Would You Be Guilty of Insider Trading?

published 2 May 2011

If you’re an active investor who occasionally buys or sells a stock based on tips, you might be understandably nervous about the massive insider trading crackdown surrounding Galleon Group. The now-defunct hedge fund is linked to more than 20 guilty pleas and more than two dozen arrests involving an array of alleged conspirators, including lawyers, consultants and investment managers.

Editor's Note: On May 11, 2011, after the original publication of this story, hedge fund billionaire Raj Rajaratnam, a managing member of Galleon, was found guilty of 14 felonies -- nine counts of securities fraud and five of conspiracy to commit securities fraud. Each securities fraud conviction carries a maximum penalty of 20 years in prison and a $5 million fine. The ruling marks the 35th insider trading conviction over the past 18 months for the U.S. Attorney's office for the Southern District of New York.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-200-80.png

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

No. If this couple bought or sold shares -- or called you and tipped you off in private -- it would be a violation. But illegal insider trading requires that you not only trade on the basis of important nonpublic information but that you also have some sort of duty to keep the information confidential. Former football coach Barry Switzer was sued for insider trading following a similar scenario in 1981, but he won the case because he had no duty to ignore a conversation he overheard in a public place.

For you? No. For them? Maybe. Executives can sell their own company’s stock without running afoul of the rules as long as they’re not trading based on information they haven’t shared with the public. The SEC sued Countrywide’s CEO, Angelo Mozilo, and several other insiders in 2009 (after the company had been acquired by Bank of America), alleging that they had improperly traded on undisclosed information about the evil lurking inside the company’s loan portfolio. Mozilo, who netted some $140 million selling Countrywide stock before the company collapsed, eventually settled the suit without admitting or denying guilt by paying $67.5 million in fines and disgorging profits.

A woman in your Bunco group says she’s about to quit her job because she can’t stand the strain of working in a medical office where all the patients are dying. Because of previous casual conversations, you know that patients in this office are involved in early trials of a new drug. You know what the drug is and who makes it. You sell short shares of the drug’s developer, betting that the stock will fall in value. Did you violate insider-trading rules?

This probably would not qualify as insider trading. Your playing partner is sharing information that’s so general it can’t be used to gauge whether the clinical trial will result in failure. Thus, the tip fails the materiality test. It’s not significant enough to the company’s stock price. And because the woman is just sharing information about the status of the office’s patients and not the trial (including whether the ailing patients are taking the new drug or a placebo), no one appears to have a duty to keep quiet.

Yes. You’ve been fed important information from an insider, who has said that the information was confidential. The SEC recently filed an insider-trading case against two individuals -- a hedge fund manager named Joseph “Chip” Skowron and a medical researcher, named Yves Benhamou, who was overseeing a drug trial. The SEC alleges that Skowron paid Benhamou with envelopes stuffed with cash for confidential information about the results, which he then used to avoid tens of millions in stock losses on his holdings in Human Genome Sciences. Benhamou pled guilty; the case against Skowron is pending. The hedge fund Skowron worked for settled without admitting or denying guilt.

Maybe. The SEC filed suit against homemaking personality Martha Stewart in 2003 with these exact facts. Stewart did end up going to prison -- but not for insider trading. She was convicted of obstructing justice and lying to prosecutors. Stewart settled the SEC’s insider-trading case, paying a fine and agreeing to never violate securities laws in the future. The settlement eliminated the need for a trial as well as a definitive answer about whether she had “a duty” to ignore the tip. But the case was complicated by the fact that Stewart had once been a stockbroker. The SEC contended that she should have known better.

This situation probably would not be considered insider trading. The key to the case against Galleon CEO Raj Rajaratnam, says Stoltmann, hinged on whether his lawyers were able to establish that his trading was based on assembling a “mosaic” of information or whether he paid “consulants” to feed him insider tips. The former, says Stoltmann, is perfectly legal. The latter is not. (See the above Editor's Note for an update on the case against Rajaratnam.)

Topics

Stock Watch

Kristof, editor of SideHusl.com, is an award-winning financial journalist, who writes regularly for Kiplinger's Personal Finance and CBS MoneyWatch. She's the author of Investing 101, Taming the Tuition Tiger and Kathy Kristof's Complete Book of Dollars and Sense. But perhaps her biggest claim to fame is that she was once a Jeopardy question: Kathy Kristof replaced what famous personal finance columnist, who died in 1991? Answer: Sylvia Porter.