On May 12, the day investment banker Dennis B. Levine was arrested on criminal charges stemming from the largest insider trading case in history, the stock of American Brands Inc. was selling for $93 a share. In the next three days, the price plunged 10 percent.
The stock had been buoyed partly by rumors that American Brands, a major tobacco company, might be acquired by one of Levine`s clients. After the arrest, ”A lot of people wanted to sell it, not to have it in their portfolios, since it was considered part of Levine`s leaks,” said one arbitrager, a trader who speculates on stocks involved in takeovers.
The cooling of speculative fever surrounding American Brands is a dramatic example of the chill that has swept Wall Street since the Securities and Exchange Commission launched its recent crackdown on insider trading
–illegally profiting from significant facts that haven`t been announced to the public and are likely to affect stock prices.
The rumor mill hasn`t creaked to a halt, but the arbitragers, or
”arbs,” and investment bankers who fuel it are watching their words more closely. Those who specialize in trading on rumors are picking their stocks with care. And overall trading volume has been somewhat sluggish.
”Things are as quiet as I`ve ever seen them,” said an arb who has been in the business for 15 years. ”The government accomplished what it wanted to accomplish.”
As a result, the SEC is clearly riding high these days. The agency`s reputation for protecting small investors has taken something of a beating in the last five years under John Shad, who was appointed by President Reagan. Critics charged that the SEC rushed to embrace deregulation while failing to fight for the resources needed to adequately police the nation`s fast-growing securities markets.
But the Levine case and two other major insider-trading actions since May have helped refurbish the agency`s image as a tough cop. An SEC staffer compared the favorable press attention to what he termed the agency`s halcyon days in the 1970s, when it was probing corporate slush funds used for illegal campaign contributions and bribes to foreign governments.
The numbers on the agency`s insider trading drive are impressive: 18 cases filed in the first eight months of the 1986 fiscal year ending Sept. 30, up from 20 in all of 1985 and 13 in 1984; 40 convictions of New York insiders through the U.S. Attorney`s Office in Manhattan in the last 18 months; and about $25 million of illegal profits expected to be recovered this year, including $11.6 million from Levine.
There have been so many insider trading cases that two SEC employees were overheard joking the other day about a new TV show, to be called ”Wall Street Vice.” The latest black humor among arbs has it that yuppies have been replaced by yippies–young indicted professionals.
Though SEC officials deny it, many experts are convinced that the string of recent flashy cases represents an orchestrated attempt to flaunt the agency`s enforcement power.
”By picking out the big cases, the SEC creates the illusion of three dimensions, the illusion that they are everywhere,” said Harvey Pitt, a former SEC general counsel who represented Bank Leu International Ltd., the Bahamas bank through which Levine traded.
A House securities oversight subcommittee has scheduled a hearing Wednesday on whether the SEC needs even more enforcement tools to fight insider trading, including additional power to compel aid from foreign governments. Meanwhile, the General Accounting Office has been investigating the overall job done by agency enforcers.
Many observers praise the SEC`s efforts as a way to clean up Wall Street. ”This is exactly what the SEC should be doing,” said Samuel L. Hayes, a Harvard Business School professor. ”The most important mandate regulators have is to maintain confidence and fairness in the system.”
Peter Romatowski, an ex-assistant U.S. attorney who prosecuted former Wall Street Journal reporter R. Foster Winans for insider trading, said: ”The sophisticated public, the investing public, certainly believes that the problem continues to grow. The attention to the Levine case is exactly what the government needs.”
Not everyone is cheering, however. Some critics charge that the SEC`s pursuit of insider trading has come at the expense of other important regulatory activities.
”Insider cases are the easist cases to make,” said a senior Senate staffer who has examined SEC enforcement practices. ”The fact is that the SEC has limited resources and they aren`t using them to protect investors. They`re going for the headlines.”
”The SEC is like a police force that`s so badly stretched it only spends resources on capital crimes and not day-to-day law enforcement,” said Richard Phillips, a Washington attorney and former SEC assistant general counsel. He cites a decline of nearly 5 percent in agency staffing in the last 10 years.
A vocal band of academicians insists that the agency`s insider trading campaign is misguided, because trading by insiders may actually help the stock market function more efficiently. And, despite the SEC`s best efforts, enforcement of insider trading laws may be a futile task in light of the huge profits to be made, some observers maintain.
Trying to police insider trading is ”just like dropping thousand dollar bills on State Street and having a law against picking them up,” said Henry Manne, incoming dean of George Mason University Law School, Fairfax, Va., and a long-time SEC critic.
Gary Lynch, SEC director of enforcement, brushes off criticism of the agency`s actions. ”We`re in a better position to determine how we allocate our resources than people who don`t see what we see,” Lynch said.
He said the suggestion that many Wall Streeters are apt to ”succumb to the temptation of easy money” is ”an insult to the vast majority of people involved in the securities business.”
Insider trading is a ”serious problem, but it isn`t so serious that it has a substantial effect on the integrity of the marketplace,” Lynch said.
”I seriously doubt if more than .001 percent of daily volume on any exchange results from trading by people with inside information.”
That may be true, but there is plenty of circumstantial evidence of widespread insider trading before takeover announcements. A survey conducted for The Tribune showed that the stock prices of target companies involved in 33 of the top takeovers since 1985 jumped an average of 11.6 percent in the month before the announcement.
That increase was five times as large as the 2.3 percent average rise of the Standard & Poor`s 500 stock index in the same periods, according to the survey by Evaluation Services Inc., Dumont, N.J., and Securities Data Co., New York. More precise studies, using bigger samples and taking into account that price changes may be partly due to the riskiness of the stocks involved, have shown similar results.
Five stocks in the survey were among the 54 in which Levine allegedly traded on inside information; there the pattern is unmistakable. The price of American Natural Resources Co., for example, increased 21 percent in the month before a tender offer on March 1, 1985, by Coastal Corp. That compared with a 1 percent rise in the S&P 500 in the period.
According to the SEC, Levine, who helped engineer the Coastal offer while employed by Drexel Burnham Lambert Inc., bought 145,000 shares of American Natural Resources stock in the two weeks before the offer at an average price of $49.93. Three days after Coastal announced its offer for $60 a share, Levine cashed in his shares for a profit of $1.4 million, the SEC said.
Of course, all such price movements don`t stem from insider trading. The acquiring company itself may buy shares, for example, and other traders may take positions in the stock on a hunch that an announcement will be forthcoming. Or speculators may snap up shares in a company simply because there has been a flurry of takeover activity in the firm`s industry.
Nevertheless, ”If the truth be known and we were able to put together all the facts, in most cases when there is a (price) run-up at least some of the traders are trading on inside information,” said Lynch.
Besides the proliferation of multibillion-dollar takeovers, the growth of trading in stock options has also made it easier to profit on inside information. Options, contracts granting the right to buy or sell stock at a specified price by a given date, provide the chance for huge returns on small initial investments.
For example, a Kuwaiti businessman named Faisal al Massoud al Fuhaid parlayed $50,000 into $1.1 million by buying options on Santa Fe International Corp. in September, 1981, shortly before the company was acquired by Kuwait Petroleum Corp. Faisal and seven other foreign investors accused by the SEC of insider trading agreed earlier this year to give up a total of $7.8 million in profits.
In another case involving options, Thomas C. Reed, a former Reagan administration official, reaped $427,000 in two days on a $3,000 investment in options on Amax Inc. in advance of Standard Oil of California`s 1981 bid for the company. Reed settled a civil suit with the SEC and agreed to give back the profits; he was recently acquitted on criminal charges.
Those who applaud the SEC`s efforts say strict enforcement of insider trading laws is needed to boost public confidence in securities markets. They link the decline in individual participation in the stock market–to about 11 percent of the trading on the New York Stock Exchange from 25 percent 10 years ago–partly to a perception that small investors don`t get a fair shake.
But some legal scholars and economists aren`t convinced that anybody is hurt by insider trading. ”Sophisticated academics are much more skeptical about what the SEC is doing than most people are,” said Daniel Fischel, director of the University of Chicago`s law and economics program.
The SEC bases its crusade on the idea that small investors shouldn`t be at too much of a disadvantage to better informed traders. Academics, on the other hand, start with the notion that trading by those with better information helps the market reflect a firm`s true value. Incentives to collect this data are needed to encourage trading, they argue.
But there are economic arguments on the other side. Lawrence Glosten, assistant finance professor at Northwestern University`s Kellogg Graduate School of Management, argues that market makers on stock exchanges must widen their bid-ask spreads to protect themselves in trades against people with much better information.
Bid-ask spreads represent the difference between what a market maker is willing to pay to buy a stock, on the one hand, and the price he demands to sell it, on the other. This suggests possible damage from insider trading, because bigger spreads mean higher trading costs for investors.
Concedes Fischel: ”There`s no economic theory that currently exists which can measure what the right amount of informed trading is.” However,
”having people with superior access to information isn`t only pervasive but necessary and desirable.”
Indeed, much trading by insiders occurs legally. Federal securities laws prohibit officers, directors and major shareholders from short-term trading and from short selling (selling borrowed shares on the hope that prices will fall). But they may invest in their companies` stocks as long as they don`t do so based on nonpublic information that is legally ”material,” or significant.
Studies have shown that insiders, trading legally, are more successful than average investors. Such inside traders must file reports with the SEC, and many services have sprung up to track their activities as a guide for other investors.
Still, academic theories haven`t won much support. ”The academic arguments make for interesting discussion, but the reality of the matter is that investors–whether small investors or institutions–want to invest in fair markets,” said Lynch.
However, SEC enforcers, bent on applying restrictions to an ever wider circle of insiders, have often been rebuffed in court. The basic prohibition against insider trading comes under federal antifraud statutes; the term itself is mentioned nowhere in the law.
The Supreme Court in an important decision in 1980 said that financial printer Vincent Chiarella didn`t have a duty to the general public to disclose nonpublic information simply because he had access to it. In another significant decision three years later involving securities analyst Raymond Dirks, the court ruled that restrictions don`t automatically apply to persons outside a company who are told or find out about inside information.
The court said a violation occurs only if the person passing on the information breaches a fiduciary duty to his employer and also benefits from the tip, according to New York attorney Pamela Chepiga, formerly of the U.S. attorney`s office in Manhattan.
Because Levine pleaded guilty, it`s not clear whether the SEC would have pressed a novel theory about the 35 stocks (out of a total of 54) in which Levine traded but didn`t play an investment banking role–and therefore must have been tipped off by others. But in its complaint the agency relied partly on a six-year-old rule, known as 14e-3, that has been largely untested in court. The rule applies only to tender offers and appears to be a much broader ban on trading on nonpublic information.
Some securities lawyers contend that recent SEC cases, including the one against Winans, have created gray areas under federal law. There`s concern that information may dry up because of fears that those trading on rumors may be breaking the law–even if their tips don`t come from insiders.
But others say the areas of uncertainty are overstated. ”People know what`s right and wrong in these areas, at least most of the time,” said John A. Wing, president of the securities firm Chicago Corp. and a former SEC enforcement attorney.
In any case, it`s clear that the recent SEC actions have triggered extreme nervousness on Wall Street. ”There isn`t an investment banking head who is sleeping well now,” said a 20-year veteran of the arbitrage business. One result may be prompter reporting of legal insider trading, says Bob Gabele, president of Invest/Net, a Miami firm that records insider filings. Gabele and others have long criticized the SEC for lax enforcement of reporting deadlines.
But filings in May were up 11 percent from a year earlier, Gabele said. Some of that may represent ”a rush to clean up house,” he added.
Most securities firms, including those that have no reason to suspect wrongdoing, are reviewing their policies for handling confidential
information. ”All of us are receiving memos from our outside lawyers,” said Wing.
But it`s not easy for big investment banking houses to deter would-be lawbreakers. When Salomon Brothers Inc. created its compliance department in 1971 to oversee trades and set standards, there were typically 1,000 to 2,000 trades a day to check. Now there can be 20,000 a day, according to Allan Pessin, who supervises the firm`s compliance efforts.
Said the SEC`s Lynch: ”It`s very difficult for any institution to control someone who is hellbent on abusing confidences.”
