INSIDER TRADING : THERE’S JUST NO STOPPING IT : Despite a series of highly publicized prosecutions, violations are still rampant.
Hot on the trail of inside traders, Richard Chase and his aides unfolded a street map of Brooklyn, N.Y., and began sticking in pins.
Chase, the head of the Philadelphia Stock Exchange’s surveillance unit, was looking for a pattern. Each pin marked the home address of people who had bought Colt Industries stock options in a flurry of unusual trading just before Colt announced a plan to buy back much of its stock from the public.
The announcement sent Colt’s shares skyrocketing by nearly $27 in one day. It made the otherwise worthless options turn a profit of about $1.5 million on an investment of $38,000. The hasty buying just before the announcement seemed more than a coincidence. And as the pins were put in place, the investigators saw that all of the options buyers lived within a few blocks of each other in Brooklyn’s garment district.
This bit of detective work, prompted by a computer warning of unusual options trading, led to the conviction of a 34-year-old New York lawyer on criminal insider trading charges. The lawyer, Israel Grossman, made more than 40 phone calls, tipping relatives and friends in his Brooklyn neighborhood of the Colt stock buy-back that his law firm was working on.
Although the Colt episode occurred over a year ago--Grossman was sentenced to two years in prison in 1988--it is an example of the detective work that specialized analysts at the Philadelphia, New York, American and other exchanges still perform regularly. For, despite the huge, highly publicized insider trading cases that the Securities and Exchange Commission and the Justice Department have brought since 1986, insider trading is continuing to plague the nation’s stock and options exchanges.
SEC officials say that--for the moment, at least--they have eradicated large-scale insider drading by investment bankers and senior Wall Street traders. If true, it is a major victory. But they acknowledge that little progress has been made in deterring people outside the securities industry. Officials say that insider trading remains rampant among non-professional investors, including ordinary citizens who happen upon inside information, and among lawyers, employees of law firms and corporate executives who know that their companies are about to disclose market-moving news.
Despite a crackdown on insider trading that began in the mid-1980s, and the highly publicized chain of cases sparked by investment banker Dennis B. Levine and stock speculator Ivan F. Boesky, the general public still hasn’t gotten the message, according to investigators who monitor trading. David S. Ruder, who will step down soon as chairman of the SEC, said in an interview that “the public still seems to be as greedy as ever.” He added: “When a member of the public gets a piece of information, many of them don’t seem to understand the law, and many of them continue to act on that information.”
Illegal insider trading occurs when someone buys or sells securities on the basis of confidential information that, when revealed to the public, is likely to move the price of a company’s stock up or down. For example, a person would be guilty of insider trading if he or she bought stock in a company because a next-door neighbor, the company’s executive vice president, confided during a friendly chat that a merger would soon be announced.
Yet even when they know that profiting from inside information can lead to criminal charges and jail sentences, many people continue to take the risk. Why?
Seymour G. Ruderman, a former Business Week magazine employee who is serving a six-month prison sentence after pleading guilty to insider trading, says he believes that people haven’t been deterred by the crackdown on illegal trading because “the urge to get rich is still dominant, and it clouds people’s judgment.”
Ruderman, who was employed by Business Week to give stock market commentary on radio stations, had advance knowledge of the magazine’s closely followed “Inside Wall Street” column. Over more than two years, he used the advance information to make about 50 small trades for a profit of $15,000. Ruderman said people who trade illegally on a small scale probably still don’t realize that they’re breaking the law. “They don’t think they’re doing anything wrong,” he said.
There are few hard statistics on insider trading. The SEC refuses to disclose how many cases of suspected insider trading are referred to it each year by the exchanges. Gary Lynch, who is going into private practice after four years as SEC enforcement director, says the number probably has gone up. But he says this is probably due to more vigilant monitoring by the exchanges rather than an actual increase in illegal trading.
For their part, stock exchange officials who monitor trading say they haven’t seen any drop-off in suspicious trading that occurs shortly before public disclosure of market-moving corporate news. Jay S. Bono, the head of the computerized Stock Watch unit that monitors unusual stock trading at the American Stock Exchange, said: “There’s clearly no meaningful decline in things that look funny enough to warrant an investigation by the Amex.”
Rumors or even astute guesswork by sophisticated investors often account for unusual trading. This makes it difficult to sort out trading based on hard, inside information. But exchange officials say there are many examples in which rumors alone don’t seem to explain the trading. Anecdotal evidence abounds of recent suspicious trading.
It was disclosed just last week that the SEC and the New York Stock Exchange are investigating a jump in the stock price of Squibb Corp. on July 26, the day before a $12.1-billion merger with Bristol-Myers was announced. Squibb stock rose 37.5 cents a share to $87.75 in heavy trading on the New York exchange. The pattern of buying suggested that a small number of people who knew about the deal may have traded on the inside information.
The American Stock Exchange is said to be investigating a surge in options trading of Ogilvy Group on April 28, just one day before WPP Group PLC announced a $45-a-share offer for the advertising company. Options trading swelled to 921 contracts on April 28, up from 133 the day before. As a result of the announcement, Ogilvy’s stock soared. Some of the highly risky options ended up paying about $900 each on an investment of $25.
And the New York Stock Exchange is looking into the surge in the stock price of Holiday Corp. just over a week ago, immediately before the company announced it was selling its hotel chain as part of a major restructuring.
During an interview in his office earlier this summer, Bono displayed a sheaf of reports on his desk of incidents of suspicious trading in the preceding 10 days that had been referred for further investigation. Pulling a sheet at random, he cited an Amex-listed stock that had traded stably in the $50 range for several days. It had then jumped $3 in a single day on light trading volume. The jump came just a day before the company announced publicly that it had retained a major investment banking firm to explore selling or restructuring the company. Bono declined to identify the company because the matter is still under investigation.
“There’s insider trading that occurs on a daily basis,” Lynch says. Stephen L. Lister, head of the Intermarket Surveillance Group, which coordinates investigations among the various exchanges and the over-the-counter market, says that for the most part “John Q. Public thinks it’s still OK to act on a tip he received from his cousin.” Lister and SEC officials say many people have only a hazy understanding of the insider trading laws.
But ignorance of the law clearly isn’t the only explanation: Lynch and Lister acknowledge that a disproportionate number of recent insider trading investigations involve lawyers and employees of law firms. SEC officials--lawyers themselves--deny that there has been an outbreak of immorality in the legal profession. They attribute it instead to the fact that law firms have become increasingly involved in corporate takeover fights and routinely have access to confidential corporate information.
Statistical evidence shows that there is still a great deal of run-up in stock prices in the days preceding a market-moving corporate announcement. In a 1987 study, Gregg A. Jarrell, former chief economist at the SEC, found that in corporate tender offers from 1981 to 1985, on average 38% of the total price run-up in the stock around the time of the announcement occurred before the announcement was actually made.
The study notes many legitimate reasons for such a run-up, including rumors and earlier reports that the acquiring company had bought a block of stock in the target company. But even after attempting to factor out such explanations, the study concluded that “we are unable to explain a great deal of the pre-(takeover) bid trading.”
Jarrell, now a business professor at the University of Rochester, said figures for 1989 takeover stocks show no statistically significant change from the earlier study. A computer run performed by the university’s Managerial Economics Research Center shows that, among 46 takeover offers since Jan. 1, the stock price run-up before the announcement was still well over 30%.
Insider trading, whatever its actual level, persists despite increasingly sophisticated techniques developed for catching it. The exchanges’ computerized surveillance units are on the front line in the fight against illegal trading, monitoring the activity in each stock and option from minute to minute to detect unusual swings in price or volume.
In a glass-enclosed room several floors above the frenzied trading floor of the American Stock Exchange, a computer-generated male voice alerts human analysts to suspicious trading. “High price, AHP,” calls out the computer, known as SWAT, for Stock Watch Alert Terminal. The machine has determined that a price rise minutes before in the stock of American Home Products was unusual given the stock’s trading pattern in previous days.
The rise in American Home Products’ stock was later attributed to ordinary market factors, as it is in the vast majority of such computer “kick-outs.” Normally, a jump in price or unusually heavy volume turns out to be caused by a favorable report by an analyst at a brokerage firm, or by some publicly available corporate news or rumor. But of the 80 or so warnings that the computer makes each day, all are looked at by Stock Watch’s staff. When no obvious explanation is found--usually at least one case per day--the matter is referred to another Amex department for further investigation. If officials still fail to find a legitimate explanation, the case is turned over to the SEC.
At the American Stock Exchange, the sophistication of the monitoring techniques was demonstrated in the days immediately following the October, 1987, stock market crash. Although trading in many stocks then was wildly erratic, the Amex was still able to sort out suspicious trades in the stock of Irvine-based Ultrasystems Inc. The unusual trading came just before the company announced that it was being acquired. The alert work at the Amex led the SEC to file civil insider trading charges earlier this summer against an executive of the company, Dennis W. Evans, of Mission Viejo. Ultrasystems has said that Evens will fight the charges. The case is still pending.
The surveillance units also have databases filled with the names and addresses of people connected with the companies whose stock is traded on the exchanges. When the database was first installed at the New York Stock Exchange, its usefulness was demonstrated almost immediately, according to Robert J. McSweeny, head of the exchanges Stock Watch unit. In 1986, analysts in the unit noticed a $5.50 price jump, to $37.50 per share, in the stock of Los Angeles-based Thrifty Corp., on extremely heavy volume the day before Pacific Lighting Corp. announced an agreement to acquire the company for $886 million.
After obtaining a list of brokerage accounts for which the trading was done, the computer alerted the analysts to the fact that the zip code on the address of one of the brokerage accounts, in Dallas, matched the zip code of the home address of a member of Thrifty’s board of directors. After further investigation by the SEC, the director, William S. Banowsky, a former president of Pepperdine University, settled SEC civil charges and paid $750,000 in penalties for allegedly having leaked information about the pending acquisition to friends and relatives.
The suspicious trading continues despite greatly stepped up criminal prosecution of insider trading cases by the Justice Department, and despite a tough new law enacted by Congress at the end of last year. The law, the Insider Trading and Securities Fraud Enforcement Act of 1988, increased the fines for both individuals and firms and established a program for rewarding tipsters who turn in inside traders.
But the growing sophistication of computerized monitoring and the tough new sanctions don’t guarantee that individuals will be prosecuted. “There is a big difference between getting caught and getting prosecuted,” Lister says.
Lynch demurs when asked if there’s a better-than-even chance these days that an inside trader will be prosecuted. “I don’t know if I would say that,” Lynch replies.
Glut of Cases
The SEC remains seriously short-handed. The number of insider trading cases filed by the SEC in 1988 dropped to 25 from 36 in 1987. Lynch says this isn’t because insider trading has declined but because the agency had to devote so much of its limited resources to the mammoth investigation of Drexel Burnham Lambert Inc. and its former junk bond chief, Michael Milken.
The same problem applies at the U.S. Attorney’s Office in Manhattan, which handles much of the criminal prosecution of inside traders. Despite increases in staff, there are still far more violations than the securities fraud unit can cope with. “If we had twice as many (assistant U.S. attorneys), we’d do twice as many cases,” says Bruce Baird, the head of the unit.
Compounding the problem is the fact that some inside traders have become more sophisticated. SEC lawyers say individuals sometimes evade detection simply by using public telephones, setting up brokerage accounts under phony names and exchanging money in cash.
Individuals intent on evading prosecution also can do their trading through offshore brokerage firms. Lynch estimates that about one-third of insider trading investigations involve at least some trading through foreign brokers.
The SEC in recent years has made a huge push to get foreign governments to cooperate with U.S. insider trading investigations. The agency has made notable progress with some countries, including notoriously secretive Switzerland. But despite the progress, some governments still refuse to cooperate. And even with the stepped up cooperation from Switzerland, the SEC still hasn’t cracked what has long been rumored to be one of the biggest insider cases of all time, involving trading in U.S. securities done through Ellis AG, a small Zurich-based investment firm. The firm has denied any wrongdoing.
The drive by Congress, the SEC and the Justice Department marked an attempt to restore public confidence in the stock markets after the financial world was rocked by scandals in 1986. As a result of the Dennis Levine case and its aftermath, the public got a glimpse of an investment banking world that was rife with illegal trading on knowledge of pending mergers and takeovers.
Levine and Boesky
Levine, a former investment banker at Lehman Bros. Kuhn Loeb, was accused of making $12.6 million by trading on his inside knowledge of pending mergers and takeovers. Levine soon implicated Boesky, who at the time was one of Wall Street’s best known stock speculators. Boesky allegedly made at least $50 million based on leaks from Levine and other investment bankers.
Levine and Boesky, cooperating with prosecutors, in turn implicated a slew of other Wall Street figures in insider trading and securities fraud.
But the difficulty of deterring illegal trading was shown two years after the Levine and Boesky cases became public when the SEC uncovered the second-largest insider trading case on record. It involved an investment bank employee.
Stephen S. Wang Jr., a trainee analyst in the mergers and acquisitions department at Morgan Stanley & Co., was accused of leaking information about corporate deals that the department was working on. He later pleaded guilty to charges of leaking the information to Fred C. Lee, a Taiwanese businessman then living in the United States. Lee, currently a resident of Hong Kong, recently settled SEC charges by turning over to the U.S. government $25 million in illegal profits and penalties.
The current level of insider trading is important, since Wall Street firms are still reeling from a drop in business from individual investors who were scared out of the stock market by the 1987 crash. In attempting to lure investors back, brokerages want to assure customers that trading isn’t distorted by a handful of investors with inside information.
Since brokerage firms themselves are much less likely these days to be the source of the insider trading, Lynch says he hopes this might provide some new assurance to investors. In the meantime, there is no risk of underemployment among the SEC enforcement staff. Thomas C. Newkirk, the SEC’s chief litigation counsel, says: “There’s certainly enough out there to keep all of us busy full time.”