This past week in Hidden Gems, I interviewed Dr. Nejat Seyhun, author of the outstanding book Investment Intelligence from Insider Trading. I asked him his opinions about the Martha Stewart case and, by extension, about insider trading laws in America.
The full transcript runs more than 20 pages, with Dr. Seyhun outlining when insider trading is predictive of future stock price movements. What follows here is an abbreviated version of the interview, during which he explains the basics of insider trading.
Tom Gardner: Nejat, can you simply define for us who is an insider in the public markets?
Dr. Nejat Seyhun: It is said, as defined by law, to be officers, directors and more than 10% shareholders. So a company usually designates who the officers are. They become insiders. They typically have corporate-wide decision responsibilities. They're probably sitting on some executive committee as well. So it doesn't go by title; instead, it goes by function. And the company decides who will be considered an insider. So in different companies they have a different number of executive officers who are considered insiders.
Also, anybody who owns more than 10% of any equity class of security would be considered an insider.
Tom: We have heard a lot about insider trading courtesy of the Martha Stewart conviction and the effects on her company, Martha Stewart Living Omnimedia (NYSE: MSO ) . Can you define, as best you can, what is illegal insider trading?
Dr. Seyhun: There are various sections of the Securities Exchange Act that define illegal insider trading activity. For instance, Section 10B basically states that it is illegal to either buy or sell shares, equity shares or any class of equity shares, in any public company if you are in possession of material non-public information. So what is material and what is non-public? That's left up to the courts to decide. So it's a judgment call. If I know something is material and unknown about the business, and I buy or sell in possession of that information, then I'm violating this particular section of the code.
There are other sections that regulate things like short swing profits, short selling, and so forth, but the main weapon in the SEC's arsenal is Section 10B.
Tom: Nejat, I'm constantly hearing and reading about money managers that dig around everywhere for every little bit of information they can get. Where is the line drawn? If they find something material, I perceive that they view that as a golden opportunity to buy. In fact, in observing some of these money managers, I'm convinced they would have sold ImClone (Nasdaq: IMCL ) also, if they'd heard that Sam Waksal was parting with his shares.
When I hear a money manager say "Yes, I spoke to the CFO" or "I spoke to the head of marketing at a cocktail party" or "I'm friends with him from years back; he's in my network of people that I talk to as an investor and I picked up this little bit of information about the company," is what they're engaging in illegal? It seems like a very gray area.
Dr. Seyhun: Of course, Tom, it depends on specifically what the CFO or CEO said to that person, but I would agree with your characterization that it falls in a gray area. If the executive is expressing personal feelings or wishes, well, that's probably OK. If, however, the executive is relaying some corporate announcement that would be forthcoming, that is definitely not OK. Information on certain specific events, like rejection of a drug by the FDA, that's definitely material inside information. And that's what apparently prompted Waksal to sell. That would clearly be illegal for Waksal to trade.
Tom: Right. With Waksal, that's about as clear as it gets.
Dr. Seyhun: Right. The question, though, is if somebody else, say, a money manager simply found out that Waksal was selling and they sold, would that be illegal? My feeling is no. If somebody just found out that he was selling and they didn't know why he was selling, they didn't know about the drug rejection, then the fact that they would imitate Waksal by itself is not illegal.
Tom: Your exhaustive work studying 21 years of insider trading data is something I use in my stock research in Hidden Gems. One interesting sidenote that I picked up is that you concluded from your work that one-fifth of the price move from a takeover occurs before the announcement is made.
Dr. Seyhun: Right.
Tom: Do you think that's an indication of information leaks in advance of buyouts? There must be something illegal going on here. Is it really just educated speculation by outside investors? Or do you think there is illegal insider trading happening here routinely?
Dr. Seyhun: We haven't been able to nail down exactly what percentage is what, but they're both present. Sometimes you'll read in the financial press that two companies are talking to each other about a possible merger, with no immediate announcement. The speculation begins then. That can happen. Of course, though, there is leakage of insider information leading to illegal trading.