SEC doing enough to fight insider trading?

Scott Jagow Aug 28, 2006

SCOTT JAGOW: If your workplace is anything like mine, I bet rumors spread like wildfire, don’t they? Now, if it’s just who’s dating whom or who got drunk at the Christmas party, that’s one thing. But let’s say your company is about to be sold. And somebody who knows about it buys up a bunch of shares. That’s insider trading. And of course, it’s illegal. The New York Times just looked at the 90 biggest mergers of the past year. And in 41 percent of those deals, the stock of the company being purchased showed unusual trading patterns in the weeks before the buyout was announced. John Coffee teaches at Columbia law school.

JOHN COFFEE: Recently we’ve seen the nature of deals change from hostile deals, where the bidder knows that the market price will move and keeps the information confidential, to a new world in which management buyouts are complicated transactions. In that kind of world, the number of people goes up dramatically. And when that happens, the risk of insider trading goes up exponentially.

JAGOW: Brokerage houses seem to be a particular danger zone here. They have rules about leaking information but they also stand to profit a great deal from knowing these things first. How big of a problem do we have with the brokerage firms, do you think?

COFFEE: Well, I think the investment banking industry learned its lesson in the 1980s. And I think that there are fairly good controls within the merger and acquisition teams of most investment banking firms. Once, however, you bring in new players, like all of the buyout firms who participate in friendly management buyouts, there we get a sort of loose gossip. And that loose gossip gets around Wall Street very quickly and it’s worth trading on.

JAGOW: What’s the usual defense in these kinds of cases?

COFFEE: Typically, you’ll say, “Well, everybody knew this was a consolidating industry and that there was going to be some major mergers, and we decided to take some position in advance.” For example, if there was a major merger announced in two weeks involving General Motors or Ford with some foreign automobile companies, that’s been rumored on the front page of The New York Times for the last six weeks. So you can come up with that kind of cover story. And what you really need to defeat it is to show the actual disclosures. Sometimes that can be done through plea bargaining. Sometimes it’s just luck. And often there are whistleblowers who tip people off.

JAGOW: But even though the number of mergers and acquisitions has increased quite a bit over the past few years, the number of insider trading cases prosecuted by the SEC has stayed about the same. Why do you think that’s the case?

COFFEE: Well, the SEC has its hands full on a variety of fronts. In the years 2000 to 2002 we saw Enron, WorldCom, Global Crossing . . . all of those were financial irregularity cases. And I think that the SEC had to devote its manpower to fighting that kind of accounting fraud. They are prosecuting some of these cases, often very successfully. But you need more than simply knowing that a particular entity traded in advance of a takeover or a merger’s announcement. You’ve got to be able trace that trading party back to the receipt of the nonpublic information — finding out who they learned it from and when. And that often takes a very detailed investigation.

JAGOW: Who do you think loses in a case of insider trading?

COFFEE: Well I think there is a loss both to the shareholders and the company, and then, ultimately, to the market as a whole. Because if you feel that other people will be privileged and will get information that you don’t receive, you will pay less for stocks. You’ll demand a higher return and it’ll be more difficult to take companies public or to get the highest price that you could get for them if the market were perceived as fair and a level playing field.

JAGOW: OK, John. Thanks as always.

COFFEE: Very good.

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