Insider Trading On June 4, 2003, the Securities Exchange Commission announced that it was pursuing charges against investor Martha Stewart and stock broker Peter Bacanovic for securities fraud. The fraud occurred on December 27, 2001 when Stewart sold stock in ImClone Systems, after receiving an unlawful tip from Bacanovic, who at the time was working for Merrill Lynch. The SEC also accused the two of attempting to cover up the insider actions, and of making false statements regarding the ImClone trades to SEC investigators (SEC, 2003). Stephen Cutler, the SEC director of enforcement said in the SEC's press release about the charges that "It is fundamentally unfair for someone to have an edge on the market just because she has a stockbroker who is willing to break the rules and give her an illegal tip. It's worse still when the individual engaging in the insider trading is the Chairman and CEO of a public company." This statement and the philosophy behind it is a central part in the debate about the merits, not so much about the case against Stewart but against the prosecution of Stewart. The SEC sought redress not only in the form of monetary penalties and prison time, but it also sought to have Stewart removed from a position as officer of Martha Stewart Living Omnimedia (SEC, 2003).

The Case

ImClone was a relatively small pharmaceutical firm. At the time of the offense, ImClone was awaiting a decision from the Food and Drug Administration regarding the status of Erbitux, a cancer drug that was one of the key products for ImClone. Pharmaceutical companies spend hundreds of millions, if not billions, on development of pharmaceuticals. When these drugs are granted approval by the FDA for sale, the FDA also grants a monopoly on the technology for several years, allowing the firm to earn monopoly rents on the product and recoup the steep R&D costs. For any pharmaceutical company, when a product has a large potential market, the FDA decision to grant the product final market approval or not is worth billions. For a small company with a limited product base, this decision is even more critical to the value of the firm.

For any firm, the value of the company's stock is related to the present value of the expected future cash flows from ownership of that firm. The expected future cash flows for a pharmaceutical firm will vary considerably depending on whether a key drug is approved by the FDA for sale or not. Compounding this issue is that in many countries, FDA approval is all but essential for approval for sale in that country as well. Thus, if the FDA approves a drug, it is likely to be sold worldwide; if the FDA does not approve the drug then there are unlikely to be approvals in Canada, Europe or Japan either. The value of the firm is therefore highly dependent on such key FDA decisions.

ImClone's CEO Sam Waksal and his daughter were also clients of Bacanovic. They placed orders to sell stock in ImClone just prior to Bacanovic contacting Stewart. The actions of the Waksals were insider trading as well, for which Sam Waksal was sentenced to a seven-year prison term, but that is a separate case. For Bacanovic to take that information and rely it to Stewart amounted to insider trading because he was essentially relaying information from the CEO about the fate of the drug's approval to Stewart, before that information was made public by either the company or the FDA.

The next day, December 28, 2013, it was announced that Erbitux had not been accepted by the FDA for filing, a rejection of the application that meant Erbitux would not receive FDA approval for sale. This was a Friday, and on the following Monday the stock had dropped 16% to $46 per share. This reflected the revaluation of the company's stock following the Erbitux announcement. By selling on December 27th, Stewart averted losses of $45,

673 that she would have incurred had she sold the stock after the announcement was made. Stewart and Bacanovic were also accused by the SEC of lying to investigators, claiming that Stewart had no knowledge of the Waksals' trade and that she had a pre-existing set of spoken instructions to sell the stock if it fell below $60 per share (SEC, 2013).

In March, 2004, Stewart was convicted of obstructing justice, conspiracy and making false statements. Her prison term stemmed from this conviction. It was found that in addition to the securities fraud, she and Bacanovic had indeed lied to investigators and attempted to cover up...

She had faced a charge of securities fraud on the idea that she misled shareholders in her company when she proclaimed her innocence but that charge was thrown out by the judge (AP, 2004). The witness for the prosecution was Bacanovic's former assistant Douglas Faneuil who testified to the instructions to have Stewart sell her stock, and then to cover up the insider nature of the transaction (Ibid).
Legal Case

The SEC holds jurisdiction for the pursuit of securities fraud cases, and filed the case in the federal court in Manhattan (SEC, 2003). This is the court that resolved the case as well. The Securities Exchange Commission has jurisdiction over securities fraud because it is charged under several acts of law with the enforcement of regulations governing the trade of securities in the United States. These acts include the Securities Act of 1933 and the Investment Advisers Act of 1940. The SEC therefore pursues investment advisors, their clients and publicly-traded companies. The SEC has this power because it is considered to be critical to the efficient function of securities markets. In the wake of the 1929 stock market crash, the SEC was created to restore public trust via laws and enforcement mechanisms in the function of America's equities markets. If some investors are perceived to have an advantage, this undermines the confidence of investors, and results in far less money coming into the investment system, thereby reducing investment opportunity, economic growth and liquidity in the system (Rasmussen, 2013).

The Stewart Prosecution

One of the critical elements of the Stewart prosecution is found in the SEC's announcement of the charges, where it is revealed that the SEC has taken specific interest in this case because of Stewart's status and her role as a CEO and Board member of a public company, that being Martha Stewart Omnimedia (SEC, 2013). This element of the case has proved controversial. While doubtless Stewart's celebrity is responsible for propelling the case into the media spotlight, the SEC highlighting the fact that it was pursuing Stewart as a means of sending a message about its enforcement of regulations is another reason for the publicity surrounding the case.

The facts are simple enough, that Stewart was indeed guilty of attempting cover up the trade, and was most likely guilty of securities fraud as well, as she likely knew that the Waksals were selling their shares. There are many such cases that the SEC prosecutes, but it sought to leverage Stewart's celebrity to make a point. The milieu at the time was focused on securities fraud of a more serious sort. The SEC was under pressure and public confidence in American markets had eroded as the result of a succession of scandals in the early 2000s, including WorldCom, Enron and Global Crossing. Many of these concerned accounting fraud, thus resulting in tens of thousands of investors being defrauded, and the cost to the economy entering the billions. Stewart's crime was nothing of the sort. While it was a crime, the dollar value was minimal, inconsequential to Stewart and to the broader market as well other than for its symbolism.

Heminway (2003) notes that Stewart's celebrity brought about not only the prosecution but the vigorous pursuit of it. Prosecuting the trade cost far more to the SEC than the trade cost to the markets. Podgor (2005) notes that "prosecutorial discretion plays an important role in deciding who will be charged with criminal conduct and what, if any, charges will be pursued." The pursuit of Stewart at a cost far exceeding the crime reflects a desire of the SEC to make a statement not only about insider trading but also its ability to enforce existing securities law. The SEC had lost some faith among the public, but also in Congress, where the issue of securities fraud was being debated. Clearly, the SEC saw the Stewart case as a way to make a statement not only to the proverbial middle America but also to the members of Congress to vote on securities law and laws that help finance the SEC.

The SEC achieved its objective. Stewart, as noted early, was charged with conspiracy and related charges; she was not specifically charged with insider trading. Though it is a reasonable assumption, proving that Stewart knew about the Waksal trades would have been difficult, perhaps even with Faneuil's testimony. The media, however, has frequently referred to the case as an "insider trading" case; in fact the insider trading…