Would You Be Guilty of Insider Trading?

All investors rely on trading tips from others, but you need to be sure you’re not crossing into illegal activities.

If you’re an active investor who occasionally buys or sells a stock based on tips, you might be understandably nervous about the massive insider trading crackdown surrounding Galleon Group. The now-defunct hedge fund is linked to more than 20 guilty pleas and more than two dozen arrests involving an array of alleged conspirators, including lawyers, consultants and investment managers.

Editor's Note: On May 11, 2011, after the original publication of this story, hedge fund billionaire Raj Rajaratnam, a managing member of Galleon, was found guilty of 14 felonies -- nine counts of securities fraud and five of conspiracy to commit securities fraud. Each securities fraud conviction carries a maximum penalty of 20 years in prison and a $5 million fine. The ruling marks the 35th insider trading conviction over the past 18 months for the U.S. Attorney's office for the Southern District of New York.

And Galleon is only the latest in a bevy of recent insider-trading prosecutions, including one case filed against a group of technology salespeople who traded Apple shares based, allegedly, on confidential information and another case that nabbed a doctor for blabbing about clinical trials for a new drug.

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Yet if people couldn’t trade on tips, Jim Cramer, the host of CNBC’s Mad Money program, would be out of work. In reality, it is perfectly legal (although potentially unwise) to trade on some tips that you hear or overhear. Illegal insider trading is all about facts and circumstances. Which situations constitute illegal insider trading and which don’t?


Situation #1: Coffee Talk

You are standing in line at Starbucks, and a well-dressed couple in front of you is talking about retiring to Majorca after they sell their company. You recognize them as the founders of a publicly traded company and figure out that the deal hasn’t yet been announced. You snap up as many shares as you can afford and make a killing when the takeover is announced. Is this insider trading?

No. If this couple bought or sold shares -- or called you and tipped you off in private -- it would be a violation. But illegal insider trading requires that you not only trade on the basis of important nonpublic information but that you also have some sort of duty to keep the information confidential. Former football coach Barry Switzer was sued for insider trading following a similar scenario in 1981, but he won the case because he had no duty to ignore a conversation he overheard in a public place.

Situation #2: Office Eavesdrop

You’re a janitor at a major company. You hear members of the company’s board convening outside the room you’re cleaning and decide to hide in the closet. The board okays a deal to sell the company for a fat premium to the current share price. You load up on the shares. Illegal insider trading?

Definitely. This is not a public place, and “you’d be in a position to understand that confidential information was being disclosed, which changes the calculus,” says Andrew Stoltmann, a Chicago-based securities lawyer.

Situation #3: Stranger Danger

You hop in a cab at JFK and are startled by the driver’s Armani suit and solid-gold pinkie ring. You learn that the driver is merely taking this shift as a favor for a friend. The driver is now happily retired, living on his investment portfolio. When you whine about your own, he says: “Look, I’ll give you a break. Buy as much stock in Google as you can.” You do. Insider trading?

No . It may be unwise -- because the cab driver could as clueless as you -- but you have no reason to believe he’s telling you anything that’s not public information.

Situation #4: Proud Papa

Once again a cab driver is offering stock tips, but this time he mentions that his son is an attorney at Skadden, Arps, Slate, Meagher & Flom, a major law firm in the merger game. Insider trading?

This scenario could qualify as insider trading. It’s all about whether you have reason to believe that you’re receiving important, nonpublic information from a person who has a duty to keep that information private. The cab driver’s trading would definitely be verboten. Yours is in a hard-to-defend gray area, says Stoltmann.

Situation #5: Mass Exodus

You read a few years back that executives at Countrywide Financial, the big mortgage lender, were unloading their stock. You decided that they must know something you didn’t, so you followed suit and sold your shares, too. Now you worry that the Feds are going to come after you. Insider trading?

For you? No. For them? Maybe. Executives can sell their own company’s stock without running afoul of the rules as long as they’re not trading based on information they haven’t shared with the public. The SEC sued Countrywide’s CEO, Angelo Mozilo, and several other insiders in 2009 (after the company had been acquired by Bank of America), alleging that they had improperly traded on undisclosed information about the evil lurking inside the company’s loan portfolio. Mozilo, who netted some $140 million selling Countrywide stock before the company collapsed, eventually settled the suit without admitting or denying guilt by paying $67.5 million in fines and disgorging profits.

As for you: Mozilo’s trades were disclosed in SEC filings and in numerous news stories. Trading based on publicly available information is perfectly legal.

Situation #6: Disgruntled Employee

A woman in your Bunco group says she’s about to quit her job because she can’t stand the strain of working in a medical office where all the patients are dying. Because of previous casual conversations, you know that patients in this office are involved in early trials of a new drug. You know what the drug is and who makes it. You sell short shares of the drug’s developer, betting that the stock will fall in value. Did you violate insider-trading rules?

This probably would not qualify as insider trading. Your playing partner is sharing information that’s so general it can’t be used to gauge whether the clinical trial will result in failure. Thus, the tip fails the materiality test. It’s not significant enough to the company’s stock price. And because the woman is just sharing information about the status of the office’s patients and not the trial (including whether the ailing patients are taking the new drug or a placebo), no one appears to have a duty to keep quiet.

Situation #7: Disgruntled Employee’s Boss

Your friend’s boss calls and begs you to talk your friend out of quitting. The boss tells you confidentially that the drug trial your friend is upset about will soon be terminated because the drug is probably responsible for the deaths of those in the trial. You sell the developer’s stock short. Are you violating insider-trading rules now?

Yes. You’ve been fed important information from an insider, who has said that the information was confidential. The SEC recently filed an insider-trading case against two individuals -- a hedge fund manager named Joseph “Chip” Skowron and a medical researcher, named Yves Benhamou, who was overseeing a drug trial. The SEC alleges that Skowron paid Benhamou with envelopes stuffed with cash for confidential information about the results, which he then used to avoid tens of millions in stock losses on his holdings in Human Genome Sciences. Benhamou pled guilty; the case against Skowron is pending. The hedge fund Skowron worked for settled without admitting or denying guilt.

Situation #8: Shared Broker

Your broker calls and says you need to get out of ImClone Systems now because the CEO, who is also his client, is selling all his shares. Insider trading?

Maybe. The SEC filed suit against homemaking personality Martha Stewart in 2003 with these exact facts. Stewart did end up going to prison -- but not for insider trading. She was convicted of obstructing justice and lying to prosecutors. Stewart settled the SEC’s insider-trading case, paying a fine and agreeing to never violate securities laws in the future. The settlement eliminated the need for a trial as well as a definitive answer about whether she had “a duty” to ignore the tip. But the case was complicated by the fact that Stewart had once been a stockbroker. The SEC contended that she should have known better.

Situation #9: Gordon Gekko

You’re a hedge fund manager, buying and selling stocks constantly. You pay a series of experts to feed you hush-hush information about pending mergers, and you earn millions in profits by buying shares of takeover targets before deals are announced. Insider trading?

Absolutely. If you bribed or bought insider information and traded on it, you’re going to prison.

Situation #10: Information Seeker

You’re a hedge fund manager, and you pay dozens of analysts and consultants to provide seasoned advice about stocks to buy and sell. Some of those consultants may have access to secret information, but you trade based on a wide array of factors, including examination of public documents and detailed analysis about industries and companies operating within them. Insider trading?

This situation probably would not be considered insider trading. The key to the case against Galleon CEO Raj Rajaratnam, says Stoltmann, hinged on whether his lawyers were able to establish that his trading was based on assembling a “mosaic” of information or whether he paid “consulants” to feed him insider tips. The former, says Stoltmann, is perfectly legal. The latter is not. (See the above Editor's Note for an update on the case against Rajaratnam.)


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Kathy Kristof
Contributing Editor, Kiplinger's Personal Finance
Kristof, editor of SideHusl.com, is an award-winning financial journalist, who writes regularly for Kiplinger's Personal Finance and CBS MoneyWatch. She's the author of Investing 101, Taming the Tuition Tiger and Kathy Kristof's Complete Book of Dollars and Sense. But perhaps her biggest claim to fame is that she was once a Jeopardy question: Kathy Kristof replaced what famous personal finance columnist, who died in 1991? Answer: Sylvia Porter.