Martha Stewart and Insider Trading

Insider trading laws have been around for a long time, even before the SEC Act of 1934. Martha Stewart’s recent trial and incarceration have brought a higher degree of awareness and caution to investors who are potential beneficiaries of insider trading.

This article will define insider trading, explain the intent of the insider trading laws, and give some tips on how you can avoid becoming involved in such a legal nightmare.

Insider Trading Defined

Simply stated, insider trading is the buying or selling of a company’s securities based upon information about the company that has not been made public. Such trading with the benefit of inside information gives the participant an unfair advantage over others who are buying or selling the security but who don’t have access to such privileged knowledge.

Insider trading, according to the above description, is against the law in most countries because it deprives securities markets of a “level informational playing field.”

Who Are Insiders?

The definition of an insider includes the company’s majority shareholders, directors, management, lawyers, accountants and others who have a fiduciary relationship to the organization. This means, basically, anyone who is privy to information that is not available to the general public.

Access to special information puts “outsiders,” like you and me, at a great disadvantage. In effect, insiders are a step ahead of the general public and are at a specific advantage when it comes to reaping unfair profits or avoiding serious losses.

The Laws’ Intent

If we really think about how unfair it is for someone to know something “special” about a company, something that the general public doesn’t know, we’ll realize that the public — you and I — are put at a terrible disadvantage to the insider.

Why is this so bad? Well, besides being patently unfair, it creates turmoil and undermines public confidence in the securities markets. This is so because markets operate most efficiently if they consist of informed buyers and sellers who are on a level playing field.

You might ask how one could be as knowledgeable as a security analyst. Well, the fact is, under most circumstances, you can’t. However, it is also a fact that everyone has access to the same information as that to which the security analyst has access.

It might be easier for the analyst to garner such information (because that’s all he or she does), but the fact is that such data is public and is therefore available to you.

This process, an equitable sharing and availability of data, keeps the markets functioning efficiently. Just think, if insider trading were running rampant throughout the markets, there would be total pandemonium, and it would be almost impossible for even an astute investor to determine a fair price for a particular stock.

Martha Stewart’s ‘Demise’

Most of us are somewhat familiar with what happened to Martha Stewart, at least what allegedly happened to her. She supposedly got inside information that the FDA hadn’t approved a particular cancer drug that was central to the company’s profits.

It was alleged that because of that, she did what many of us might have done — she sold her stock in the company. If that is how it happened, then maybe, at that point, she didn’t realize that she was violating the insider trading laws. Before the notoriety from the Stewart trial, many of us would have thought that such actions were a natural response to the situation.

What went wrong, in my opinion, was that when she was confronted by the authorities, she didn’t fess up. If she had, I would think, she might have gotten a slap on the wrist and been done with it. Unfortunately, based upon the court proceedings and what the jury believed, she didn’t tell the truth about why she did what she did — namely sell her position in ImClone Systems.

Personal Revelation

I was recently retained by an official of a publicly held company to give him and his company some financial advice. In that capacity, I became privy to certain information about the company that was pretty optimistic. No, I didn’t then go out and buy stock in the company. That would have been an obvious violation of the law.

What I was tempted to do was call a friend who had a sizeable investment in the company and was worried about the company’s future. I was tempted to tell him not to worry, that there were some very exciting things on the horizon. I reasoned that so long as I didn’t give him any specifics about what I knew, I wouldn’t be sharing insider information.

Upon reflection, I decided to tell him nothing. Technically, I’m not sure that if I had just given him a generally rosy scenario about the company and his investment I would have violated any insider trading laws. However, I knew that my friend might have pushed me for more information and I would have had to turn him down.

So, discretion being the better part of valor, I told him nothing and left him to his worries. The point is that anyone who obtains privileged knowledge about a publicly held company should keep such knowledge private and not act upon it for personal gain.

Safe Path

Insider trading has now become a pretty prominent phenomenon. Nowadays, there is no excuse for any of us to stumble and fall when it comes to violating this law. The best bet is to be extremely cautious and to keep greed and pride at bay. If you have any doubts about a particular situation that you think could be faintly related to insider trading, by all means consult your attorney.

Keep on the safe regulatory path. And, good luck!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which deals in bringing small-cap companies public. He also is a frequent speaker on the subject of financial advice for small businesses as well as the IPO process. He can be contacted at [email protected].

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