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Springfield Business Journal Articles
Sarah Delano Pavlik and Tom Pavlik write a monthly column on legal and business issues for the Springfield Business Journal.


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By now you've heard that Martha Stewart is under investigation for insider trading. Whether you love her or hate her, you may be wondering if she actually broke the law, and, if so, what type of punishment she could receive.

Insider trading is one violation of the Securities Exchange Act of 1934 (the "Act"). The Act and other federal securities laws was enacted in response to the Great Depression and the irregularities that contributed to the collapse of the stock market. The Act states that its purpose is to "protect interstate commerce, the national credit, the Federal taxing power, to protect and make more effective the national banking system and Federal Reserve system, and to ensure the maintenance of fair and honest markets in such transactions." The SEC describes securities laws as follows: "The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it."

Toward this end, the Act mandates certain disclosure by all corporations that are traded on the securities exchanges such as the New York Stock Exchange. In addition, that Act requires companies with more than $10 million in assets and more than 500 shareholders to file annual reports. These reports must be prepared by certified public accountants. The preparation of the reports is a significant portion of the work of large accounting firms. Therefore, it was a tremendous blow to Arthur Andersen when the SEC ruled that public reports could no longer be prepared by that firm.

The Act also created the Securities and Exchange Commission (the "SEC") and empowered it to engage in market surveillance searching for fraud, manipulation and misrepresentation (the type of conduct depicted in the movie Wall Street).

One violation that the SEC looks for is insider trading. The Act prohibits the purchase or sale of a security while a person has "material, nonpublic information" about the issuing corporation. In addition, the rules under the Act make it unlawful to "omit to state a material fact . . . in connection with the purchase or sale of any security." According to the SEC, "Insider trading is illegal when a person trades a security while in possession of material nonpublic information in violation of a duty to withhold the information or refrain from trading."

The requirement of "nonpublic" regarding information is generally easy to prove. The requirement of materiality is more difficult. The courts have been faced with this issue many times. Some examples of information the courts have found to be material include a new discovery of oil or other minerals, the invention of a new product, a significant change in the company's financial condition, or a change in dividends.

In the Martha Stewart case, the corporation was ImClone. The inside information was that the Food and Drug Administration had rejected ImClone's new drug for treating cancer. When this information became public, ImClone's stock price dropped by almost 20%. Obviously, the rejection by the FDA of ImClone's drug was material information. Stewart sold her stock the day before the news became public.

Stewart was not an officer or director of ImClone, however, the Act does not require a person to be an officer or director of the corporation in question. An outsider who receives inside information is known as a "tipee." The Supreme Court has addressed the issue of trading by tipees many times. In a 1983 case, the Court stated: "Not only are insiders forbidden by their fiduciary relationship from personally using undisclosed corporate information to their advantage, but they may not give such information to an outsider for the same improper purpose of exploiting the information for their personal gain. . . . In determining whether a tipee is under an obligation to disclose [nonpublic information], it is thus necessary to determine whether the insider's 'tip' constituted a breach of the insider's fiduciary duty."

Since the ImClone information was nonpublic and material, the SEC will need to prove that Stewart knew the information and that she knew she received it in violation of a duty to withhold the information. For example, if she received the information directly from Sam Waksal, the CEO of ImClone, she should have known that he had a duty to withhold that information. Stewart was a securities broker before she embarked on the creation of her empire. In addition, as the CEO of a public company, she should be very familiar with the SEC rules.

If Stewart is found guilty of insider trading, she will face fines and penalties. In addition, she could face criminal prosecution, although that is unlikely. Nevertheless, in the wake of Enron, the SEC may begin to ask for harsher penalties against those who violate the securities laws as the stability of the financial markets is questioned.
Posted in: July, 2002
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