Scandals

Imagine a boardroom of these corporate executives, along with their lawyers, accountants, and investment bankers, plotting and planning to take over a public company. The date is set; an announcement is only weeks away. Once the meeting is over, several phone their brokers and instruct them to purchase tons of stock of the Target Company. When the buyout is announced, the share price zooms up and the investors drop these stock shares for millions of dollars in profits. Insider trading is perfectly legal. The officers and directors who owe a duty to stockholders have the same right to trade and purchase the security as the next person does. The primary difference between legal and illegal insider trading lies in the motive. What I plan to explain in this paper is investigating the illegal aspects of insider trading and the scandal of it.

What is insider trading? According to Section 10(b) of the Securities Exchange Act of 1934, it is "any manipulative or deceptive device in connection with the purchase or sale of any security." This ruling served as a deterrent for the early part of this century before the stock market became such a vital part of our lives. But as the 1960"s arrived and illegal insider activity to be a lot, courts were chained by the vague definition. So members of the judicial system were now forced to interpret "on the fly" since Congress failed to resource them with a concrete definition. This resulted in two theories of insider trading liability that have evolved over the past three decades through judicial and administrative interpretation. The classic and the misappropriation theory, is the classic concept is the type of illegal activity one usually thinks of when the words "insider trading" are said. This theory started from the 1961 SEC administrative case of Cady Roberts. This was the Sec's first time to regulate these security trading's by corporate insiders. The ruling basiacally brought about the way that we define insider trading - "trading of a firms stock or derivatives assets by its officers, directors and other key employees on the basis of information not available to the public." The Supreme Court officially recognized the classical theory in the 1980 case U.S. v. Chiarella. U.S. v. Chiarella was the first criminal case of insider trading. Vincent Chiarella was a printer who put together the coded packets used by companies preparing to launch a tender offer for other firms. Chiarella broke the code and bought shares of the target companies based on his knowledge of the takeover bid. He was eventually caught, and his case clarified the terms of what has come to be known as the classical theory of insider trading. However, the Supreme Court reversed his conviction on the grounds that the existing insider trading law only applied to people who owed a fiduciary responsibility to those involved in the transaction. This sent the SEC scrambling to find a way to hold these "outsiders" equally accountable. As a result, the misappropriation theory evolved over the last two decades. It attempted to include these "outsiders" under the broad classifications of insider trading. An outsider is a "person not within or affiliated with the corporation whose stock is traded." Before this theory came into existence, only people who worked for or had a direct legal relationship with a company could be held liable. Now casual investors in possession of sensitive information who were not involved with the company could be held to the same standards as CEOs and directors. This theory stemmed from a 1983 case, Dirks v. SEC, but the existence of the misappropriation theory had not been truly recognized until U.S. v. O"Hagan in 1995.The case - U.S. v. O"Hagan - involved an attorney at a Minneapolis law firm. He learned that a client of his firm (Grand Met) was about to launch a takeover bid for Pillsbury, even though he wasn't directly involved in the deal. The lawyer then bought a very sizable amount of Pillsbury stock options at a price of $39. After Grand Met announced its tender offer, the price of Pillsbury stock rose to nearly $60 a share. When the smoke finally cleared, O"Hagan had made a profit of more than $4.3 million. He was initially convicted, but the verdict was overturned. The case bounced around in the Court of Appeals for several years before it made its way to the Supreme Court. It is there, the Supreme Court held that O"Hagan could be prosecuted for using inside information, even if he did not work for Pillsbury or owe any legal duty to the company. In a 6-3 ruling, the court indicted O"Hagan and, in doing so, upheld the foundation of the misappropriation theory. I believe that the SEC is correct in its efforts to punish this white-collar activity, but there is still much work to be done. According to Rule 16(b), "if an insider buys and sells a security in any six-month period leading up to or following a significant company event, he must hand over his profit to the company." Suppose a board member buys some stock and four months later Microsoft comes along and buys his company. The profits are taken back from that transaction and the executive is left with nothing to show for his investment. You can see the one-sidedness of this rule. Executives must take the losses, but the company takes back the gains. However, in order to secure confidence in our markets, it is essential that there be some type of governing backbone to protect our investments. Going back to the O"Hagan case, consider yourself a small shareholder in Grand Met before the tender offer is announced. You have no idea of the takeover bid because it is material, nonpublic information. Naturally, Pillsbury wants its shareholders to receive a premium on the deal. O"Hagan comes along and buys millions of dollars worth of Pillsbury stock. At the time of negotiations, the price of the stock was $39. But due to O Hagan's heavy buying, Pillsbury's market price jumps to $47 on circulating rumors of a possible takeover. In order for Grand Met to follow through on the acquisition, they must now pay a premium over the $47 market price, instead of the $39. The acquiring company's shareholders are now penalized and must pay more for Pillsbury, possibly affecting their own stock. Now consider a hypothetical situation opposite of the previous scenario. You are a shareholder in Grand Met and approaching retirement. Grand Met is currently trading at $39 a share. O"Hagan is a major shareholder and receives a tip about Grand Met possibly going bankrupt. He goes out and quietly sells his shares, while you continue to hold onto yours. The announcement is made a week later that Grand Met is indeed filing for bankruptcy. By this time, you have reacted too slowly and the market price dives to $5 a share. Is this what you had in mind heading