Academic journal article Journal of Financial Education

You Decide: The Company You Keep

Academic journal article Journal of Financial Education

You Decide: The Company You Keep

Article excerpt


Police struggle to keep the crowd under control as hundreds of reporters, television crews, and other onlookers pack the street outside the federal courthouse on the cold winter morning. Eventually, the police clear a path for the car bringing Dennis Levine and his lawyers to sentencing, but the courthouse is too small for the surge of public interest. In 1987, there is considerable public controversy about the criminal prosecution of insider trading. The first charge of insider trading had just occurred in 1978 and large-scale cases were rare. Dennis Levine, Ilan Reich, Robert Wilkis, and the financial world anxiously await your decision as the sentencing judge.


Who are insiders? In general, an insider is a person who has access to private company information such as pending takeovers or mergers, unexpected sales performance or potential lawsuits regarding hazardous products or environmental impact. In other words, insiders have asymmetric knowledge of company information that outsiders, or the public, do not have. Additionally, the knowledge is material, meaning that if the information were revealed, it would impact the value of the company. More specifically, insiders are readily identified as directors serving on the board, corporate executives, and those who have fiduciary responsibilities such as auditors, investment bankers or lawyers.

Legal or illegal? Most insider trading is actually legal.2 Company insiders can make perfectly legal trades in the stock of their company as long as the trades are in compliance with the reporting rules set by the U.S. Securities and Exchange Commission (SEC). Through section 10(b) of the Securities Exchange Act of 1934, U.S. prosecution of illegal trading by insiders has been based on violation of Rule 1 Ob-5, a general antifraud rule that prohibits deceptive conduct in trading. Having 'a fraudulent intent is an element that must be proven' (Rao, 2011). Violations are handled in civil court by the SEC or in criminal court by the Department of Justice (Nagy, 2010).

For legal trading, the SEC requires company insiders to declare that their trades are based on public information. Some do not believe in prohibiting any insider activities because the costs of investigation far outweigh the dollars recovered. This argument may have been somewhat valid in the past when fraudulent dealings only involved stocks, but with the rise in traded derivatives, exponential returns could be made to the demise of the option writer (Rao, 2011).

Illegal insider trading cases have been prosecuted under two basic theories (Nagy, 2010). Persons who have acquired nonpublic material information, according to the Classical Theory, are to "either disclose it to the investing public, or .. .abstain from trading in or recommending the securities concerned while such inside information remains undisclosed" (2d Cir. 1968). Through similar court decisions, the accepted definition of an insider is broadened to include fiduciaries for the company not just the officers, directors and employees. The more controversial Misappropriation Theory was endorsed by the US Supreme Court in its 1997 case U.S. v. O'Hagan (Nagy, 2010, pilló). Prior to this time, several federal courts had used this interpretation while a few had refused. This judgment extended Rule 10b-5 to include a category of outsiders, fiduciary-tumed-traders, who have a fiduciary responsibility to sources of private information and deceptively utilize the confidential information entrusted to them, e.g., a lawyer who trades on information she gathered during a routine visit from a client who happens to be an executive for a company going through a merger.

Any steps taken by a company as part of its corporate governance set the tone for what is considered acceptable and unacceptable employee behavior. In an effort to limit illegal insider trading, many public investment companies, particularly investment banks, have enacted guidelines for certain trading activities. …

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