Insider Trading and Abuse of Power

he second part of the story is undoubtedly of more interest to securities lawyers, judges and law professors, but the rest of you should continue reading. Government abuse is a topic that affects all of us, and unfortunately happens too often. The abuse involves quests for power and attacks on constitutional rights, which of course, affects everyone.

Plus, the story is interesting, and a demonstration of the power that the government has to “get” you, if it really wants to do so.

Insider Trading

First, lets delve briefly into the law. Insider trading which violates the federal securities laws involves buying or selling a security while in the possession of material, non-public information. There is no specific “insider trading rule”, but the law has always been, that in order to violate the law, the person trading on the information had to have a duty to speak – that is – he needed to have an obligation to the company whose information was being used. In the words of the caselaw – insider-trading liability “occurs when a corporate insider trades in his corporation’s securities on the basis of material, confidential information he has obtained by reason of his position.”

I won’t bore you with the details, but in 1985, in a case where I represented a printer accused of insider trading, the SEC attempted to expand the persons covered by the prohibition to include persons outside of the company, in my case, a proofreader at a financial printer. After a three-week trial, and a series of appeals, the government was successful and it became a violation of the federal securities laws to trade on material non-public information, if the trader violated a fiduciary duty, in obtaining the information. (In my case, the defendant was accused of stealing the information from his employer, and using the information to trade. Many other cases have been brought under that theory in the years since). In 1997 the Supreme Court adopted this view, and the SEC expanded its power and jurisdiction over persons who had nothing to do with the securities industry, and breaches of fiduciary duty that had nothing to do with securities firms or issuers.

It took the SEC decades to change the definition of insider trading, and today the definition is that a person is guilty of trading on inside information, if he trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the issuer – the entity whose stock is being traded.There are many commentators who believe this definition is not supported by the varied securities acts, and is an extreme example of judicial legislation, but none of us are on the Supreme Court, and its their opinion that counts, not ours.

The only remaining caveat is that the person accused of the violation must have willfully committed the act; meaning he, or she, must know of the rule that is being violated, and know that he, or she, is violating that rule. This will become important later.Bit by bit that definition was expanded further, and insider trading became trading on information that was obtained in breach of a fiduciary duty from anyone. The Business Week and the Wall Street Journal cases are examples of that expansion – the information that was “stolen” was an upcoming article in the publication, which would move the price of the stock.

I provided this little securities law lesson since the history of inside trading is important. It is important for us to understand that the securities statutes themselves do not make it a crime to buy securities using confidential information that was misappropriated from the source of the information. The statute is what Congress, the body that has the power to create law, enacts. The courts interpret the law, and the executive branch (here the SEC and the prosecutors) enforces the law.

All securities fraud cases brought under Rule 10b-5 must meet the requirements of the statute, which only make illegal frauds, schemes and devices which are conducted “in connection with the purchase or sale of a security”. Clearly, the proofreader’s “theft” of information which he learned about a third party during the course of his employment is not a fraud in connection with the purchase or sale of a security. Assuming it is a fraud at all, it is in connection with his employment, not his stock trading.

One more piece of legal theory. Persons who trade on information that they know, or should have know, was obtained in violation of the insider trading laws, are also liable for insider trading. This concept, known as “tippee liability” has been around as long as insider-trading rules have been in effect. While the legal aspects of the rule are not in dispute, the application of the rule to factual situations can be difficult, at best.In any event, the Supreme Court overruled the lower court, and disagrees with this analysis. The point of this story is that the law of insider trading has already been expanded well beyond its intended bounds, and well past anything that Congress intended.

Even under this greatly expanded definition of insider trading, Martha did not trade on inside information. At best, according to the indictment, she sold her stock because she was told that Sam Waskal was selling his. She might have assumed that he was selling because there was a problem with the company, or even with the FDA approval, but Martha did nothing wrong, and even cooperating witnesses do not say that she was aware of the pending FDA action. All she knew, and all she was told, was that Sam Waskal was selling.

I submit, and I believe the indictment supports this proposition, that Martha did not violate even the greatly expanded insider trading rules. She did not breach any fiduciary duty to ImClone; in fact, in selling her stock she did not breach any duty to any person or entity. She was fully and completely entitled to sell her stock simply because Sam Waskal sold his. It is also clear that the US Attorney’s office agrees with this assessment of the case, since they did not obtain an indictment for insider trading.

But what then of the SEC? Are they simply misinformed regarding the law or the facts, and thus commenced civil proceedings for insider trading? Of course not, but they do have another goal in mind, aside from suing Martha. The other goal? Another expansion of the definition of insider trading.

This time, the definition is going to be that a person is guilty of insider trading when he trades on information which is not public, but is obtained from someone who breaches a fiduciary duty to anyone, regardless of the type or source of the information, or even the connection between the issuer and the information. You see, the SEC is alleging that the broker, Peter violated his fiduciary obligation to Merrill Lynch when he told Martha what another customer was doing. Telling Martha that Sam was selling violated Merrill Lynch’s internal rule and policies regarding the confidentiality of customer information. And the SEC is alleging that Martha knew, or should have known, that Bacanovic was violating internal Merrill Lynch rules when he disclosed Waskal’s sales.

Thus, the new theory is, Martha Stewart violated Rule 10b-5 because she traded on information regarding the securities transactions of a corporate officer, obtained by her by virtue of a breach of fiduciary duty by her broker, to the corporate officer’s brokerage firm. And no one is alleging that Martha breached any duty to any person.

The case is hardly a slam-dunk, if the SEC can win it at all. The SEC is going to have to prove not only that the law supports the theory, but that the sales, or pending sales, were not public knowledge, that broker did in fact breach his fiduciary duty to Merrill Lynch, and that Martha knew that the information was not public, and that the broker was breaching a duty in telling her that Sam was selling.


Not an easy task, and the SEC knows it is not easy. According to the New York Times, the federal prosecutor admitted that insider trading allegations against Martha would be “unprecedented.”

Take a look at the civil complaint, it is replete with logic stretches in order to plead that Martha knew that the broker was breaching a duty – for example, that since she was a Merrill customer, she knew that her broker could not share trading information of another customer. I don’t know if that is true, and I don’t know that its a breach of a duty by the broker, but I do know that if Sam told the broker it was alright to share his information with Martha, there is no breach, regardless of what the duty is supposed to be.


The Really Cheap Shot


While the media is full of headlines proclaiming that Martha was indicted in an insider trading scandal, and that she was indicted for securities fraud, no major media outlet has picked up on the fact that the indictment is for obstruction, perjury and manipulation of MSLO, not ImClone.


The cheap shot is the prosecutors are using Martha’s public statements in defense of herself, as the basis for an allegation that she lied to the public in order to stop the price of MSLO from declining! I don’t pretend to know every market manipulation case that has been decided over the last 70 years in this country, but I am willing to believe that no manipulation case has been so thin, so flimsy and so outrageous as this one.


First, lets understand that it is not a crime to lie. It is certainly unseemly, immoral, a sin, and in some cases a breach of fiduciary duty, but it is rarely a crime. It is a crime when you lie about something important, and you are under oath, and it is a crime when you lie about something important to a government employee, but it is not a crime to stand in front of a group of reporters and to proclaim your innocence from criminal charges. I submit that it is not even a crime to stand up in front of a group of reporters to deny criminal charges, and to lie about where you were on the night of the crime, or to put forth some fabrication about preexisting stop loss orders.


It is not a crime because our Constitution prevents it from being a crime. We all have a right to free speech, and a right to defend ourselves. That right is an important part of our constitutional protections, and is even more important when you are speaking to defend yourself from accusations that have not formally been brought, and that have been leaked to the press by the government itself.


What kind of government leaks stories to the public, and then prosecutes the subject of the stories when she tries to defend herself in front of the same press? There are a few governments that might try this nonsense, but I thought that one was just toppled and the rest of them are on the other side of the world.


Quite honestly, this is nonsense, and a tact that is unworthy of the United States Government. Apparently they have Martha dead to rights on the perjury claim. They have a witness, the person who passed the information to her, telling the truth. They have forensic evidence that the broker altered his notes, and they even apparently have evidence that Martha altered the tape recording on her answering machine. (I am giving the government the benefit of the doubt here – the indictment alleges that she did that, and I am hoping that the government has proof of their allegation before they put it in an indictment. My criminal law partner is laughing at this assumption, but lets assume for the moment that they can prove that allegation.)


You have her on perjury. You have her facing approximately 20 years in potential jail time. Her career is ruined, her standing the community is destroyed, and she is facing permanent expulsion from the company she created and made a national entity. Why in the world would you risk a slam-dunk to attack her constitutional rights, and to include the flimsiest counts of market manipulation in such an indictment?


Here is where I should be answering my own question but I cannot do it. I cannot come up with an answer to that question, which leaves, as the only explanation that we are dealing with a vengeful prosecutor, and prosecutor who is more concerned about headlines than about justice


Categories: Corp Finance