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Editor's Note: It is all too easy to forget the insider-trading rules if you suddenly see a chance to profit or avoid loss through a simple stock trade. The well-publicized case against TV celebrity Martha Stewart presents valuable lessons that are more important than ever in our age of stock market volatility and Wall Street scrutiny. For background on insider trading, see a related article elsewhere on this website.
Recent market volatility and the redoubled scrutiny of Wall Street make this a good time for reviewing the rules against insider trading. It would be a big mistake to assume that the SEC and criminal prosecutors are interested in pursuing only insider trading by people such as hedge-fund managers and Wall Street executives. Recent SEC cases show a renewed interest in detecting and prosecuting insider trading and tipping at all levels of employment or financial gain, both high and low.
You may remember the case of alleged insider trading by TV celebrity Martha Stewart several years ago. Whether you think she was guilty or innocent of insider trading, or that the government should not have brought criminal charges against her, she made a number of rash mistakes that led to her criminal prosecution. You can learn from them to prevent your own "Martha Stewart moment" when faced with a tricky decision about a stock transaction. Pausing to think twice before trading in your company's stock may save you from committing insider trading, which can lead to dismissal from your company, big fines, and sometimes even a prison term.
Company Rules
You may come across confidential information at work and quickly trade or tip without thinking about whether you should. Even though many companies have detailed insider-trading policies and routine blackout periods during sensitive times, employees sometimes forget the rules, or their values, when they have a chance to quickly make money or prevent losing it. In preparing the Think Twice videos for educating people about the dangers of insider trading, I observed that the likelihood of this lapse increases when the information involved is about a supplier, a customer, or a client and not directly about the employee's company.
You may also mistakenly think the rules do not apply to you. Former ImClone CEO Sam Waksal, whose tipping and attempted sales started the chain of events that allegedly prompted Martha's actions, seemed to imply this misunderstanding of the law in an interview from his jail cell. ImClone had nicely drafted insider-trading prohibitions. It sent an email enforcing a blackout/no-trading period in the days before the deadline of the FDA decision on its drug application. Yet these procedures did not stop Waksal from trying to sell his stock, buying put options, encouraging his daughter to sell her stock, and tipping other relatives to sell. (His case provides a much clearer picture of common insider trading and tipping than Martha Stewart's unique case. For details, see the complaint by the Securities and Exchange Commission (SEC).)
Martha's Mistakes
Her obvious mistakes were lying to government investigators and tampering with evidence. These actions turned what might have been an SEC settlement into criminal charges. Apart from this, she fell into three traps.
Develop A Preapproved Trading Plan
Martha claimed she had a stop loss order to sell ImClone stock when it fell below $60 per share. Yet no documentation of this arrangement exists. Whenever you intend to sell stock in the future at certain prices or at certain times of the year, such as to pay for college tuition or a big house renovation, write this down in a formal trading plan (under SEC Rule 10b5-1, adopted a few years ago).
Make this plan at a time when you do not know confidential information about your company. Then, when the preset time or price point comes to exercise your options and sell company stock, or to sell stock you already own, having this document can give you an affirmative defense against any later charges of insider trading.
Brokers May Not Disclose Trades
The assistant of Martha's broker told her about the trading activities of Sam Waksal and his daughter, prompting Martha's decision to sell her shares of ImClone stock. The brokerage firm that works with your company to handle option execution and stock trades by employees and executives may not reveal what insiders are doing with their stock. Therefore, should a broker tell you confidentially that his client, a big wheel at X company, is selling or buying his company stock before this appears in SEC filings (e.g., Form 144 or Form 4), or that his family members are trying to, you want to avoid any dealings with that broker.
Revealing confidential information about other clients' trades, and encouraging you to piggyback on their trades, is a clear violation of NASD and brokerage firm rules. (For more details, see the SEC lawsuit against Martha Stewart, and the subsequent settlement with the SEC.) Martha never explained why, as a former stockbroker and CEO of a public company, she traded after being told this confidential information. Once you know or possess this type of information, it's very hard to convince the SEC that it played no role in your trading decision.
Even after all the trials and settlements, we do not know the full story of Martha's thinking. A chain of events probably led to the improper stock sales. Martha had already sold a big chunk of her ImClone stock in her retirement plan, and she may have kept a small number of shares just out of loyalty to her friend Sam Waksal, the convicted former ImClone CEO. Martha's broker probably encouraged her to sell all the stock, and they talked in general terms about when that would happen, depending on the stock's performance. After the ImClone stock began dropping, she may have started to seriously consider selling it. When she then received the news that even Sam and his daughter were trying to dump their stock, she went ahead with the fateful sale of her remaining shares.
Being Too Smart For Your Own Good
Martha was never told that ImClone's FDA application was going to be rejected, which was the event that caused the stock price to fall. Instead, she inferred this result from nonpublic information about the stock sales of company executives and family members. "Why else would they be selling?" Martha must have thought, thus making the mental connection to the unannounced FDA action and prompting her to sell her stock. Knowing this information at the time of the trade, combined with no formal trading plan to sell the stock when it dropped below $60, was the weakness of her defense and public explanations.
You cannot draw any inferences you want about the future direction of a company's stock price from information you discover, particularly when you learn that information at your job or from some other nonpublic source. Insider-trading law remains somewhat unclear in situations when you are a company "outsider," the information is not from an insider, and the information has value only if you make a two-step connection to the stock price.
Unlike Sam Waksal's very clear case of tipping and trading, Martha Stewart's case falls into this gray area of insider-trading law. Eventually, she settled the insider-trading charges with the SEC. The settlement required a disgorgement of losses avoided ($45,673, including interest) plus penalties ($137,019). It also included a five-year bar from serving as an officer or director, or even in some employee roles, at a publicly traded company.
Admit You Can Learn From Martha
You can be too smart for your own good, thinking you reached a quick brilliant conclusion or that somehow you are entitled to use information that falls into your lap. But this will be hard to explain if the SEC or US Attorney calls. In addition, any information you learn on the job about your company or another company belongs entirely to your company under the "misappropriation theory" of insider trading.
Unlike the other executives marching to trial and settlement, Martha Stewart's actions were not motivated by corporate abuses or insider knowledge of her company. Martha reacted in a rash but very human way when given a chance to avoid a financial loss. As employees, holders of company stock and options, and investors in other companies, we all can learn from these and similar mistakes.
Bruce Brumberg is the Editor-in-Chief of myStockOptions.com and the producer of the Think Twice video series for educating people about insider-trading law (www.insidertradingvideos.com).
