Insider Trading

http://en.wikipedia.org/wiki/Insider_trading

This is a very important topic, because it seems to be the rule that investors most often get in trouble over, and the consequences can be extremely serious. It's especially tricky because there is a legal and crucial investor method called "scuttlebutt" which can cross the line into the illegal use of material nonpublic information if you aren't careful.

http://meyersandheim.com/how-to-win-an-insider-trading-case/

Questions to answer:

Q: What is insider trading? What activities count as insider trading?

Here's the SEC on the issue: http://www.sec.gov/answers/insider.htm

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.
[...]
The SEC adopted new Rules 10b5-1 and 10b5-2 to resolve two insider trading issues where the courts have disagreed. Rule 10b5-1 provides that a person trades on the basis of material nonpublic information if a trader is "aware" of the material nonpublic information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-existing plan, contract, or instruction that was made in good faith.

Rule 10b5-2 clarifies how the misappropriation theory applies to certain non-business relationships. This rule provides that a person receiving confidential information under circumstances specified in the rule would owe a duty of trust or confidence and thus could be liable under the misappropriation theory.

Insider Trading—A U.S. Perspective, a speech by staff of the SEC
http://www.sec.gov/news/speech/speechar ... pch221.htm

An excellent history of insider trading laws:
http://www.sechistorical.org/museum/gal ... /index.php

Mark Cuban on insider trading:
http://blogmaverick.com/2014/01/21/my-f ... -schvacho/

My understanding of insider trading law is that in order for it to be insider trading, there must be some violation of trust. In other words, if someone walked up to you and said “Im the CEO of this public company and I’m about to make the biggest cash sale in the history of the company and we will blow away all wall street numbers and you should buy the stock”. That is without question material, non-public information. But if you trade on the information, is it insider trading ? The answer as best I understand the law is NO. It is not insider trading. Why ? Because the CEO did not ask you to keep the information confidential. Nor did he ask you not to trade on the information. You have no responsibility to him. You can trade and tell the world about his deal if you would like.

The CEO may be in trouble for any number of reasons, but the person receiving the information will not be. Trading on insider information is not illegal. Nor is receiving insider information illegal. It becomes illegal insider trading when you tell that CEO that you not only agree to keep that information to yourself, but you also agree not to trade on it (And for those of you keeping score at home, in my case the CEO never asked me to keep the information confidential. He sent me an email after we talked saying i was free to give information about the deal to anyone that i chose to, and that they were free to call the investment banker for the deal (who as a practice did not ask or require a confidentiality agreement) to get as much information about the deal as they wanted. The SEC chose to ignore these facts)

In any event, I bring this up because NO ONE truly understands what is legal and what is not legal when it comes to insider trading. This SEC has made the conscious decision (a huge mistake IMHO) to regulate through litigation. IN other words, they love the confusion around insider trading laws. They realize that when you combine this legal confusion with the authority and unlimited resources of the SEC, it is incredibly easy for them to bully and intimidate individuals and companies into settling their cases. Which in turn creates the box scores that SEC attorneys use to get their next job. Of course none of this helps protect the markets or improves investor confidence in the markets or improves capital formation , but no one at the SEC seems to really care about these issues.

2016.05.23 - NYT - How to Get Away With Insider Trading

Q: Why is insider trading illegal?

Q: Where exactly is the line drawn between legal scuttlebutt and illegal insider trading?

From the SEC cases I've heard about so far, it looks like the SEC is mainly concerned with people who make money by getting prior knowledge of some specific secret announcement that will affect the stock price. Examples: a merger with some company, whether a drug is likely to be approved, whether a crucial patent will be approved, whether some contract was won, etc.

What I'm wondering is, 1) if you're doing scuttlebutt and talk to some employees of a company you own stock in at a bar and find out the CEO is a drug addict, is it insider trading to sell your stock before it becomes widespread knowledge? It seems like it's material nonpublic information. And 2) if you use that information to refrain from investing in the company at all, is that still illegal on your part (even assuming that it was illegal on the other guy's)?

A:
re: 1 - It may depend on whether the employee signed a confidentiality agreement that would prohibit him from sharing that kind of information. If that's the case, then whenever you are investigating a company it is crucial to find out what the confidentiality agreements of its employees state.
re: 2 - I haven't heard of a case like that yet, but I would guess that the courts would rule it to be just as illegal (again, assuming that the other guy was breaking the law by giving you the information). If the other guy wasn't breaking the law then you wouldn't be either.

Q: What exactly counts as "nonpublic" information?

Q: What exactly does the law say?

Q: Why do people engage in insider trading?

Here's my initial general answer: people trade on inside information when the perceived expectation value of doing it is positive. So the real question is, when will these people perceive the expectation value to be positive?

1. Managers may engage in insider trading if there's no other way for them to make the money that they need/want to make to maintain their fund and/or style of living, or if they're facing losses and feel intense pressure to do whatever it takes to escape from those losses. The below quote paints a pretty scary picture of how much pressure someone can face to get sucked into insider trading.

Mr. Skowron, known as Chip, had pleaded guilty this summer to avoiding $30 million in trading losses for his Morgan Stanley-owned hedge fund, FrontPoint Partners, by bribing a French doctor to leak him confidential results about clinical drug trials.
Source: http://dealbook.nytimes.com/2011/11/18/ ... o-5-years/

2. They don't realize they're engaging in insider trading. (this has not been the case in the stories I've heard so far, but it seems possible, especially in borderline situations)
3. They don't think they will get caught.
4. The combination of the risk of getting caught and the penalty when caught is outweighed by the gains they can make.

Q: What can investors do to minimize the odds that they'll feel pressure to engage in insider trading in the future?

1. Keep your living expenses down - Having an expensive lifestyle will put pressure on you to make a lot of money.
2. Avoid being around people with high incomes &/or expensive lifestyles who are therefore applying pressure for you to do the same.
3. Avoid living/working around people who are engaging in insider trading or are likely to do so in the future. Being around them may make you underestimate the likelihood of being caught, and may make you feel pressure to follow their lead.
4. Avoid being in situations in which you'll be exposed to inside information that you know will affect the stock price of the company. Knowing that you could make money from this information will put pressure on you.
5. Pay someone to monitor all of your communications so that you'll be caught by your own employee before you're caught by the US Government:

SAC takes strong measures to prevent traders from dealing in insider information, investors say. Cohen's staff of 800 includes 20 legal and compliance workers who, among other things, monitor instant messages and e-mails, including those sent and received by Cohen.

Source:
http://www.washingtonpost.com/wp-dyn/co ... 802_4.html

Q: Assuming that a given investor feels no motivation to solicit inside information (the Q above), what can that investor do to minimize the odds that they'll be given inside information when doing scuttlebutt?

Some ideas:
1) get copies of the confidentiality agreement(s) that the company has employees sign
2) before talking to people, explain what information you're not allowed to have
3) come up with very specific questions to ask people (employees) so that you minimize the chances that inside information will spill out. This is what trial attorneys do when calling people to the witness stand: they ask very specific predecided questions so that all and only the information they want comes out of the witness's mouth.

Q: How do people get caught engaging in insider trading?

It looks like there are several ways that people get caught.

Someone reports you [Confirmed]
In 2011/2012 there have been a lot of stories about various hedge fund managers getting swept up in an FBI investigation. It seems like the FBI is using the same tactics against insider trading that helped destroy the mafia: you catch one guy and give him a choice between a long prison sentence and a plea bargain agreement in which he reports other people who have engaged in insider trading and agrees to serve as a witness against those people. [That's how the movie Goodfellas ends, for example].

Agency monitoring of the Internet [Confirmed]
The SEC monitors the Internet for leads. It doesn't look like they had an automated system as of 2006, but they'll probably eventually have one. From what I can tell it looks like they may just rely on their investigators randomly coming across tips via comments on articles on the Internet. If they're doing Google searches then forum posts would also be coming up in their results.

The insider trading investigation of Mark Cuban, the billionaire owner of the Dallas Mavericks basketball team, began more than two years after the trading took place, when a lawyer for the Securities and Exchange Commission discovered a post in an Internet chat room suggesting that the trading was illegal, according to an S.E.C. report released Friday.

Here's what the actual report says: [it looks like the source was an online article, and these were comments on the article]

On or about December 6, 2006, while conducting an investigation of another PIPE transaction, then SEC Enforcement staff attorney, and current Assistant Director, [NAME-CENSORED] came across the following instant message exchange dated July 2, 2004:
Billionaire Mark·Cuban Sells His Stake in Mamma.com
VERY SUSPICIOUS TIMING OF HIS SALE ... I AM SURE THE SEC WILL LOOK AT THIIS
Reply: very SUSpICIOUS.
Reply: CAN U SAY JAIL TIME?
Reply: after the SEC is through with him, he'll need a benefactor.

Broad agency monitoring of stock activity [Some evidence for this]
I don't know if the FBI/SEC are doing this, but it seems plausible, and wouldn't be illegal: they could set up an automatic computer program that detects if there's been a surprise announcement that affects the stock price of a company, and then the computer program could check if the stock price & volume in the weeks prior to that announcement were unusual. For example, Mark Cuban sold 600,000 shares of Mamma.com before it announced that it would be diluting people's stock; I don't know what Mamma.com's average daily volume was at that time, but I wouldn't be surprised if it had a noticeable effect on the reported volume. The problem with this method is that it wouldn't tell them who was doing the trading; it could only alert them that there may have been illegal trading going on. They would need to do more investigating to figure out who was doing the trading.

Here's some evidence that they're doing something like this:

We opened this investigation in March 2004 into the Internet search engine Mamma.com after the company's stock price increased by over 200% over a two-day period with trading volume of twenty times available float. [taken from the SEC Inspector General report on the Mark Cuban case]

What isn't clear is whether they were tipped off by a news article about Mamma.com's price move or instead by a broad computerized system. Given my understanding of the level of technological sophistication available to most government agencies, I would guess the former (they were tipped off by a news article).

Broad agency monitoring of traders' brokerage accounts [Possible]
This is a more specific version of the method above. I don't know if the FBI/SEC are doing this (or if it would even be legal), but again, it seems like it would be a smart way for them to check for illegal activity: They could have a computer program monitor the trading accounts of people to check for unusual trades right before surprise announcements were made that affected the stock price of the company. For example, the SEC complaint against Zirinsky et al mentions that looking at the trading accounts of the defendants showed that the trade involving inside information was clearly abnormal behavior. Even someone who didn't know that the person was trading on inside information could have looked at the account and seen that something was amiss.

Q: How many SEC / FBI investigators are there assigned to investigating insider trading?

From the SEC press releases I've seen, there seem to be 2-3 SEC employees assigned to the typical case. IDK if SEC employees each work on more than one case at a time (I would imagine so, otherwise that'd be really boring). I'm not sure.

The SEC's budget was $1.32 billion in 2012 [Source], but IDK how much of that went to investigating insider trading.

Q: How many people have been charged/convicted of insider trading?

Provisional answer: around 100 per year are charged. Idk yet what the conviction rate is.

Here's a list of insider trading cases filed by the SEC from 2001-2006:
http://www.sec.gov/news/testimony/ts092606lct-exa.pdf
I didn't actually count all the names in that list, and a bunch of the cases are against multiple defendants, but it seems like they went after around 600-1000 people in those 6 years.

Q: What have been the punishments for insider trading?
It looks like the initial punishment is that you need to forfeit the money you made and pay a penalty based on the amount you profited. It looks like the penalty is somewhere around 15% of your profits, but it may very well vary depending on the situation.

Q: If you're having a conversation with a manager about some stock and you lie and say that you have material inside information that the company is going to do X which will increase its share price, but it's not true, does that manager still have to cease trading in that stock? Would it be a crime for them to continue to trade in that stock?

My initial guess is that it would depend on whether or not your claim is believable. In addition, the SEC seems to seek damages in proportion to the profits gained, so if the person doesn't make any money off the tip then the SEC may not waste the time going after the guy.

From the quote that follows it seems that if you think you're getting inside information then you're not allowed to trade in that stock: "Rule 10b5-1 provides that a person trades on the basis of material nonpublic information if a trader is "aware" of the material nonpublic information when making the purchase or sale." But if the manager can use emails to prove that he was planning on investing in the company anyway, and that this extra piece of information was not a factor in his decision, he may be safe.

Stories on investors who have been charged with insider trading:

2012/02/10 - California Fund Manager Charged With Insider Trading
http://dealbook.nytimes.com/2012/02/10/ ... g-charges/
Basically this guy had a hedge fund and was living near and friends with people in the industry in which he was investing. He repeatedly asked for tips and was eventually successful at getting them. He got caught because he was getting tips from someone who was also giving tips to other people, and when the authorities nailed those other people they forced them to give them more names (I guess?) and that led to his getting arrested. So it's kind of like how the mafia were brought down, or how the dictatorship in Argentina in the '70s ended the resistance movement there.

Douglas F. Whitman, the founder of Whitman Capital in Menlo Park, Calif., surrendered to the F.B.I. on Friday. Federal prosecutors accused him of using confidential information to trade in the shares of Google, Marvell Technology, and Polycom, netting $900,000 in illegal profits.

The case against Mr. Whitman hinges on tips he supposedly received from Roomy Kahn, a former Intel executive and tipster at the center of the Galleon case, and Karl Motey, a former technology-industry analyst. Both have pleaded guilty to insider-trading charges and are cooperating with authorities.

Ms. Kahn, a friend and neighbor of Mr. Whitman’s, once rebuffed Mr. Whitman’s request for insider tidbits for fear of getting caught, according to the Securities and Exchange Commission, which filed a parallel civil case on Friday. But Mr. Whitman pushed back, threatening to cut off their relationship if she wasn’t going to be a “slimeball” anymore, the S.E.C. said.

About.com - Understanding Insider Trading
http://beginnersinvest.about.com/cs/new ... 02702a.htm

Just what constitutes insider trading? The question is much trickier than it seems. In order for the SEC to prosecute someone for insider trading, they must prove that the defendant had a “fiduciary duty” to the company and / or intended to personally gain from buying or selling shares based upon the insider information. This test of duty, however, was significantly weakened by the Supreme Court's United States vs. O'Hagan ruling. In 1988, James O'Hagan was a lawyer at the firm of Dorsey & Whitney. After the firm began representing Grand Metropolitan PLC, which planned to launch a tender offer for Pillsbury, Mr. O'Hagan acquired a large number of options in the company. Following the announcement of the tender offer, the options soared, resulting in a four million dollar gain. After being found guilty on fifty-seven charges, the conviction was overturned on appeal. The case eventually found its way to the Supreme Court where the conviction was reinstated (for more information, read Getting the Appropriate Misappropriators: An Analysis of the Supreme Court's Decision in United States vs. O'Hagan).

Barry Switzer, then-Oklahoma football coach, was prosecuted by the SEC in 1981 after he and his friends purchased shares in Phoenix Resources, an oil company. Switzer was at a track meeting when he overhead a conversation between executives concerning the liquidation of the business. He purchased the stock at around $42 per share, and later sold at $59, making around $98,000 in the process. The charges against him were later dismissed by a federal judge on a “lack of evidence”.

SEC - AA buddy of PHLY executive makes $1.8 million on the stock's merger; he tells one guy who tells another guy who tells all of his family.
http://www.sec.gov/news/press/2012/2012-41.htm
- the complaint doesn't seem to explain why the people trading on the inside information were motivated to do it. I can only guess that they thought that they would get away with it. My question is, had they known friends/acquaintances of theirs to do this in the past? How did they judge the likelihood of getting away with it?
- the people who bought the stock were really blatant about it, so that anyone who was monitoring the contents of their portfolio would have been able to see that they had been tipped off. they 1) bought as much as they could w/ the money they had immediately available, 2) sold other stuff they owned to buy even more, 3) they increased the amount of margin they were using to buy even more, 4) their family members' accounts displayed the same activity, 5) all of this buying was happening within about a week before the merger announcement, 6) the dif. parties sold from 1/3 to "most" of their stock on the day of the announcement, 7) none of the parties had ever traded in this stock before.
- the SEC can get into your emails, see your history of phone calls (who you made calls to, when, and how long you spoke for), and can see the history/contents of your trading accounts
- the SEC's explanation of why the information was material (pp18-19): "A reasonable investor would have viewed this as being important to his investment decision or a significant alteration of the total mix of information available to the public."
- the complaint doesn't explain how the SEC found out about this
- Q: Is the SEC allowed to broadly monitor the activity of trading accounts in order to look for unusual behavior?

Further Reading:

Articles

Wikipedia entry on insider trading
http://en.wikipedia.org/wiki/Insider_trading

Insider Trading from the Internal Auditor’s Perspective
http://www.theiia.org/download.cfm?file=29265

MyStockOptions.com - good info
http://www.mystockoptions.com/articles/ ... 594775DBE5

SEC Historical Society
http://www.sechistorical.org

CFA Institute:
This topic is addressed in Book 1 (Ethical Standards), Standard II A: Material Nonpublic Information (p49)

Books

Insider Trading Law and Compliance Answer Book 2011-12 [Practicing Law Institute]
http://www.amazon.com/Insider-Trading-C ... 1402416032
You can find a sample of the book here.

Bainbridge's Securities Law: Insider Trading
http://www.amazon.com/Bainbridges-Secur ... 1566627370
A review says this is a 200 page primer on insider trading.

Investment Intelligence from Insider Trading
http://www.amazon.com/Investment-Intell ... 0262692341
A review says this book is about how to make investment decisions using SEC filings re: company-insiders' buying and selling of their company's stock.

Things analogous to insider trading

- Athletes are usually prohibited from making bets on the outcome of events that they will participate in because of the conflict of interest that would arise. Q: Are athletes allowed to make bets on the outcome of events that they will not participate in based on secret information they've obtained? (eg if their buddy on some other team is injured) A: My guess is that it's probably not allowed because the people with the power to set the rules have an incentive to prohibit it (because it could conceivably harm the reputation of the sport) and no incentive to allow it.