In today’s stock market, detecting illegal insider trading is a complex business, with elaborate surveillance techniques, artificial-intelligence programs–and some old-fashioned detective work.
The effort begins at the stock markets. The surveillance arms of the National Association of Securities Dealers and New York and American Stock Exchanges hunt through countless trades a day for suspicious activity.
Market officials are reluctant to discuss details of their surveillance efforts publicly, so as not to tip their hand.
But they use sophisticated computer monitoring, cross-referencing trades with thousands of company news announcements each day, looking for any connections. A new system at the NASD, honored this year by the American Association for Artificial Intelligence for its innovation, has generated more than 180 cases referred to federal authorities in less than two years.
Much of the real work, market officials say, is done by human analysts who examine dozens of leads the computers generate each day, and the thousands of tips they receive each year.
In some cases, market officials bring penalties themselves, and refer others to federal authorities.
The NYSE’s market surveillance division, for example, has referred cases against nearly 100 individuals or companies who have paid $30 million in penalties since 2000.
Critics, however, say that is only the tip of the iceberg of illegal insider trading. Indeed, Securities and Exchange Commission officials say additional resources would mean many more enforcement actions.
Once cases are referred, SEC officials face the difficult task of sifting through brokerage records, company documents, phone records and other information to make connections between what the traders knew, where the information came from and when they got it.
“This is the closest thing the SEC does to what I call street crime,” said Neil Lang, a former chief trial attorney for the SEC’s enforcement division who is now a partner at the Sutherland Asbill & Brennan law firm in Washington.
“It’s a lot of digging and putting things together.”
In their search for insider trading, experts say officials look at a variety of factors.
These include the size of trades and the stock’s subsequent change, unusual trading patterns, the proximity of transactions to the announcement, and potential connections between traders and people in a position to know the news in advance.
“It is not one thing that gives us a determination not to follow something,” an NYSE official said on condition of anonymity. “On the other hand, one little thing can make us follow it.”
Large gray area
Vital to any case is documenting that the information insiders had was “material,” or significant enough to affect its stock price or influence investors’ decisions. That standard, of course, involves a large gray area and considerable judgment about when information crosses over the line.
Experts said earnings preannouncements tend to be difficult cases for several reasons, including the availability of public information from analyst research and the challenge of linking truly material, non-public news to those who traded.
Michael Malloy, a University of the Pacific law professor and former SEC enforcement policy special counsel, said it’s “probably not surprising” earnings warnings lead to few enforcement actions.
He noted that warnings sometimes don’t send a stock falling enough to attract regulators’ attention, partly because more firms are issuing them in borderline cases.
“In many situations, you’re going to get an earnings warning that represents an excess of caution on the part of the issuers,” he said.
The majority of SEC actions on insider trading stem from transactions before merger or tender offer announcements–nearly 72 percent in the four fiscal years ending in 2002, according to a Tribune analysis.
Current and former SEC officials said regulators examine many factors to set priorities. Deterrence is important, including high-profile cases and people who keep trades small, thinking no one will care.
“We try to bring cases of all kinds, including some relatively small cases, so people don’t get the mistaken idea that they can fly under the radar,” said Thomas Newkirk, the SEC’s associate director of enforcement.
Indeed, experts said officials may closely examine transactions by people with a history of suspicious trades; they sometimes become emboldened if they slip a couple of sales by.
Aside from market surveillance referrals, the commission receives about 200,000 tips of all sorts each year, but it has just over 1,000 staffers to do triage. “It’s hard work to sort through these things,” Newkirk said.
In the era of Enron, HealthSouth and their kin, more SEC insider-trading cases are linked to alleged financial reporting misconduct.
In October, for example, the SEC settled a case against former top Waste Management executives Rodney Proto and Earl DeFrates. Without admitting or denying guilt, they agreed to pay $3.8 million over allegations they sold stock after presenting a “materially false or misleading” picture of company results.
One earnings preannouncement case this year involved Kenneth Mellert, a former Chicago-based regional sales director for PeopleSoft Inc.
In February, regulators alleged he learned the software firm would preannounce a shortfall on April 1, 2002. They said he told a friend who bought put options, which rise in value if a stock falls.
When PeopleSoft shares fell 33 percent the next day, authorities said, Mellert and his friend split a profit of more than $218,000 before taxes.
Mellert pleaded guilty. In sentencing him to two months in a community facility and four months of home detention, the judge called the situation “one of the least pernicious insider-trading cases” she had seen, and said his actions were a deviation from an “exemplary” life.
`A momentary lapse’
“It was indeed a momentary lapse in judgment,” said Mellert’s attorney, Edwin Prather. “Ken is an outstanding executive who normally isn’t privy to inside information or if he got any, he might not even have known he’d received it.”
Overall, insider-trading cases made up just over 10 percent of all SEC enforcement actions in the past few years. Even though earnings warnings can send a stock reeling, trades before those events make up only a handful of cases.
“If they knew about the earnings warning, they would be violating the law,” former SEC Chairman Arthur Levitt said.
Detecting it, he said, is another matter.
“I think any insider-trading case is very often circumstantial evidence,” Levitt said. “They’re tough cases to make.”
That difficulty, and human greed, makes insider trading all but impossible to stamp out.
“There is still a fairly wide band of people out there who do think they’ll be able to slip this one by,” Malloy said. “It’s one of these battles where you have to stay committed to it.”
