Quiz: Spot the Inside Trade

by Illustrations by Evan Wexler

The rules of Wall Street can be tricky business, but when it comes to insider trading, the Securities and Exchange Commission says there should be little confusion. In Rule 10b5-1 — the SEC’s main prohibition against insider trading — the agency states that a trade becomes illegal when one side of the deal acts based on what’s known as material, nonpublic information: proprietary information that can move a company’s stock.

In practice, the law isn’t always so cut and dry. The government has stepped up enforcement, but with that crackdown, say critics, has come greater confusion over what counts as legitimate information to trade on, and what can get you in trouble.

So where exactly is the line? We picked six examples from the annals of trading history to provide some perspective. See if you can tell the difference between deals that ended well for the accused and those that were ruled illegal. Good luck.

Scenario #1: Right place, right time

While sitting in the stands at a track meet, you happen to overhear a high-level executive tell his wife that his firm will soon be liquidated. The next day, you tell two friends about the information and together you buy tens of thousands of shares in the executive’s company. You sell them days later for a combined profit of roughly $600,000.

Is it insider trading?

Yes

No

Answer: No

Answer: No

In 1981, Barry Switzer, then the head football coach at the University of Oklahoma, said he heard about the liquidation of Phoenix Resources, an Oklahoma City oil firm, while sunbathing at a university track meet. The SEC brought a case against Switzer, but a judge threw it out, ruling that the coach had no duty to ignore a public conversation about a company he was not involved with. “That’s the rule,” said Peter Henning, a professor of law at Wayne State University. “If you overhear it, you can trade on it.”

Scenario #2: The family tip

Two railroad workers have a hunch that their company may be for sale after seeing several businessmen touring their firm’s rail yards. They tell four relatives that a deal could be in the works, and together all six go on to earn more than $1 million after loading up on shares of the company.

Is it insider trading?

Yes

No

Answer: Possibly

Answer: Possibly

As far as the SEC is concerned, the above scenario counts as an illegal deal. In 2007, Gary Griffiths and his nephew, Cliff Steffes, realized their employer, Florida East Coast Industries, might be for sale when they noticed “people dressed in business attire” being shown around the rail yard. The SEC alleged that as employees, Griffiths and Steffes were subject to a code of conduct that prohibited them from trading company stock if they knew significant nonpublic information about the firm.

Critics call the case an example of SEC overreach. “I would say that these people didn’t really have inside information, they merely had seen some investment banker types walking around the rail yards,” said John Coffee Jr., a professor of law at Columbia University. “This is not an example of the law working at its best.”

In 2012, Griffiths agreed to pay $120,000 to settle the allegations, without admitting or denying wrongdoing. Steffes is still fighting the charges.

Scenario #3: The shareholder advantage

A CEO calls his company’s largest investor to tell him the firm is planning a private stock offering. He says the information is confidential, but the investor sells his stake in the firm anyway, avoiding roughly $750,000 in losses when the stock offering is made public.

Is it insider trading?

Yes

No

Answer: No

Answer: No

The SEC believed so, but in October, a federal jury rejected SEC claims that Mark Cuban, the billionaire owner of the NBA’s Dallas Mavericks, engaged in insider trading when he sold his stake in the Canadian internet firm Mama.com.

The case was a test of the “misappropriation theory,” which in essence says that corporate “outsiders” have a duty not to trade on confidential information provided by a company insider. The idea behind the theory was to keep an attorney, for example, from obtaining information from a client and then trading on it. But the Cuban case added a new wrinkle to the theory: What happens when an investor is given unsolicited confidential information?

“The heart of the Cuban case is that just because you’re a shareholder, that doesn’t make you into an insider,” explained Henning. In other words, Cuban had no duty or obligation to Mama.com to not trade on the information. “He got information, was not obligated to refrain from trading, therefore, not liable.”

Scenario #4: A Loophole for Lawmakers?

A U.S. congressman attends a closed-door briefing in which top officials from the Treasury Department and the Federal Reserve warn of a high likelihood of decline in the markets. The next day, he makes a series of short-term options trades — in essence a bet against the economy. He collects a profit of $5,715.

Is it insider trading?

Yes

No

Answer: No

Answer: No

In 2012, the Office of Congressional Ethics cleared Rep. Spencer Bachus (R-Ala.) of wrongdoing after investigating a series of trades he made during the height of the financial crisis. Bachus was said to have completed the trades based on information obtained during a closed-door policy briefing with Federal Reserve Chairman Ben Bernanke and former Treasury Secretary Hank Paulson.

The case against Bachus was the first of its kind involving a member of Congress, and it brought attention to a loophole that once allowed lawmakers to trade on non-public information gleaned through their legislative roles. Soon after Bachus was cleared, Congress passed the STOCK Act, a bipartisan bill designed to prevent lawmakers from trading on inside information.

Of course even with the STOCK Act in place, policing insider trading in Washington can be tricky, says Henning. That’s because it’s hard to prove that a lawmaker can know for certain what impact a specific policy decision might mean for a company.

“It really starts to get vague,” says Henning. “The easy [insider trading] cases are fortunately easy. Merger announcement, bang, I know the company. If Congress is going to cut back on the defense budget, who is that going to impact? Lockheed Martin? Boeing? How do I assess that as inside information?”

Scenario #5: Stitching together a mosaic

A hedge fund manager makes a series of lucrative trades based on research from analysts at his firm and conversations with industry consultants. Some of those consultants have access to nonpublic information, but the manager doesn’t trade on just a single thread of data. Instead, he culls together various tidbits of information from every nook and cranny of the market to stitch together a picture of a company.

Is it insider trading?

Yes

No

Answer: Could be

Answer: Could be

The so-called “mosaic theory” has been a popular defense in insider trading cases, but not always an effective one.

In Raj Rajaratnam’s 2011 trial, for example, attorneys for the former head of the Galleon Group argued that Rajaratnam’s most successful deals were actually based on legitimate research and publicly available data, such as newspaper articles, analyst reports and company press releases.

The defense didn’t hold up. While he may have been piecing together disparate pieces of information, federal authorities also caught Rajaratnam on wiretaps matter-of-factly swapping material, non-public information with corporate insiders and other traders.

In other instances, the mosaic theory can be perfectly legitimate.

“The courts have basically said that the mosaic theory is OK, but you better be damn sure that every little piece of the mosaic is not material,” said Stephen Crimmins, a partner with K&L Gates and a former trial attorney for the SEC’s enforcement division.

Scenario #6: The broker says sell

The CEO of a drug company sells his stock in the firm after learning that the Food and Drug Administration has rejected its application for a new cancer drug. The executive’s broker relays the sell-off to another of his top clients, recommending that the client also unwind his stake. The client takes the advice, shedding nearly 4,000 shares just one day before the FDA announces its decision.

Is it insider trading?

Yes

No

Answer: Most likely

Answer: Most likely

In 2003, the SEC charged Martha Stewart with insider trading after she sold her shares in the biopharmaceutical firm ImClone Systems based on a tip from her broker. The SEC also charged ImClone CEO, Sam Waksal, and their broker, Peter Bacanovic, alleging all three acted on nonpublic, inside knowledge of the FDA’s decision. Waksal pleaded guilty to insider trading and was sentenced to 87 months in prison and ordered to pay $3 million in fines.

Stewart and Bacanovic also served jail time, but for the charge of obstructing justice and making false statements, not insider trading. Both went on to settle their insider trading charges with the SEC as well. Stewart paid $195,000 in fines and penalties, while Bacanovic was fined $75,000. Neither was forced to admit or deny wrongdoing.

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