Insider trading was likely just another nebulous financial term to much of the public before lifestyle mogul Martha Stewart brought this form of investment fraud to the forefront of media coverage. In 2004 Stewart was sentenced to five months in a federal penitentiary after the courts determined she had made an illegal stock sale based on insider information.
What Made This Case Insider Trading?
What Stewart did was considered stock fraud because she traded based on information not made public. She and others involved in the case were informed that the FDA was not going to approve ImClone’s experimental new drug. They sold their shares before the information was formally disclosed, knowing that the FDA announcement would devalue their investment.
Who Commits Investment Fraud Based on Inside Information?
Certain people are in a much better position to commit insider trading. Those who work for the company being traded, as well as their friends and family, have access to knowledge not publicly known. The same is sometimes true for those employed by banks and investment firms. Even government employees might have access to knowledge that can be used to make fraudulent sales and purchases.
Stewart Made it News, but She was Hardly the First
Insider trading has been around as long as securities, and may unfortunately be more common that most realize. One of the most notorious early cases involved Albert H. Wiggin, then-president of Chase National Bank. Just before the stock market crash in 1929, Wiggin made a public show of trying to improve market stability by making large investments on behalf of his bank — ostensibly in an effort to stabilize the market.
What supportive investors did not know was that at the same time he was selling off his personal shares in his bank in anticipation of the crash. His plan was to then repurchase those shares at the lower price created by the market crash and make a profit as the market eventually stabilized.
What Wiggin did, known as "selling short," was not illegal at the time, and even today happens legally. His position at the bank and use of his own companies, however, would make these transactions fraudulent by current laws, because his profit was based on inside information not known to the public.
When is Trading Inside Information Not Stock Fraud?
The law allows for cases where inside information is acquired but does not constitute investment fraud. The SEC’s Rule 10b5-1 covers this contingency for those whose trades are based on a preexisting investment plan, "applicable only when the contract, instruction, or plan to purchase or sell securities was given or entered into in good faith and not as part of a plan or scheme," to commit stock fraud.
The Penalties are Strict for Those Convicted
Those on the inside of any publicly traded corporation, as well as many others in the finance industry, have ample opportunity to defraud the system and investors. Fortunately since Wiggin’s day, and partly in response to his activities, the law has changed to account for this possibility. Today those caught committing this form of stock fraud face heavy penalties.
Stewart spent five months in prison for her crimes while Samuel D. Waksal, ImClone’s founder and the source of the inside information, was sentenced to over seven years imprisonment and ordered to pay more than four million dollars in fines and back taxes.