with my student Yalonda, who doesn’t yet have the savings to meet the minimum-investment requirement of online brokerages with real-time trades.)
Why has the SEC undertaken a mission in information egalitarianism that favors certain classes of investors/strategies? Surely this is an inequity that also needs to be fixed by say, further intervention to keep corporations at least in a narrow range of capitalization. Why is there such an emphasis on short-term realizable gains or losses? And while we’re on the subject of equal treatment, if Microsoft is a monopoly deserving of legal pursuit and remedy (including possible breakup), then what type of market structure does the National Association of Securities Dealers represent?
