When hot stock tips can get you into hot water
New York — Great Aunt Harriet has just returned from the beauty parlor, ablaze with the news that the woman who had her hair colored in the next chair is married to an officer at a major New York Stock Exchange corporation. That same corporation, Harriet says breathlessly, will be taken over next week.
Is such a serendipitous tip free from the slings and arrows of a Securities and Exchange Commission investigation on insider trading?
If a cabbie driving two investment bankers to Wall Street overhears them discussing a merger, can he relay the news to his cousin, who is a stockbroker, without the risk of prosecution?
If your brother-in-law, a noted mergers and acquisitions lawyer, keeps flying down to a small town in Alabama where there is only one publicly held company, would your investing in that firm be deemed the result of insider information?
If you are dating the secretary to an officer of a major corporation and she tells you she saw documents about a proposed takeover, can you trade on that information without fear of culpability?
The investment banks, legal firms, and accounting houses involved in the proliferating number of mergers and acquisitions have long tried to protect their insider knowledge scrupulously.
For example, before it was acquired by American Express, Lehman Brothers Kuhn Loeb had a covert board room unknown to most clients in a modest office building on New York's Upper East Side - far from the firm's Wall Street headquarters. Here, boards of directors and officers of corporations involved in top-secret merger negotiations were shepherded.
Says a former Lehman partner: ''If the top officers from two major publicly held firms were seen marching down Wall Street to the Lehman building and shaking hands with our M&A (merger and acquisition) guys, everyone on the street would have known there was something going on, and the stock price could start to move. This board room served as a secret war room.''
Professionals involved in mergers and acquisitions generally guard the knowledge from snoops and are scrupulously tight-lipped about their activities. But the fact that merger activity is jumping means that tens of thousands of people who are peripherally involved in chauffeuring executives to negotiations, fixing their beepers, delivering their documents, or otherwise serving their lawyers, accountants, and bankers are capable of obtaining and using information not generally available to the investment public.
Trading on such information can be an offense that is prosecuted either civilly or criminally.
For instance, in a recent incident that occurred at the New York law firm of Skadden, Arps, Slate, Meagher & Flom - which does a lot of acquisition law - a proofreader and word processing operator scanned the confidential files of the firm's clients and learned which ones were engaged in acquisition activites.
They tipped a taxi driver and others with the information. The participants pleaded guilty of misappropriation of information and mail fraud for insider trading. According to Dennis J. Block, a partner at Weil, Gotshal & Manges, a New York law firm that does a lot of M&A work: ''This is an indication of a trend to more criminal prosecution of insider trading.''
If this ''insider trading'' seems more like ''outsider trading,'' that is not surprising. The rules and regulations the SEC has constructed involving ''insider trading'' have frequently extended to outsiders who ''misappropriate insider information'' or are on the receiving end of tips knowingly given by insiders for their own or another party's profit. ''The SEC has made trading on material nonpublic information (''insider trading'') whether by insiders or outsiders, its No. 1 enforcement priority,'' says Mr. Block, who previously served as chief enforcer for the SEC's New York office before joining Weil, Gotshal.
During his stint at the SEC, Block was involved in prosecuting one of the landmark cases of insider trading - the Texasgulf Sulfur case, in which officers of the company bought stock from shareholders without first disclosing that the firm had recently found a huge mineral deposit.
Such news is often available to insiders in a company who may know about lower earnings or a surprise mishap in the company before the investing public finds out. ''The classic insider principle,'' asserts Block, ''is that the person who is using the material (insider information) either to profit or for the benefit he will receive has some fiduciary responsibility to the public before he can commit the crime. In other words, before an insider can be charged with the crime of insider trading, he must first violate a duty to someone.''
But when the rules extend to outsiders making use of the same information for profit, the liability is not so simple. When it comes to the relatives of insiders, or other people they talk to, there are a lot of gray areas. Block cites the case of University of Oklahoma football coach Barry Switzer, who supposedly learned of insider information while attending a track meet at which the principal officer of Texas International talked abut a deal with Phoenix Resources. Mr. Switzer supposedly bought stock on that information and told other people.
In this case, it was decided that the material insider information was not intentionally passed to him, according to Block, so the conclusion, he says, is that ''if you gain insider information accidentally, you can't have misappropriated it and you can't be a tippee, because the tipper did not intentionally give it to you for his benefit or for the purpose of profiting.'' Adds Bruce Rich, A partner at the New York law firm, Spengler, Carlson, ''If there is no sign they opened up accounts in Switzerland or elsewhere to secretly make purchases, it would be difficult to prove intent to deceive.''
Therefore, the answers to the first two questions at the beginning of this story are yes, they can use the information without liability.
But other levels of opportunity may be even more complex. Take the case of a fireman who gets to a blaze, where a public company's main factory is burning down, and calls up his broker and sells his shares short. Cer-tainly such an action is not misappropriation of insider information, nor is there any fiduciary responsibility to shareholders. Or if a secretary at a law firm sees the chairman of a major company go into intensive negotiations with another group of officers and her firm's M&A experts, can she tell her broker?
Says Block: ''The chances are, you are not an insider and you will not qualify as a tippee, because no one knowingly gave you the information, as you didn't actually see the papers on the chairman's desk. In that case, since no one misappropriated information - it was an educated guess - there is no liability. However, if there was a chance to see legal documents or other indicative information, the secretary may be guilty of misappropriating inside information.''
Gray areas surrounding insider information are growing as more cases are prosecuted. For instance, a number of complications arose out of the Ray Dirks case. Mr. Dirks had inside financial information about the Equity Funding insurance scandal. However, the Supreme Court ruled that his revealing the information to certain clients was not misappropriation of information, since he had no insider's fiduciary duty. Secondly, Dirks's tipper did not breach his duty to shareholders, because he did not benefit directly or indirectly from the disclosure.
In another case which Block believes ''may be a landmark case for the government,'' the charges against R. Foster Winans Jr., the reporter for the Wall Street Journal who allegedly leaked information about forthcoming columns to friends and members of the brokerage community, may not be a case of insider trading at all.
''Winans had no fiduciary duty to shareholders,'' Block surmises. ''If anything, he had a duty to his employer, the Journal, but he only disclosed what he would write about certain companies, and the question is whether or not anyone violated the securities law.''