Introduction
Employees and shareholders of companies can sometimes use the insider information available for trading. However, insider trading is illegal activity when non-public information is used to gain an advantage over other traders. Modern legislation regulates all transactions related to inside trading to create fair conditions in the market. However, it is sometimes difficult to determine the circumstances of illegal trading and the use of inside information, as shown by Martha Stewart’s case.
Insider Trading
Insider trading is a subject of controversy and is sometimes considered an illegal activity. It can be defined as a “trade of a company’s securities is undertaken by people who by virtue of their work have access to the otherwise non-public information” (“Definition of ‘insider trading,’” n. d.). In US, The Securities and Exchange Commission (SEC) regulates the rules and monitors transactions related to insider trading. SEC defines that an illegal insider trader “has non-public, material information, and uses this information to violate his or her duty to maintain the confidentiality of such knowledge by using it for financial gain” (“What is insider trading and why is it illegal,” n. d.). In other words, insider trading implies selling or purchasing stocks or other securities using information which is not publicly available. Thus, the trader may receive financial benefits based on insider knowledge, to which he or she has special access. This type of trading is often considered illegal as it violates rules and regulations aimed at creating a fair environment for all traders in the market.
Legal Insider Trading
Insider trading is not an exclusively illegal activity which includes legal conduct as well. Legal insider trading refers to situations “when corporate insiders, officers, directors, employees and large shareholders, buy and sell stock in their own companies” (“Insider trading – the legal and illegal, 2021). All information about transactions between corporate insiders and related transactions must be reported to the SEC. Such information is submitted to the SEC through the completion of Forms 3, 4, and 5, and the Commission provides detailed information on how to fill them. Legal insider trading does not provide insiders with any advantage over other market participants. In recent years, the legislation related to insider trading has expanded and implies responsibility for any information which is obtained in violation of a relationship of duty to any person.
The SEC is gradually tightening its rules for insider trading and handling cases related to it. In particular, rule 10b5-1 implies that to prohibit insider trading, the Commission does not need to prove the fact of using insider information to make a profit. The fact that the trader has material information is sufficient for the Commission, on the basis of which it is concluded that he or she may have been involved in illegal insider trading (“§ 240.10b5-1 trading,” n. d.). Thus, this rule puts all insider traders at additional risk. However, rule 10b5-1 also implies that a trader can prove the legitimacy of his or her activity if it was part of a contract or obligation related to the future trading plan (“§ 240.10b5-1 trading,” n. d.). Thus, if an insider trader has planned the trading activity and has a legal written confirmation, and later gained access to non-public information, then such trading is considered legal. Thus, the SEC strives to maintain fairness in the market for both insiders and other traders.
Illegal Insider Trading
Insider trading is legal or illegal based on how fair is the advantage which trader has gained from using insider information. Illegal trading refers to “buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, on the basis of material, non-public information about the security” (“Insider trading,” n. d.). If a trader uses information which is available to a small group of people and gains significant financial benefits from using it, then he or she is violating the regulation. Access to such information allows the trader to be aware of a potential increase or decrease in the company’s trading value, which gives him or her an unfair advantage over other market participants (“What is insider trading and why is it illegal,” n. d.). Thus, a person who possesses material information can use it to gain trading benefits, which is considered illegal.
However, information can be considered material and subject to insider trading only prior to its public release. Thus, an insider is a person who has a connection with the business and access to its non-public information. However, the role of the insider is to maintain a fiduciary relationship with the company and shareholders. When an insider uses non-public information to make a profit, he or she is violating the agreement by prioritizing personal interests instead of the interests of the business. SEC can monitor illegal insider trading activities by observing the trading volumes, which usually increase after the company releases public information. However, if no information was provided, but volumes still rise, then SEC initiated an investigation and examine trading activity occurred.
However, insiders can also transfer information to third parties outside of the company, who can later use it for profit. Disclosure of confidential information by insiders to third parties for profit is also illegal. Insider information is considered illegal when it gives an advantage to traders. However, if such information is used after its public release, it is still legal since no advantage over other traders is used.
Martha Stewart’s Insider Trading Case
A well-known case related to insider trading is the Martha Stewart case. ImClone Systems Inc. was founded in 1984 as a biopharmaceutical company, in which Marta owned significant shares (Rawls, 2009). In 2001, a colon cancer drug, Erbitux, developed by the company, was under review by the United States Food and Drug Administration (FDA) (O’Rourke, 2004). However, after meeting with FDA officials, it became clear that the new drug may not receive FDA approval, as was reported internally. At that time, the information was not official or public, as the company still had hope for approval. The CEO of Harlan Waksal sold his shares for $ 50 dollars two days later (O’Rourke, 2004, p. 4). He later stated that the Board of Directors knew about his decision a few weeks before trading, but there was no confirmation of his words.
Martha Stewart, as the owner of a significant share of the company, also sold it two days before the public release of the information on Erbitux disapproval by the FDA. Thus, she managed to avoid a $45,673 loss by selling shares before ImClone’s stock fell by 16% (Moffatt, 2020). While it was obvious that Harlan Waksal was using inside information to trade illegally with Martha, the proof was more difficult. During the investigation, it appeared that Martha did not use non-public information about the FDA’s disapproval of the drug but a tip from broker Peter Bacanovic, who also worked with Waksal. Bacanovic knew that Waskal was urgently selling its shares but did not know for what reason, which he informed Martha.
Thus, it was necessary to prove that Stewart had violated any obligations since there was no direct evidence of the use of non-public information. However, she was also not affiliated with the company and did not have a duty towards it that could be violated. Ultimately, the prosecution failed to prove illegal insider trading, so they charged covering the facts of the case. Martha was sentenced to five months in prison, a $ 195,000 fine in a related case, and the removal from her position of the CEO of her company Martha Stewart Living Omnimedia, for five years (Moffatt, 2020). Thus, the case shows that it is not always possible to interpret insider information and its use unambiguously, and some cases remain controversial.
Conclusion
Martha Stewart’s case is a great example of how circumstances play a key role in insider trading. On the one hand, it is evident that she knew about unfavorable conditions within the company, which made her sell her stake. On the other hand, it is impossible to prove that she is not just an extremely far-sighted or lucky person. Either way, the use of inside information for personal financial benefit is a serious threat to the markets, so SEC control is justified. Insider trading should not be used in the interests of certain people, as it creates unfair conditions and destroys business opportunities.
References
§ 240.10b5-1 Trading “on the basis of” material non-public information in insider trading cases. (2000). Code of Federal Regulations. Web.
Definition of ‘insider trading.’ (n. d.). The Economic Times.
Insider trading. (n. d.). U. S. Securities and Exchange Commission. Web.
Insider trading – the legal and illegal. (2021 ). The Law of the Financial Markets.
Moffatt, M. (2020). Martha Stewart’s insider trading case. ThoughtCo.
O, Rourke, J. (2004). Martha Stewart Living Omnimedia Inc.: The fall of an American icon. Public Relations Review, 30(4), 447-457.
Rawls, K. L. (2009). Martha Stewart and insider trading. Faculty Publications and Presentation, 3, 1-9. Web.
What is insider trading and why is it illegal. (n. d.). Legal Resources.