If You Buy and Sell Individual Stocks, Do You Know the Insider Trading Rules?
From time to time, insider trading cases pop up in the financial news. Years ago, there were a flurry of cases including the big case of billionaire hedge fund manager Raj Rajaratnam garnering plenty of attention. He was found guilty on 14 counts of securities fraud and conspiracy and was sentenced to 11 years of jail time in addition to paying large financial penalties (more on this later).
Rajaratnam was one of numerous investment industry folks being prosecuted by the Securities and Exchange Commission for insider trading. In speaking with various industry professionals and regulators, I have been struck by sometimes divergent points of view on what does and does not constitute insider trading.
I decided to subject myself to a quiz designed to assess one's knowledge about the insider trading rules. The quiz was developed by Robert Heim, Principal and former SEC investigator with the law firm of Meyers & Heim.
I didn't do too well on the quiz (which is below) - I only answered four of the eight questions correctly, and this despite the fact that the quiz questions had yes-no answers! "Insider trading rules include a lot of gray areas and the rules are not as clear as they should be. Unless you're a lawyer who specializes in the area, you're not going to know all the details," says Heim.
As I suspected, Heim's quiz is designed to test the "grayer" parts of the securities' laws so that made me feel just a little bit better about my performance. But, the intricacies of the insider trading rules should strike some fear into any person who invests in individual stocks and who tries to gather research and information on a company's business, customers, competitors, etc. Frankly, the risk of violating insider trading rules is another reason to do what I do and invest in mutual funds and shun stock picking!
Test Your Knowledge
If you've ever traded or will trade individual stocks, you should be aware of the insider trading rules. For each of the eight questions below, on a sheet of paper, write down ‘Yes' or ‘No' in response to each of these questions (the answers are at the end of this article):
- Nancy is a trader at a hedge fund concentrating in technology companies. She occasionally speaks to John, a former executive of a tech company who left the position two years ago. John tells Nancy that the tech firm, in which Nancy owns shares, had systemic inventory problems when he was there. May Nancy's fund sell the shares of this technology company?
- John also told Nancy that he read an article reporting that the technology company recently lost one of its key customers. In fact, John learned this information from a phone call with his friend who is a vice president at the company - he lied to Nancy and said the information came from an article. Is Nancy guilty of insider trading if she sells shares of the company?
- Peter is a psychologist whose patient is Fred, a manager at a publicly traded oil exploration company. During one of their sessions, Fred tells Peter that next week his company will announce a major new oil find on one of the company's properties. Peter does not trade any stock of the oil company but he tells his brother about what Fred said. Unbeknownst to Peter, his brother buys shares in the oil company and makes a substantial profit. Is Peter guilty of insider trading?
- Mary and Robert are married and Robert works for a publicly traded computer services company. Mary owns a large number of shares in her husband's company. One evening at dinner Robert tells Mary that the long term CEO of his company is resigning unexpectedly, and the news will be announced the following week. May Mary sell her shares in John's company since she does not work at the company?
- Janet is a secretary at a medical research company. She never has access to drug trial results before they're announced but one evening she was working late and noticed that someone had left a report in the copier. The report said the company's important new drug had performed very well in a recent clinical trial and the results would be announced the following week. May Janet purchase shares in her company before the announcement?
- Thomas is a student at a local college. One day while sitting in a local park he overhears two investment bankers sitting on a bench next to him discussing a forthcoming acquisition of a small public company at a significant premium. May Thomas purchase shares in the target company before the announcement?
- Joseph and Brian work as train repairmen for a publicly traded railroad. One morning they noticed the president of the company was giving a tour of the rail yard to five men and women in business suits. Later that same day their boss asked Joseph and Brian to count all the rail cars in the yard and prepare a report with the count. Joseph and Brian assume the railroad is in play and preparing for a sale. May Joseph and Brian purchase shares of their company?
- John is the vice president in the human resources department of his company. He is not involved in the preparation of earnings announcements but he learns from a co-worker that his employer will make an earnings announcement next week that is significantly better than what analysts expect. May John purchase stock in his company because he was not involved in preparing the earnings announcement?
Punishing Insider Trading
After my humbling performance on the insider trading quiz, I delved further into what would get an investor in trouble with the SEC by asking former SEC investigator Robert Heim. He conducts training sessions for broker-dealers and hedge funds to educate them about insider trading rules.
"Technically for insider trading to have taken place, there's a requirement that the person knew they were doing something wrong. Judges, however, are pretty loose in the requirements here," says Heim. And beware that just because you didn't make a profitable trade yourself, judges can see intent if you passed along inside information to say a family member who profited from a trade based upon information you provided.
The punishments for insider trading can be severe. In addition to having to pay back all profits from such trades, the SEC can also levy penalties of up to three times the profits (this is generally reduced to one times profits if you settle before trial).
In addition to the financial punishments, there's also the prospect of jail time. According to Heim, sentencing guidelines are based upon the length of time over which the illegal conduct took place and the size of the profits. The range of sentences goes from several years for a minor offender to up to about 20 years.
If you trade individual stocks, to learn more about the insider trading regulations, at a minimum, you should familiarize yourself with the SEC guidelines on the topic. However, as I said earlier, the more I've learned on this topic, the more I feel better off investing in mutual funds!
In an op-ed in the Wall Street Journal Yale Law School professor Jonathan Macey said the following about the recent prosecution of insider trading cases by the SEC:
"Decades ago, Justice Lewis Powell, speaking for the court in Dirks v. SEC, made clear that traders should be free to collect information and trade on it. Imposing a duty to abstain from trading in a stock "solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market." The court added that it is "commonplace for analysts to ferret out and analyze information and this often is done by meeting with and questioning corporate officers and others who are insiders."
The Supreme Court recognizes that if a person acquires information in the course of legitimate business activities, like research or mining sources appropriately, then he has a right to that information and should be able to trade without disclosing it. The government, on the other hand, espouses a socialist philosophy that valuable information belongs to the people-regardless of how it was obtained...
For decades, the SEC has kept the insider-trading rules vague and undefined. This ambiguity increases the SEC's power and allows government lawyers to pick and choose among prosecution targets.
Some, though by no means all, trading on the basis of informational advantage is and should be illegal. But the government should be compelled to provide clear guidance as to what constitutes illegal insider trading and what constitutes legitimate, albeit aggressive, research.
Answers to the Insider Trading Quiz
- No. Even though the information is two years old, unless the company's inventory problems have been made public it's likely that a court and the SEC would consider the information to be material.
- No. In order for Nancy to be guilty of insider trading she must know that John obtained his information from a source at the company. Since he told Nancy his information was from an article, she is not guilty of insider trading.
- Yes. Peter is guilty of illegal tipping and can be held liable for the profits made by his brother plus substantial fines.
- No. The CEO's resignation would be material information and since she knows it is nonpublic she may not sell her shares.
- No. Because Janet learned of the drug trial results in the course of her employment, it's insider information. It does not matter that Janet normally does not have access to drug trial results.
- Yes. Thomas may purchase the shares of the target company because he has no duty to either company not to use the information about the acquisition he overheard.
- No. The SEC has sued people for insider trading on similar facts on the theory that the information learned by the rail workers rose to the level of being material.
- No. John may not purchase stock in his company because he is in possession of material nonpublic information that he learned from his coworker. It is irrelevant that John normally does not usually learn about earnings announcements in his job.