A New Hunt Is On for Insider Trading
By STEPHEN LABATON and DAVID LEONHARDT
The New York Times
6/30/02
They're back. Insider-trading investigations, which haunted Wall Street nearly a generation ago as prosecutors pursued Ivan F. Boesky and others, have returned to center stage.
Early this month, Samuel D. Waksal, the former chief executive of ImClone Systems, a biotechnology company, found himself sitting in a jail cell next to a man accused of selling drugs. Last week, on the "The Early Show" on CBS, Martha Stewart had to answer questions about an investigation into her trades before the anchor allowed her to make a chicken-and-shredded-cabbage salad. And on Friday, the Securities and Exchange Commission announced an insider-trading case against the Carreker Corporation, a Dallas company whose vice president for investor relations tipped off his brother, a broker, who then tried to profit in advance of a news release on declining earnings, prosecutors say.
Suddenly, S.E.C. officials are combing intently through piles of trading records involving huge numbers of stock sales by executives and others privy to confidential information. In particular, they are looking for cases against executives tied to the accounting and disclosure problems that have tainted a growing number of the nation's largest corporations.
In recent years, investigations focused largely on the small fish of Wall Street and corporate America, often because cases were easier to make against them. But investors have grown so disgruntled that prosecutors are now searching aggressively for any and all illegal profiteers during the precipitous decline in the stock market.
"One of the things we look at in every accounting and disclosure case is whether those involved in any misconduct were selling stock," said Stephen M. Cutler, director of the enforcement division at the commission. "One also has the sense that everyone in the current climate is sensitive to breaches of public trust by officers and directors, so it should come as no surprise that courts are more sensitive to these issues as well."
Mr. Cutler said the commission was imposing tougher penalties in an effort to restore confidence to the markets. It is no longer willing to automatically assess a penalty equal to only twice the ill-gotten gain as the price for a defendant who voluntarily acknowledges illegal trading. The agency is also stepping up efforts to bar officers and directors who are guilty of illegal insider trading from working for publicly traded companies.
It is too early to tell how many scandals will be uncovered this year. But the investigations are all but certain to fall short of the sweeping post-bubble reckoning that many outraged investors and laid-off employees appear to want. The reason is simple: the overwhelming number of executives who struck it rich shortly before their stock plummeted probably did so without breaking any laws at all.
Because they awarded enormous piles of stock options to top executives, boards have enabled them to accumulate vast wealth by selling small portions of their holdings regularly. In late 2000, in one of his final acts as chairman of the S.E.C. under President Bill Clinton, Arthur D. Levitt persuaded the commission to adopt a rule that permits executives to set prearranged schedules for their stock selling, further insulating them from insider-trading charges.
The commission wanted to allow executives to sell stock without taking advantage of what they knew. As part of its so-called safe harbor approach, the S.E.C. is expected to soon require companies to make public such prearranged trading plans.
"If a 55-year-old executive has most of his entire estate in his company's stock, most advisers would tell him he's got too many eggs in one basket and he should liquidate," explained Otto G. Obermaier, a former United States attorney in Manhattan who is now at Weil, Gotshal & Manges. "He ought to be entitled to do so without fear that he winds up trading as earnings go down and he is accused of insider trading."
Still, many executives have sold a lot of stock since 2000, either with an inkling that it was overvalued or to diversify generous compensation packages of stock and options in a well-timed way. They did do even as they continued to make predictions about their companies that would prove to be badly exaggerated in 2000 and 2001.
Consider the 25 companies whose executives and other employees have sold the largest amounts of stock since the start of 2000 — a list compiled by Thomson Financial, the research company. Among the 25 — including AT&T, Dell Computer and Microsoft — the median decline in stock price over that same period, through May, has been 65 percent, a larger drop than even the Nasdaq composite index has suffered.
So even as profits have all but disappeared, layoffs have spread and long-term investors have taken a beating, many executives have walked away with rewards worthy of a bull market.
At AOL Time Warner, where shares have fallen 80 percent since the beginning of 2000, Stephen M. Case, the chairman, has sold $100.4 million of stock over the period, according to Thomson. One vice chairman, Ted Turner, has sold $79.1 million, and another, Kenneth J. Novack, has sold $34.7 million. Richard D. Parsons, the chief executive, has sold $35.3 million worth of stock.
The sales were "consistent with their regular selling patterns," said Edward Adler, a spokesman. He added that all top executives continued to hold large amounts of company stock and were suffering along with other investors.
WorldCom, which the S.E.C. accused of accounting fraud last week, did not make the list of 25. But an executive at the center of the inquiry, Scott D. Sullivan, the former chief financial officer, sold $44.1 million of WorldCom stock from 1997 to 2000, when the shares were worth many times what they are now. Because the trades do not appear to have taken place during the period for which the S.E.C. is alleging fraud, Mr. Sullivan's profits may be safe.
Burned investors aren't waiting for the outcome of the inquiries by the authorities, however. Led by some of the largest institutional investors, they have filed class-action lawsuits against current and former executives at companies like Enron and Global Crossing. Unless they are settled, as they often are, those cases may present the first legal tests of the safe-harbor provision put in place by the S.E.C. nearly two years ago.
For many investors and employees, the most galling examples are those in which executives clearly failed but walked away with millions.
Few companies offer a sharper contrast than Ariba, a software company in Sunnyvale, Calif., near the center of Silicon Valley. The company went pubic in June 1999 amid the Internet mania, promising to create Net marketplaces where companies could buy and sell goods. When analysts talked excitedly about the future of "B2B" — business-to-business electronic commerce — they often mentioned Ariba.
Ariba's stock soared above $150 in early 2000 and, after falling more than two-thirds, recovered to an all-time high of $168.75 that September, as its executives offered an enticing vision of the future.
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"We're seeing an incredible amount of demand out there," Keith J. Krach, the chief executive, said in April 2000. Three months later, he told Dow Jones Newswires, "This marketplace is red hot." And in October of that year, he said, "Profitability is imminent."
It never arrived. Ariba's software had bugs, and its B2B marketplace attracted fewer users than the company had projected. When it announced a newly aggressive accounting method in 2001, investors worried that the company was exaggerating sales, and the stock fell sharply. The company has laid off hundreds of workers, and in its most recent fiscal year reported a $2.7 billion loss.
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But Mr. Krach and his colleagues have done well. In 2000 alone, as he was making some of his optimistic pronouncements, Mr. Krach sold $167.4 million worth of Ariba stock, according to Thomson. Over all, insiders have sold more than $850 million of stock since the start of 2000.
"I find it appalling," said Glenn Luksik, a former Ariba shareholder from Columbus, Ohio, who is a plaintiff in a class-action lawsuit filed against the company last year, related to Ariba's initial public offering.
"Has big business always been like this, with all of these inside deals?" Mr. Luksik asked.
Lauren Ames, an Ariba spokeswoman, said that most of the executives who sold large amounts of stock no longer worked at the company, and that Ariba was a much stronger company today than a year ago. Mr. Krach, now chairman, was unavailable to comment, Ms. Ames said.
Ariba's case may be extreme, but there appear to be dozens of cases in which insiders legally sold millions of dollars of shares shortly before the stock price sank.
Now some people are asking whether trading rules should change again, this time making it more difficult for executives to accumulate vast wealth from a temporary blip in their company's stock price. Regulators or corporate boards could, for example, require executives to hold their options and shares for years.
Huge stock-options grants "put great incentives on the short term," said Peter G. Peterson, a former secretary of commerce who is now on a private-sector committee trying to devise better guidelines for corporate governance. "Maybe we'd get the long-term point of view if the holding periods on stock options were longer so that there was not the incentive to manage earnings in the short term."
The committee, set up by the Conference Board, a business-backed research group in New York, plans to make its proposals later this year.
To many investors, however, a voluntary guideline is not enough. They say the worst transgressors should be sent to prison.
Yet for investigators, building cases will not be easy. The S.E.C. regulations adopted 20 months ago made it easier for executives to sell stock without fear of being prosecuted for illegal insider trading. The rule has yet to be tested in court.
On one level, insider trading is easier to prove than complex accounting or financial fraud.
"This is not securities law litigation," Mr. Obermaier said. "This is basically cops and robbers. The issue is, `Did you get the information and did you trade on it?' "
But the rules that have been laid down by the S.E.C. and by several court decisions, though largely favorable to prosecutors, still require the government to prove that an investor made a trade with particular knowledge of confidential information, a high burden under any circumstances. That difficulty has led investigators in some cases, like the one pending at ImClone, to also look at whether some of the principals in that case may have violated other laws, like making false statements or obstructing justice.
The main tools of prosecutors in combatting insider-trading abuses are the broadly worded securities-, mail- and wire-fraud laws, which give wide latitude to the authorities in building cases.
During the Wall Street scandals of the late 1980's, a group of lawmakers, regulators and defense lawyers tried to come up with a statutory definition of insider trading. But the effort, led by Harvey L. Pitt, failed for a variety of political reasons, and it now turns out that Mr. Pitt, who last summer became the S.E.C. chairman, may be better off for having failed.
Supporters of an explicit statutory definition argued that it was a matter of basic fairness. Investors, they said, are entitled to know clearly what kind of information is proper, or not, to trade on.
"A legitimate businessman," Mr. Pitt said in 1989, "is entitled to know what the rules of the game are before he gets carted off to jail."
But opponents of that proposal, including some enforcement officials at the time, said there was a downside. They said that innovative lawyers and creative traders would be able to circumvent any statutory prohibition and that no law could anticipate all kinds of improper trading.
One reason for the debate was a split in the courts over how far prosecutors could go in charging insider trading. For decades, it was settled law that a corporate executive could not trade on confidential information, but a debate raged over whether the law also covered outsiders, like lawyers, research analysts and printers, who were privy to confidential information. With mixed success, prosecutors had tried to make such cases under the so-called misappropriation theory, which held that corporate outsiders who gained information by virtue of a special relationship could not "misappropriate" that information to personal gain.
The Supreme Court largely settled the issue in 1997, when it upheld the insider-trading conviction of James H. O'Hagan, a Minneapolis lawyer who tried to capitalize on his law firm's representation of Grand Metropolitan in its tender offer for Pillsbury nine years earlier. While Mr. O'Hagan's law firm was working for Grand Met, he bought call options and shares of Pillsbury stock. When the tender offer was announced, he sold the options and stock, making a profit of more than $4.3 million.
A federal appeals court had tossed out his conviction because Mr. O'Hagan was neither an employee nor a fiduciary of Pillsbury. But the Supreme Court reversed, saying in effect, that anyone who gains inside information under conditions in which that person knows it is supposed to remain confidential may not use it for trading.
The decision contained important restrictions, but it did not bar all kinds of insider trading. Someone who obtained confidential information innocently — by finding a document on the street, for example — could still trade on it. Moreover, the court required prosecutors to show that the trader knew or had reason to know that the information was coming from a confidential source. That, combined with the S.E.C. rule changes in 2000, has all but eliminated the calls for a statutory definition of insider trading.
The recent scandals suggest that the rules and the earlier cases have done little to deter trading on insider information. "I'm amazed," Mr. Obermaier said, adding, "It's always surprising when people of substance, as opposed to street criminals, believe that they can capitalize on something that society has said is an impermissible action."
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