In 2004, famous businesswoman and TV personality Martha Stewart served five months in federal prison at Alderson in West Virginia. After she served her time at the federal prison camp, she was placed on two additional years of supervised release, a portion of which she spent in home confinement. What was her crime? The case was all about insider trading.
What Is Insider Trading?
When most people hear the term “insider trading,” they think of the crime. But by its most basic definition, insider trading is the trading of a public company's stock or other securities by individuals with access to nonpublic, or insider, information about the company. This can include the perfectly legal buying and selling of stock by a company's corporate insiders. But it can also include illegal actions of individuals attempting to benefit from a trade based on that inside information.
Legal and Illegal Insider Trading
Legal insider trading is a common occurrence among employees who hold stock or stock options. Insider trading is legal when these corporate insiders trade stock of their own company and report these trades to the U.S. Securities and Exchange Commission (SEC) through what is known simply as Form 4. Under these rules, the insider trading is not secretive as the trade is made publicly. Legal insider trading is but a few steps away from its illegal counterpart.
Insider trading becomes illegal when a person bases their trade of securities of a public company on information that the public does not know. Not only is it illegal to trade your own stock in a company based on this insider information, but it is also illegal to provide another person with that information, a tip so to speak, so they may take action with their own stock holdings using that information. Acting upon an insider stock tip is exactly what Martha Stewart was charged with. Let's take a look at her case.
The SEC's job is to make sure that all investors are making decisions based on the same information. Most simply put, illegal insider trading is believed to destroy this level playing field.
The Martha Stewart Insider Trading Case
In 2001, Martha Stewart sold all of her shares of the biotech company, ImClone. Just two days later, ImClone's stock fell 16% after it was publically announced that the FDA had not approved ImClone's primary pharmaceutical product, Erbitux. By selling her shares in the company prior to the announcement and subsequent drop in the stock's value, Stewart avoided a $45,673 loss. However, she was not the only who benefitted from a quick sale. The then ImClone CEO, Sam Waksal, had also ordered the sale of his extensive share in the company, a $5 million stake to be exact, prior to the news being made public.
Identifying and proving the illegal case of insider trading against Waskal was easy for regulators; Waksal attempted to avoid a loss based on the nonpublic knowledge of the FDA's decision, which he knew would hurt the stock's value and did not comply with the Security Exchange Commission's (SEC) rules to do so. Stewart's case proved to be more difficult. While Stewart had certainly made a suspiciously timely sale of her stock, regulators would have to prove that she had acted on insider information to avoid the loss.
Martha Stewart's Insider Trading Trial and Sentencing
The case against Martha Stewart proved to be more complicated than first imagined. Over the course of the investigation and trial, it came to light that Stewart had acted on a piece of nonpublic information, but that the information was not explicit knowledge of the FDA's decision about ImClone's drug approval. Stewart had actually acted upon a tip from her Merrill Lynch broker, Peter Bacanovic, whom also worked with Waskal. Bacanovic knew that Waskal was attempting to unload his large stake in his company, and while he did not know precisely why, he tipped Stewart off on Waksal's actions which lead to the selling of her shares.
For Stewart to be charged with insider trading, it would have to be proved that she acted upon nonpublic information. Had Stewart traded based on knowledge of the FDA decision, the case would have been strong, but Stewart only knew that Waskal had sold his shares. To build a strong insider trading case then, it would have to be proved that the sale violated some duty of Stewart's to refrain from trading based on the information. Not being a board member or otherwise affiliated with ImClone, Stewart did not hold such a duty. She did, however, act on a tip that she knew breached her broker's duty. In essence, it could be proved that she knew her actions were questionable at the very least and illegal at the worst.
Ultimately, these unique facts surrounding the case against Stewart led to prosecutors to focus on the series of lies Stewart told to cover the facts surrounding her trade. Stewart was sentenced to 5 months of prison time for obstruction of justice and conspiracy after the insider trading charges were dropped and securities fraud charges dismissed. In addition to the prison sentence, Stewart also settled with the SEC on a separate, but related case in which she paid a fine of four times the amount of the loss she avoided plus interest, which came to a whopping total of $195,000. She was also forced to step down as CEO from her company, Martha Stewart Living Omnimedia, for a duration of five years.
Punishments and Rewards Associated With Insider Trading
According to the SEC website, there are almost 500 civil enforcement actions each year against individuals and companies that break securities laws. Insider trading is one of the most common laws broken. The punishment for illegal insider trading depends on the situation. The person can be fined, banned from sitting on the executive or board of directors of a public company, and even jailed.
The Securities Exchange Act of 1934 in the United States allows the Securities and Exchange Commission to give a reward or bounty to someone who gives the Commission information that results in a fine of insider trading.