Martha Stewart Insider Trading Case: Law and Ethics

Introduction

As reported by Rawls (2009), Martha Stewart owned shares of a company called ImClone Systems. In 2001, ImClone received notification that a new prescription drug, Erbitux — in which the company had invested large amounts of money for research and development — would not receive approval by the Food and Drug Administration (FDA). Sam Waksal, the CEO of ImClone, called his stockbroker, Peter Bacanovic, and instructed him to sell his personal shares of company stock in order to avoid financial losses. Bacanovic also served as a broker for Martha Stewart and notified her that the CEO was liquidating his stock and that it would be in her financial interest to follow suit by selling her own 3,928 shares. The Securities and Exchange Commission (SEC) noticed an unusual coincidence between the mass selling of shares by the CEO of ImClone and by Martha Stewart, and began an investigation to determine whether Stewart was guilty of insider trading.

Insider Trading: Definition and Legal Precedents

The Securities and Exchange Commission (SEC) defines insider trading as 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. At the beginning of the twentieth century, insider trading was not considered illegal. In fact, a Supreme Court ruling once characterized insider trading as a perk of being an executive. However, after the excesses of the 1920s and the ensuing depression, there was an inevitable backlash and shift in public opinion. Consequently, insider trading was banned and serious penalties were imposed on those convicted of engaging in the practice (Kennon, n.d.). The question of what constitutes insider trading is difficult to determine. For the SEC to prosecute and convict someone for insider trading, it must prove that the defendant had a "fiduciary duty" to the company and/or intended to personally profit from buying or selling shares based on insider information.

In 1988, James O'Hagan, a lawyer at the firm of Dorsey & Whitney — which represented Grand Metropolitan PLC — learned that Grand Met was planning to launch a tender offer for Pillsbury. Although O'Hagan never personally worked on the deal, he began buying Pillsbury stock and call options. When Grand Met announced its tender offer for Pillsbury in early October, the value of O'Hagan's stock and options holdings skyrocketed. In total, O'Hagan pocketed more than $4 million in profits. He was convicted on fifty-seven counts, but the conviction was overturned on appeal. The case eventually reached the Supreme Court, which reinstated O'Hagan's insider trading convictions. In doing so, the Court endorsed an expansive definition of "insider" that goes beyond traditional corporate insiders. The Court found that while O'Hagan had no duty to Pillsbury or its shareholders, he did have a duty to the source of his information. His failure to disclose his personal trading to Grand Met and Dorsey, in breach of that duty, made his conduct deceptive (Salceda & Rodda, 1998).

In another case, Barry Switzer — who at the time was the Oklahoma football coach — faced SEC prosecution after he and some friends purchased shares in an oil company in 1981. Switzer was at an Oklahoma track meet when he overheard a conversation between executives concerning the liquidation of Phoenix Resources. He purchased stock in the company at around $42 per share and later sold at $59, making approximately $98,000 in the process. The charges against him were later dismissed by a federal judge for lack of evidence. Based on legal precedent, Switzer probably would have been fined and faced jail time if he had received the tip from the child of one of the executives. One might say there is a fine line between being lucky and being criminal (Kennon, n.d.).

The Case Against Martha Stewart

Hoffman (2007) explains the legal problems Stewart faced before trial. First, she sold securities — a factual issue not in dispute. Second, she obtained nonpublic information: the public was not aware that ImClone's CEO was selling his shares because of an impending drop in the share price, making that information nonpublic. Third, the information was material. Everyone with an interest in ImClone knew the FDA was soon to render a decision on Erbitux, and in that context a reasonable investor would want to know that the CEO was selling stock. Finally, Stewart may have breached a duty of obligation or trust, though this element is not altogether clear. Stewart was not an officer, director, or majority shareholder of ImClone, and accordingly owed its shareholders no fiduciary duty. On the surface, then, there appears to be no breach of confidence or trust, and her conduct does not seem to constitute an inside trade.

However, the insider trading regulations include a tipper/tippee provision, which holds that an individual is liable for securities fraud if he or she receives information originating from an insider and then purchases or sells a security based on that information. In such circumstances, the receiver becomes a tippee. Moreover, if the tippee passes the insider information along, the new receiver also becomes a tippee. Accordingly, in an extended sense, Stewart could be considered an insider and subject to securities fraud liability (Hoffman, 2007).