Insider trading

Trading by Insiders
• An insider is an individual—executive, director, employee,
or advisor—who has access to material information about
the company that has not yet been released to the public.
• Under SEC rules, insiders may only trade when they are
not in possession of material nonpublic information. This
is legal insider trading
• Trades on the basis of this information is considered
illegal “insider trading”.
Trading by insiders
• Lakonishok and Lee (2001) examine whether executives use inside
knowledge of firm information to opportunistically trade equity
holdings.
• Sample: 96,147 firm-year observations, 1975-1995.
• Calculate ratio of net purchases to total insider transactions.
• Include CEO, CFO, board chair, directors, officers, president, and vice
presidents.
• Find that companies with extensive insider purchases outperform
companies with insider selling by 4.8% over subsequent 12-month
period. However, outperformance due entirely to purchases, not to
sales.
• Results most pronounced among small-cap firms.
• Conclusion: insiders have modest informational trading advantage.
Trading by insiders
• Seyhun (1986) also examines whether insiders have an
informational trading advantage over the market.
• Sample: 790 companies, ~60,000 insider transactions, 1975-
1981.
• Find that
• Insider purchases precede a period of outperformance (4.3%
over 300 days).
• Insider sales precede a period of underperformance (2.2% over
300 days).
• Insiders with access to more valuable information (CEO,
chairman) have greater trading advantage than other insiders.
• Conclusion: insiders have an informational trading advantage.
Trading by Insiders: Blackout Window
• To prevent executives from violating insider trading laws, companies
designate a blackout window in which insiders are restricted from making
trades.
• Blackout periods occur when material information (earnings, new
product, acquisition) is not yet released to the public.
• The median length of a blackout window is 50 calendar days.
• Despite these restrictions, evidence suggests that insiders still have an
information advantage in making trades.

• Insider purchases precede periods of market outperformance.

• Insider sales precede periods of market underperformance.
• CEO and chairman have greater trading advantage than other
insiders.
Insider trading
• Many recent financial scandals involve violations of securities
law and sales of stock by insiders. The stock sold was often part
of equity compensation.
• Insider is the person who is “connected” with the company, who
could have the unpublished price sensitive information or
receive the information from somebody in the company.
Fundamentals Of Insider Trading Law
• TRUE OR FALSE?
• Only a company’s officers or directors can commit insider
trading. You need to trade and be caught in the act.

• The law applies to anyone who knows material nonpublic

information at the time of the trade or tip. It applies to
stock of customers, suppliers, merger partners.
• Tipping, even if the tipper doesn’t trade, is illegal.
What is Insider Trading and who is Insider?
• You are aware of material confidential information about a
public company (whether your company or another
company).
• You trade on that information, or tip others who trade on it,
before the information is released publicly and is
absorbed by the market.
• 50% of cases involve tipping, and in 50% of those cases
the tippers do not even trade.
Forms of Insider Trading 
• Members of organization. Corporate officers, directors, and
employees of publicly traded companies are in
key positions to access information that would not
otherwise be available to the general public.
• Friends & family. Corporate employees often share information
within their own circles that is not shared with Stock Market and the
general public.
• Government officials. Officials of different government
agencies can gain access to confidential information through the
execution of their duties. They may conduct insider trading with this
information.
• Professionals/Consultants. Bankers, lawyers, paralegals, and
brokers are but  a few of the consultants who have access to
confidential documents of their corporate clients.
Insider trading
• Joseph Nacchio made $50 million by dumping his stock
on the market while giving positive financial projections to
shareholders as chief of Qwest Communications at a time
when he knew of severe problems facing the company.
He was convicted in 2007
Price sensitive information
• Price sensitive information means: information which
relates directly or indirectly to a company and which if
published is likely to materially affect the price of
securities of company for better or worse.
• Mergers/divestitures (50%)
• Accounting problems and other bad news (30%)
• Declaration of dividends/splits/repurchases/issuance
• Major expansion plans, product developments
• Changes in policies, plans or operations
Price sensitive information
• When does information become public?
• You must allow time for dissemination.
• Generally considered two business days, but Internet and cable
news can make it two minutes.
• Blackout periods and pre-clearance of trades are standard
procedures.
• Vary by level.
Purposes for Insider Trading Regulation

Provide Assure mkt

“fairness” integrity

Protect Reduce “cost

“property” of capital”
Purposes for Insider Trading Regulation
• “Insider trading corrodes investor confidence. It
undermines the integrity of the markets by tilting,
unacceptably, the playing field in favor of those whose
greed drives them to betray the duties and confidences
they owe others.”
Robert Khuzami, SEC enforcement director
Purposes for Insider Trading Regulation
Insider trading quiz
1. You work as CFO in Up-N-
Rising, a bakery franchiser, that
is opening high-end bakery
shops throughout the country.
The numbers have been good,
until this month when you notice
an internal report showing a
25% fall in royalties from pastry
sales.

Question: You sell some of

your stock. Insider trading?
 Insider trading quiz
2. You are outside counsel to
Up-N-Rising. The CFO at Up-N-
Rising calls you and tells you
about this quarter’s 25% fall in
pastry sales - resulting in a 15%
drop in earnings . She asks
whether the company should
disclose this in a press release.
 

Question: You sell Up-N-

Rising short. Insider trading?
Insider trading quiz
3. You are a friend of Ralph, who
you know is sales manager for
Up-N-Rising. Ralph tells you that
“something” is happening at the
company and you might want to
consider selling your Up-N-
Rising holdings, if you have any.
Ralph says no more.

Question: You sell your Up-N-

Rising stock? Insider trading?
Insider trading quiz
4. You are a member of a golf
foursome. One of the foursome
says, “I think something’s
happening at Up-N-Rising. You’d
probably do well to short it.” He
says no more.

Question: You may no further

inquiries and buy Up-N-Rising put
options. Insider trading?
Insider trading quiz
Jeffrey Haas, a professor of securities law at
New York Law School: “If not from a
company insider, you’re probably stupid to
just listen and trade on it” … “You don't
have a duty to find out where it came from.“

Nancy Grunberg, former assistant director of

SEC enforcement: "The SEC would want
to know -- unless it was on a piece of paper
that fell out of the sky -- whether you asked
about the source of the information before
you acted on it."
Insider trading quiz
5. New scenario. You are the
CFO of KK Donuts and have been
cogitating on what to do with all
the company’s extra cash. You
talk with the company’s CEO and
investment banker, who agree
buying Up-N-Rising would be a
good move. You begin to form a
takeover team.

Question: You buy Up-N-Rising

stock. Insider trading?
Insider trading quiz
6. You are the spouse of the
CFO of KK Donuts, who tells
you that she will be out of town
for the next few days. “We’re
looking at buying Up-N-Rising.”
You know that this is only going
to complicate your life. You wish
there were a silver lining.

Question: You buy Up-N-Rising

stock. Insider trading?
Insider trading quiz
7. You are the head of strategic
planning at KK Donuts. You are
no fool. You figure that when KK
Donuts announces it is acquiring
Up-N-Rising, the stock prices of
competitors of Up-N-Rising will
likely fall. The Up-N-Rising
acquisition is moving apace.

Question: You sell short the

stock of Up-N-Rising’s
competitors. Insider trading?
Insider trading quiz
8. You are an outside “public
relations” consultant to KK Donuts.
The company's CEO calls and
tells you KK Donuts may be
buying Up-N-Rising to expand into
the high-end French bakery
business. Given the current
political climate, you are asked if
this would be good for public
relations. You have no
confidentiality agreement.

Question: You buy Up-N-Rising

stock. Insider trading?
Insider trading quiz
9. You are the founder KK Donuts.
You hold about 40% of the
company’s stock and want to
diversify. Problem is if you sell,
during this volatile expansion
period, you will be accused of
insider trading. You tell your broker
to sell 1% every month over the
next two years – reducing your KK
position to 16%.

Question: You sell (under the

plan) when you are aware of the
Up-N-Rising deal. Insider trading?

What if you discontinue the plan?

Insider trading quiz
10. You are best friends with Karl
Konners, founder and CEO of KK
Donuts. You both use the same
broker. This morning the broker
called you and blurted, “Karl is
selling. Karl is really selling.” You
knew that KK Donuts was being
investigated by the FDA over its
products’ fat content.

Question: You sell your KK

Donuts holdings. Insider trading?
Insider trading quiz
• The mere fact that insiders are selling, even heavily, isn't
necessarily "material," or market-moving information
(though nonpublic). But if it turns out that the sales truly
are unique -- that the founders had never sold shares
before, for example -- you may be courting trouble.

David M. Brodsky,
head securities litigation,
Latham & Watkins, New York:
Insider trading quiz
11. You are in a taxi on a rainy
night in New York City. The driver
stops to pick up two wet
customers. “My gosh,” you think,
“It’s Karl Konners, the head of KK
Donuts.” Karl talks to his
associate in animated whispers
about the FDA dropping its fat-
content investigation. “Great news
for KK Donuts,” you tell yourself.

Question: You buy KK Donuts

stock. Insider trading?
Insider trading quiz
12. You are the head of investor
relations of KK Donuts. You have
been besieged by inquiries about
rumors of an Up-N-Rising
takeover. You talk to senior
management and decide on a
script: “KK Donuts is in preliminary
talks with Up-N-Rising
management.” And so on. You
answer no questions.

Question: . You call three leading

analysts of KK stock and read the
script. Can you?
The ImClone Case: The Players
• Sam Waksal—founder and CEO of ImClone Systems Inc.
• Aliza, Jack, and Patti Waksal—his daughter, father, and
sister
• Peter Bacanovic—their Merrill Lynch broker
• Douglas Faneuil—Bacanovic’s assistant
• Martha Stewart—friend of Waksal and fellow client of
Bacanovic
The ImClone Case: The Key Facts
• December 21, 2001: ImClone GC sends email
announcing a trading blackout until the FDA release on
ImClone’s application for Erbitux cancer drug.
• December 26, 2001: Sam Waksal learns that the FDA will
reject ImClone’s application for review.
• That night, Sam advises daughter Aliza and others in his
family either that the company would be receiving bad
news or to sell their ImClone shares.
• December 27, 2001: Aliza and family accountant begin
calling Faneuil at Merrill Lynch. Aliza sells $2.5M of her
ImClone shares as price falls; Jack sells $7M.
Martha Stewart the trading scandal
• Phone records indicate that Bacanovic called Martha
Stewart’s office shortly after Waksal’s  daughter dumped
her shares.
• Stewart returns Faneuil's call from her private jet, which is
en route to Mexico.
• At the end of a two-minute call, she instructs him to sell all
$228K of her ImClone shares, at approximately $58 per
share (it opened at $63.50) on December 27, one day
before the Food and Drug Administration refused to
review ImClone.
More selling by insiders
• A number of other ImClone insiders sell, including the
 company’s counsel John Landes, who dumped $2.5
million worth of the  company’s  stock, Ronald Martell
(ImClone’s Vice President of marketing sold $2.1 million
worth of company stock.)
Did ImClone Have Any Discussions On December 27 With Sam About His
Attempted Blackout Violations?

• December 28, 2001: FDA notifies ImClone about Erbitux

decision at 4 p.m. The company announces it at 6 p.m.
• Sam Waksal (whose ImClone stock is heavily margined) buys
January put options through Swiss brokerage account.
• Jack Waskal also continues to sell his ImClone stock and sells
stock in Patti’s account. Eventually sale blocked by Merrill Lynch.
• ImClone stock drops 16% to close at approximately $46 by
December 31, the next trading day.
• Martha Stewart’s earlier sale saves her about $45K on day one
(although the stock continues to fall for several days to below
$20).
Sentence
• Sam Waksal was arrested on charges of insider trading
and was jailed for seven years. (classic insider trading)
• Martha Stewart (classic outside trading) :
• sentenced to a five-month term in a federal correctional
facility and a two-year period of supervised release.
• a fine of $30,000
• disgorgement of $58,062
• civil penalty of three times the loss avoided ($137,019)
• 5-year ban from serving as a director, CEO, CFO, or any
other officer role responsible for preparing, auditing, or
disclosing financial results of any public company.
:

Sanctions for insider trading

• SEC enforcement
• Disgorge “ill-gotten gains”
• Pay monetary penalties up to three times the amount of those gains
• May be barred from serving as a director or officer at a public company.

• Criminal enforcement (Department of Justice)

• Up to 20 years imprisonment
• Fines up to $5 million for individuals
• Fines up to $25 million for corporations
• Additional prosecution may result from fraud-related charges that often
accompany insider trading violations.
• In last 10 years, closer cooperation between US Attorney and SEC,
especially if false statements, obstruction of justice etc. are present
SEC Insider Trading Enforcement Actions

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40 80

30 61
57 58
53
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46 47
44
20
37

10

0 5 0 6 0 7 0 8 0 9 1 0 1 1 1 2 1 3 1 4
20 20 20 20 20 20 20 20 20 20
FY FY FY FY FY FY FY FY FY FY
Insider Trading Prosecutions – Things Really Have Changed!

• The first SEC insider trading prosecution: The 1960 administrative

proceeding in the Cady Roberts case
• SEC found broker sold stock in several customer discretionary
accounts on the basis of inside information that an NYSE listed
company was about to cut its dividend.
• The SEC fined the broker $3,000 and suspended him for 20
business days from the brokerage industry.
• Next morning, the broker found a long line of prospective customers
lined up in front of his office.
• From the broker’s point of view, it was a good investment.
The Traditional SEC Investigative Methods

• Historically, insider trading prosecutions not considered to be easy

cases.
• Key issue is whether defendant knowingly traded on inside
information rather than on independent investment decision.
• Usually little or no documentary evidence; only circumstantial
evidence.
• Vague line between good, hard digging for information and illegal
inside information.
• Juries often skeptical of whether it was a real crime.
• Penalties imposed by judges used to reflect same attitude.
Raj – the insider trading scandal
• Raj Rajaratnam is a Sri Lankan American and a former
hedge fund manager and billionaire founder of the Galleon
Group, a New York based hedge fund management firm.
• Raj Rajaratnam cultivated a broad network of tipsters inside
large companies who, for generous fees, slipped him
nuggets that had not yet been made public.
• Because he genuinely knew a lot about the companies on
which he placed bets he had a team of expert analysts
studying them and he managed for a long time to convince
the world that his success was based on good judgment.
• Board member
• Vice president
• Account manager
• Senior vice-
president for
technology
• Marketing director
• Employee
• Lawyer/consultant

41
Raj – the insider trading scandal
• Rajaratnam profited from information received from:
• Robert Moffat, a senior executive of IBM, considered next in
line to be CEO.
• Anil Kumar, a senior executive of McKinsey & Company, and
close friend of Rajat Gupta (its former managing director) who
was later also convicted of passing information to Rajaratnam.
• Rajiv Goel, a midlevel Intel Capital executive.
• Roomy Khan, previously convicted of wire fraud for providing
inside information from her employer, Intel, to Rajaratnam.[31]
• It was reported that Rajaratnam, Goel, and Kumar were all part
of the class of 1983 from Wharton business school
Raj – the insider trading scandal
• On Sep 2008, Warren Buffet agreed to pay $5 billion for
preferred shares of Goldman Sachs. However this information
was not announced before the closure of NYSE that day.
• Before the announcement, Raj Rajaratnam bought 175,000
shares of Goldman Sachs and the next day, by which time the
infusion was public knowledge, Rajaratnam sold his shares.
• It was claimed that Rajat Gupta had called Rajaratnam
immediately after the board meeting at which Warren  Buffet’s
 infusion had been announced. Rajaratnam, as it is alleged, has
"used the information from Gupta to illegally profit in
hedge fund trades” .
• The information on Goldman made Rajaratnam's funds richer
by $17million .
Raj Rajaratnam, a billionaire hedge-fund impresario who built his
fortune in the relentless cultivation of corporate contacts, was
convicted on all 14 counts of securities fraud and conspiracy
against him in the biggest insider-trading case ever, likely
accelerating an unprecedented wave of prosecutions rocking Wall
Street.

44
The Galleon Prosecutions – 50 Years Later
Guilty
• 14 counts of insider
trading (conspiracy)
• 11 years in prison
(until July 2021)
• $150 million in civil
/criminal fines
The Galleon Prosecutions – 50 Years Later
• Criminal charges brought against 22 persons for alleged
insider trading violations
• Allegations focused on hedge fund managers/traders
• Also involved alleged issuer and consultant insiders
• More than 10 guilty pleas

• Parallel SEC Enforcement Actions

The New Galleon Investigative Model
• Aggressively pro-active investigation
• Early cooperation between SEC and U.S. Attorneys
• Unprecedented use of wiretaps by U.S. Attorney working with the FBI
• Conducted covert investigation
• By media accounts, continued for over 2 years
• Used evidence of bad acts to coerce individuals to act as
informants
• Informants wore concealed wires to record conversations with
others
• The result: A domino effect of successive indictments and additional
cooperating witnesses leading to 22 indictments.
New SEC Cooperation Policy
• The SEC traditionally has not rewarded cooperation
• Since the Madoff debacle, the SEC revamped its Enforcement
Division under leadership of ex-U.S. Attorneys
• New Cooperation Policy very important from an enforcement
perspective
• Could result in a “rush to cooperate” characteristic of many criminal
prosecutions
• May result in companies “self-reporting”
• First one in usually gets the greatest leniency
Corporate governance and insider trading
• Some research shows that compared to insiders of
poorer-governed firms, those of better-governed firms
earn significantly smaller abnormal profits from their sales
trades, but not from their purchase trades.
• These asymmetric effects of governance on the
profitability of insider trading come from two possible
channels: better monitoring and more effective
compensation structure.
• Among various governance attributes, board effectiveness
and audit quality play the most important role in reducing
the profitability of insider sales.
GENERAL COUNSEL APPROVAL TO REDUCE INSIDER
TRADING
• Jagolinzer, Larcker, and Taylor (2011) examine the roles of insider
trading policies and general counsel approval to reduce trading
advantages.
• Sample: 260 companies, 2003-2005.
• Measure abnormal profits earned by executives through trading activity.
• Compare the profitability of trades when prior GC approval is / is not
required.
• Find that:
• Executives subject to general counsel approval generate lower trading
profits.
• Impact is most pronounced when trades occur inside restricted windows.

• Conclusion: insider trading policies can reduce trading advantages.