Imagine that you receive advance word that one company is planning to take over another, that a big corporation is about to announce that its profits have plummeted, or that an influential Wall Street stock picker is preparing a highly favorable report about a particular stock.
You make a quick call to a broker and parlay that information into a handsome profit. But if you try to get rich quick, do you risk ending up behind bars on charges of illegally trading on inside information?
That depends on who you are and how you obtained the information.
If you are a traditional "corporate insider" -- an officer, director or controlling shareholder of a company -- the answer is not in dispute: If you use confidential information about your company to make money for yourself, you can be sent to prison and forced to pay heavy fines.
If you are at the other end of the spectrum -- some outsider who accidentally overhears inside information -- the answer is also fairly clear.
"I'm the bartender at the Wall Street Club, and I hear two bigwigs talking about a deal," said Columbia Law Prof. John C. Coffee Jr. "If I then go out and trade on that information, I probably am not covered" by the rules against insider trading, except perhaps in a tender offer situation.
The one possible exception -- if the information concerned one company's bid to buy another and the bartender knew the information was coming from corporate insiders, or should have known.
More and more insider trading cases, however, do not fit neatly into either of those packages. Instead, the cases involve allegations against the lawyers, accountants, investment bankers, financial printers or other individuals who work on the edges of a particular deal. Or they are brought against those even further out on the fringes who obtain nonpublic information: investment analysts or risk arbitrageurs who make their livings keeping a close eye on companies, or "tippees" completely outside the trading system.
"Insider trading is really a misnomer," said John F. Olson, chairman of an American Bar Association task force on regulation of insider trading and an attorney with Gibson, Dunn & Crutcher here.
"What we've been seeing is trading by people on the periphery who see an opportunity to make a quick buck without much risk at all. It's trading by people who have obtained a temporary information advantage, and the question is whether they've obtained that advantage properly or not."
Of 50 criminal insider-trading charges brought in federal court in Manhattan, where the bulk of the cases arise, one involved a corporate officer or director, according to a summary released last week by U.S. Attorney Rudolph W. Giuliani. In contrast, four lawyers, seven law firm employes, four investment bankers, two arbitrageurs, 11 stockbrokers and four financial printers were charged with insider trading, along with a police officer, a Wall Street Journal reporter and a dentist.
Because so many of the recent cases involve stock market professionals, there is a growing concern about the essential honesty of the securities industry and the investment process. In the past month the Securities and Exchange Commission has charged First Boston Corp., one of the nation's leading investment banking firms, with insider trading; brought its largest insider-trading case ever against Dennis B. Levine, a managing partner at Drexel Burnham Lambert Inc. who is accused of making $12.6 million in illegal profit; and instituted the first insider-trading proceedings against arbitrageurs, who speculate in the stock of takeover targets.
Government prosecutors face the challenge of proving that the defendants were trading improperly, based on confidential information -- and not taking proper advantage of their own research or the tidbits of information that circulate constantly in financial circles.
"It gets much harder to draw lines between the legitimate activity of analysts and arbitrageurs who are part of our efficient market system and are supposed to dig out information and act on it intelligently, and people who are dealing with information that has been obtained from insiders," Olson said.
"I don't think there's anything wrong in trading on a rumor -- if it is nothing but a rumor -- because you're taking a fair amount of risk," he said. "Trading on a rumor which has been confirmed by talking to somebody inside a company, somebody who has a duty not to tell you, is another matter."
Until 1980, the law on insider trading was fairly simple: Under the prevailing view, anyone in "possession" of significant, nonpublic information had to disclose the information to other investors or abstain from trading.
Then, the Supreme Court decided two cases that discarded the "mere possession" approach and made the law on insider trading much murkier.
In 1980, the high court reversed the insider-trading conviction of Vincent Chiarella, a financial printer who traded in securities of takeover targets whose identities he figured out from documents being printed for the acquiring companies. The court said Chiarella was not in a "relationship of trust and confidence" with the sellers of the target companies' stock, and thus was not guilty.
Three years later, the court overturned the SEC's censure of Raymond L. Dirks, a well-known securities analyst. Thanks to an inside tip from an employe of Equity Funding of America, Dirks helped blow the whistle on an enormous fraud at Equity Funding -- after telling his clients to sell their Equity Funding stock.
An outside "tippee" like Dirks, the court said, is guilty of insider trading only if the inside "tippers" who leak him the information do it for their own "personal gain," and the outsider knows or should know the insiders are breaching their duty.
The cases spelled out the risks for some of the players in the gray area between true insiders and those who accidentally overhear information. In a footnote in the Dirks decision, Justice Lewis F. Powell Jr. dealt with the lawyers, underwriters and others who work closely with companies to put together deals, categorizing them as individuals who essentially become temporary insiders subject to the same restrictions.
The reason for that, Powell wrote, "is not simply that such persons acquired nonpublic corporate information, but rather that they have entered into a special confidential relationship in the conduct of the business . . . and are given access to information solely for corporate purposes."
The Chiarella and Dirks cases left major chinks in the coverage of the insider-trading law -- and prompted new efforts by government prosecutors to plug the holes.
The SEC has a new weapon in most takeover situations where a tender offer is involved. A rule adopted after the Chiarella decision prohibits trading on the basis of inside information by "any person who has possession of material nonpublic information" if the person "knows or has reason to know the information has been obtained directly or indirectly from . . . insiders." In that situation, the eavesdropping bartender could be in trouble.
The SEC invoked the rule in part of its complaint against Levine. However, the rule's validity has not been thoroughly tested in court, and some scholars have suggested it might not survive a legal challenge.
The SEC also has been pressing a new "misappropriation" theory of insider trading. Under this argument individuals trading on inside information -- even though they do not owe a fiduciary duty to those with whom they traded -- violated another duty to their employers or to their employers' clients.
"The government is left to say, 'We've got an unfair card game going here and this guy can't play with five aces, and the law must be such that we can construct a theory that says you can't cheat in the card game,' " said Harvey L. Pitt, a lawyer at Fried, Frank, Harris, Shriver & Jacobson here and a former SEC general counsel. "So far the government has been successful in the lower courts."
The 2nd Circuit U.S. Court of Appeals in Manhattan -- the leading authority on insider-trading cases, short of the Supreme Court -- applied the new theory in a 1981 case involving two investment bankers who "misappropriated confidential information" about proposed mergers and acquisitions, passed it to conspirators outside the firm, and joined with them in trading on it.
"By sullying the reputations of their employers as safe repositories of client confidences," the conspirators "defrauded those employers as surely as if they took their money," wrote Judge Ellsworth A. Van Graafeiland. In addition, he said, they "also wronged the investment banking firms' clients, whose takeover plans were keyed to target company stock prices fixed by market forces, not artificially inflated through purchases by purloiners of confidential information."
In a decision last Tuesday, a divided 2nd Circuit panel gave the theory a wider reach in upholding the insider-trading conviction of former Wall Street Journal reporter R. Foster Winans for trading based on his advance knowledge of stories the newspaper would publish. The convictions of Winans' roommate and of a former stockbroker who traded on the basis of the information were also upheld.
The court found that Winans "breached a duty of confidentiality" to the Journal and therefore could be found liable for insider trading. Even though the Journal itself "might perhaps lawfully disregard its own confidentiality policy by trading in the stock of companies to be discussed in forthcoming articles," Judge Lawrence W. Pierce wrote, "its employes should be and are barred from destroying their employer's reputation by misappropriating their employer's informational property."
In a dissent, Judge Roger J. Miner criticized the majority for extending "the sweep of federal securities laws beyond all reasonable bounds," saying the law "never was intended to protect the reputation, or enforce the ethical standards, of a financial newspaper."
The implications of the Winans case "are enormous," Pitt said. Under the 2nd Circuit decision, "Lots of people are subject to lots of duties" that could be used to support insider-trading convictions.
Pitt cited the case of a New Canaan, Conn., psychiatrist who was treating the wife of a corporate executive. The SEC charged that the psychiatrist learned of the planned sale of the executive's company when the executive asked the psychiatrist to help him break the news to his wife. The psychiatrist then allegedly bought stock in the company and reaped a profit of nearly $27,000. He settled the case without admitting or denying the allegations.
The Supreme Court has yet to rule on the misappropriation theory. Until then, "I think it's safe to say that the commission has captured a lot of people's attention," Pitt said. "It sensitizes every one of us to the fact that there is a need for people to be careful about how they deal with sensitive information."