Prosecuting Investors: Not a Good Thing

As Martha Stewart’s trial moves into a third week, an important question remains unasked: Why are the feds prosecuting someone for receiving inside information, anyway? Isn’t the criminal the corporate official who acts on knowledge that the public doesn’t have?

The government charges that on Dec. 27, 2001, Stewart learned from her broker that Samuel Waksal, the chief executive of ImClone Systems Inc., was trying to sell his stock because he knew that the Food and Drug Administration would announce an adverse decision the next day about his company’s cancer drug, Erbitux. Stewart then sold her own 3,928 shares at $58. When the news became public, the stock fell to $45, so Stewart saved about $50,000.

Waksal pleaded guilty to insider trading and is serving a seven-year sentence. Stewart, who was a friend of his, wasn’t charged with insider trading but instead was slapped with obstruction of justice and fraud counts; the government charges that, by making false statements about her ImClone sale, she was illegally trying to prop up the stock of her own company, Martha Stewart Omnimedia.

The Justice Department probably would have loved to have charged Stewart with insider trading -- and, in a way, the fraud charges are a surrogate insider-trading indictment and a warning to others that tippees, not just tippers, will be prosecuted. The law, however, is murky, and it’s doubtful that an investor who picks up information about a CEO’s stock sale (even a CEO the investor knows) has violated the law.

The Securities and Exchange Commission should leave people like Stewart alone and concentrate on real corporate crooks. In fact, investors should be encouraged to ferret out information any way they can. The more that surfaces, the better for markets.

The feds have rarely been successful in cases against recipients of inside information. In two of the most famous examples -- the 1980 case against Vincent Chiarella, who worked for a financial printer, and the 1983 case against analyst Ray Dirks, who (heroically, I believe) told his clients about an insurance scandal he had uncovered -- convictions were overturned by the U.S. Supreme Court.

Although it’s clear that top officers in a company are breaching their fiduciary responsibility if, for example, they buy stock with secret knowledge that their company is about to be bought by another firm, it’s far from clear why someone like Stewart should even be considered for prosecution under the insider-trading law, which stresses misappropriation -- that is, using material, nonpublic information in breach of a duty of trust or confidence. Waksal was in a position of trust; Stewart wasn’t.

Also, who is hurt? Assume Stewart did know that Waksal was selling. That might have given her an edge over the buyer of her 3,928 shares, but the buyer was ready to buy on Dec. 27 anyway -- if not Stewart’s shares, then someone else’s.

In a book published in 1966, economist Henry Manne showed how insider trading actually makes markets more efficient because it speeds information that’s immediately reflected in share prices. That’s what we want from markets: a quick response to reality. In most other markets -- art, for instance, or cattle trading -- it is perfectly fine for one party to have inside information that the other does not. Prices ultimately reflect those facts, and prices are the way the public gleans knowledge. Still, though I think the SEC’s desire for a level playing field is public-relations hokum and bad economics, I would not go so far as Manne. If investors think that an unscrupulous management is profiting from inside information, they may be reluctant to invest in the first place. Fine, but why go after a recipient like Stewart? Unlike even Chiarella or Dirks, she was by no stretch of the imagination an insider or a trusted fiduciary.

As Michael McMenamin wrote recently, before suing Stewart the SEC had never gone after the customer of a broker who offered his knowledge of what another customer had done as a reason to make a trade. McMenamin thinks that insider trading should be regulated by existing laws that prohibit industrial espionage and the theft of trade secrets and sensitive commercial information. Stewart’s broker could be pursued by Merrill Lynch for violating its policies, but to charge a client is another matter entirely.

Economist David Haddock puts it well: “Far from the clearly settled moral issue that naive media pieces, movies and novels would have it be, both the theory and evidence of insider trading remain primitive and equivocal.”

Present rhetoric and law have far outrun present understanding. The feds may prefer the current murkiness, but it’s time for Congress to define the terms clearly. Inside trading should be a crime if the misappropriation is committed by a top manager or a trusted fiduciary, but leave investors alone. They should be encouraged to seek out information about the stocks they own, not punished for it.