Insider Trading: Ethics, Law, and SEC Enforcement Cases

Introduction: The Hypothetical Insider Trading Scenario

All of the individuals in this scenario were engaged in insider trading. They all obtained their knowledge by way of an insider—in this case, a member of the Board of Directors. Any trading based on knowledge acquired from an insider, regardless of the degrees of separation, is considered insider trading. The ex-husband clearly knew of his ex-wife's position on the Board. He passed the information along to his dentist, who may or may not have known the source of the information. Certainly, the dentist's broker would have had good reason to question where such information came from, knowing that this kind of information is not randomly acquired.

Legal Culpability of Each Party

All of the parties are culpable, though the degree may vary. The broker, Green, bears a high level of culpability as an industry professional. Green would have known that such knowledge is not easy to come by and that there was a significant risk the information originated from an insider. Green stands to lose her SEC license as a result of this trade. The others also face penalties for trading on this information. Martha Stewart went to prison for the same offense—she did not learn about ImClone directly from an insider, but from her broker, who happened to know one. The SEC generally does not accept claims that a party had no way of knowing the source of the information. Wilson knew she had insider information, Looney probably knew, and Green definitively should have known.

The only person who may not have engaged in insider trading was Sara Wilson herself. She did not trade on the news, and it is not clear whether her ex-husband did either. Normally, insider trading rules apply to family relations, not just the insider directly. Anyone close to Sara, including her ex-husband, would be forbidden from trading on the news. Whether Sara Wilson is found culpable is a more complex question, determined by whether she is considered a de facto beneficiary of any trade and by the nature of her legal relationship with her ex-husband. If neither Wilson traded, Brian would at least be held accountable for leaking the information, but no insider trading charge would be brought against him.

Criminal and Civil Penalties

The parties would all be liable for criminal actions. The SEC can and does imprison people for insider trading, though fines are a more common outcome. As the Stewart case demonstrated, prosecution and jail time are real possibilities. Sara and Brian might face other charges, but if they did not trade, they would not face insider trading charges. Looney most certainly would face such charges, as would Green. Looney could go to prison, and Green could not only face imprisonment but also lose her SEC license to trade in securities, effectively ending her career. Her clients would also see their trades reversed, as would all of the other parties involved in this scenario.

Ethical Dimensions of Insider Trading

No one in this scenario acted particularly ethically. The ethics of insider trading are fairly clear: the integrity of the securities markets requires that insider trading be prohibited. Otherwise, certain insiders would hold advantages over other market participants. These advantages undermine the trustworthiness of the markets and would discourage ordinary investors from participating in the capital markets, to the significant detriment of the economy as a whole. Actions that threaten the public's ability to trust the capital market system are therefore viewed as illegal by regulators and unethical by society.

All of these individuals behaved unethically, including the Wilsons, who may not have traded on the news. Even without trading, Sara Wilson likely had no need to tell her ex-husband about the pending deal. Brian in particular would have known he should not tell anyone, as the information was clearly privileged. The same applies to Looney and Green. All of them acted unethically and against the best interests of the American economy and the integrity of the capital markets.

Case Study: Martha Stewart and ImClone

The first case is the Martha Stewart matter. Her stockbroker received an insider tip from one of his clients, who was an insider at ImClone. Based on this tip, the broker traded on the news and advised Stewart to do the same. Securities fraud charges were filed against Stewart and her broker, Peter Bacanovic (SEC.gov, 2004). The two were also charged with making false statements to regulators about these trades. Sam Waksal, head of ImClone, had received news that the FDA was set to reject approval for a drug, which would cause the stock to drop sharply in value. The broker traded on this information and instructed his assistant to convey it to Stewart. The information included the identity of its source, who would have been known to both Stewart and Bacanovic as an insider.

The SEC pursued a reversal of the trades so that Stewart and Bacanovic would absorb the losses they would have faced had they not sold on insider information. This approach reflects the SEC's broader policy of making parties whole—undoing the effects of insider trading. The broker lost his license to trade, effectively ending his career. Stewart also faced sanction: she served prison time and was forced by the SEC to surrender her seat as a director of a publicly traded company. The assistant likewise lost his license, having knowingly conveyed the insider information. The SEC also pursued civil monetary payments as a punitive measure, and Stewart's activities as an officer of a public company were curtailed. She served a sentence of several months in prison, a notably severe outcome, likely exacerbated by her making false statements during the original SEC investigation.