Business Judgment Rule Problems

The Dodd-Frank Act requires public companies to hold an advisory shareholder vote on executive compensation every two years. Cincinnati Bell paid three of its top officers packages worth a few million dollars each at the same time that the companies share price and earnings dropped. (CEO $8.5 million – 71.7% increase in pay; CFO -- over $2 million – 80.3% increase in pay; Vice President $1.5 million – 54.3% increase in pay) 66% of the shareholders voted against the executive compensation packages. Should shareholders be able to sue on behalf of the corporation that the Board of Directors breached their fiduciary duties?

Under Ohio law, directors will face liability only if it is shown by clear and convincing evidence that their actions were undertaken with “a deliberate intent to cause injury to the corporation” or “reckless disregard for the best interests of the corporation.” Ohio Rev. Code Ann. Sect. 1701.59(D) (2011)

(NECA-IBEW Pension Fund v. Phillip R. Cox, et. al.)

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Insider Trading

"Insider trading" is a term that most investors have heard and usually associate with illegal conduct. But the term actually includes both legal and illegal conduct. The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC. For more information about this type of insider trading and the reports insiders must file, please read "Forms 3, 4, 5" in our Fast Answers databank.

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.

Examples of insider trading cases that have been brought by the SEC are cases against:

• Corporate officers, directors, and employees who traded the corporation's securities after learning of significant, confidential corporate developments;

•• Friends, business associates, family members, and other "tippees" of such officers,

directors, and employees, who traded the securities after receiving such information;

•• Employees of law, banking, brokerage and printing firms who were given such

information to provide services to the corporation whose securities they traded;

•• Government employees who learned of such information because of their

employment by the government; and•• Other persons who misappropriated, and took advantage of, confidential

information from their employers.Because insider trading undermines investor confidence in the fairness and integrity of the securities markets, the SEC has treated the detection and prosecution of insider trading violations as one of its enforcement priorities.

The SEC adopted new Rules 10b5-1 and 10b5-2 to resolve two insider trading issues where the courts have disagreed. Rule 10b5-1 provides that a person trades on the basis of material nonpublic information if a trader is "aware" of the material nonpublic information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-

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existing plan, contract, or instruction that was made in good faith.

Rule 10b5-2 clarifies how the misappropriation theory applies to certain non-business relationships. This rule provides that a person receiving confidential information under circumstances specified in the rule would owe a duty of trust or confidence and thus could be liable under the misappropriation theory.

http://www.sec.gov/answers/insider.htm

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September 22, 2011

NYTIMES Magazine

The War on Insider Trading: Market-Beaters BewareBy ROGER LOWENSTEINHow much time should Raj Rajaratnam spend in prison? Rajaratnam is the hedge fund founder who was convicted in May of trading on illegal stock tips — tips that produced fantastic results for his Galleon Group. Federal authorities compare him with notorious white-collar crooks like Bernie Madoff and Jeffrey Skilling, and they argue for a long time behind bars. His lawyers, however, say Rajaratnam is a lesser-order felon — “not . . . as culpable as a defendant who affirmatively steals,” as they put it in a pre-sentencing memorandum. The lawyers raise a problem of culture and law: Is insider trading merely an illicit version of a common American cleverness, trading on gossip from a colleague or friend that helps the trader and hurts no one? Or is it the quintessential Wall Street crime, one that has undermined Americans’ faith in the markets?Richard J. Holwell, a Manhattan federal judge, will give his answer to that question when he sentences Rajaratnam on Sept. 27. A lengthy sentence would go a long way toward validating not just the federal prosecutors who brought the case but also the Securities and Exchange Commission, which first investigated the hedge fund. Before and since the Rajaratnam trial, the S.E.C. has brought numerous cases, part of a campaign to root out insider trading and, in theory, make markets fairer for the average investor. In recent weeks alone, the S.E.C. filed complaints against traders who ran the gamut from celebrity to ordinary. It settled charges with Doug DeCinces, a former Baltimore Orioles third baseman who bought stock in Advanced Medical Optics after learning from a tipster that the company was about to be taken over; it reached an agreement with Hugh Hefner’s son-in-law, who blatantly ignored written warnings against trading in the stock of Playboy, where his wife was the chief executive; and it settled with a Denver businessman, who tipped his son, an investor, about a pending acquisition.No one knows how much cheating of this kind occurs, but regulators have developed good tools for spotting it. Every time there is market-

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moving news, like a merger or an earnings report, computers at Finra, a regulatory body, scan millions of buy and sell orders, looking for suspicious trades, like a big stock purchase in advance of a takeover. Finra refers some 250 trades a year to the S.E.C. for a closer look. Getting a stock-market tip has always been a sort of all-American fantasy, and despite the risk of detection, the desire for an edge seems irresistible. “People are greedy,” says Robert Khuzami, the S.E.C.’s director of enforcement. “They think they won’t get caught.” Even those who should know better: Donald L. Johnson, an official at Nasdaq, was entrusted with confidential information from listed companies, and he used his privileged knowledge to trade in advance of news of drug trials and other results. Johnson dimly supposed that by trading in an account listed in his wife’s name, his behavior would go undetected. He was sentenced to three and a half years.Not all cases are so black and white. The law on insider trading, which has developed over the years from judicial rulings and is not specifically found in a statute, is ambiguous enough to allow for a range of interpretations. And at a time when the government is accused of going easy on white-collar crime, Khuzami has pursued an aggressive approach, pushing the boundary of what is deemed illegal. Strengthening the S.E.C.’s long-running effort, Khuzami has focused, particularly, on the hedge fund industry, which for reasons related to its competitiveness, capital and connections, he sees as especially prone to insider trading. Wall Street has taken notice. For one thing, the Rajaratnam case, which was prosecuted by the United States attorney for the Southern District of New York, led to dozens of criminal convictions. Perhaps more important, the bread-and-butter civil actions brought by the S.E.C. is putting pressure on traders to refrain from using information that is even borderline illegal.The dollar amounts involved in such cases tend to be small, which has led critics to question whether the S.E.C. shouldn’t be spending more of its resources on larger offenses like mortgage fraud. But in truth, insider trading is just the sort of activity the S.E.C. was created to combat. Not so very long ago, the public had a sense that the agency was watching out for small investors and keeping markets safe. Then in 2008 came a pair of cataclysmic failures: virtually the entire investment-banking industry, which the S.E.C. regulated, either failed or sought a bailout; then, having ignored explicit warnings about Madoff, the agency was further humiliated by the revelation that he’d been running a Ponzi scheme.Some have criticized the emphasis on insider trading cases as a kind of quick fix to the S.E.C.’s battered image. “Nonsense,” says Khuzami, who joined the agency two months after the Madoff fiasco. But image actually is important; it’s part of providing an effective deterrent. To an unusual degree, respect for insider trading laws depends on the

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visibility of enforcement. In a survey of 2,500 traders taken in 2007, more than half said they would take advantage of an illegal tip if they were assured they wouldn’t be caught. Without S.E.C. enforcement, Wall Street would degenerate into a cesspool of conspiratorial tipping — as it was before the agency existed. If you think that doesn’t matter, ask yourself if you’d be comfortable investing in, say, Oracle, if Larry Ellison, its lavishly compensated C.E.O., were free to buy and sell the stock, and to clue in his friends, every time Oracle’s sales took an unexpected but not yet public twist. By bringing cases and challenging hedge funds, the S.E.C. aims, at very least, to remind investors that insider trading isn’t simply financial naughtiness — it’s a crime.Over the past several months, I met with Khuzami and others at the S.E.C. and pored over some of the more controversial cases on the agency’s docket. There is no question that the agency is pushing the boundaries, and the definition of insider trading was blurry to begin with. Linda Thomsen, Khuzami’s predecessor, once remarked approvingly that “the genius of insider trading law . . . is its flexibility.” Though lawmakers have proposed legislation codifying insider trading in the statutes, the S.E.C. seems to prefer a common-law approach, on the theory that it will be a less fixed — thus a more worrisome — deterrent.The courts have established that it is illegal to trade on “material” information in breach of a duty to keep the information private. The legal ambiguity arises on two fronts. First, the standard for “material”— any news that a trader would consider important — is fuzzy enough to recall Potter Stewart’s famously elusive definition (he would know it when he saw it) of pornography. Rumors and gossip circulate in the stock market every day; not all of it is “material.” Background information on an industry is clearly O.K. And it’s fine to ask the manager of a local Best Buy about the store’s iPod sales (this is called a channel check). Getting advance word on the entire chain’s sales, however, could be a problem. In general, investors are allowed to assemble pieces of information that, viewed collectively, give them a fuller picture of the whole. But if any one of the mosaic pieces is, in itself, too revealing, the S.E.C. looks askance.Second, the question of who has a duty to keep the material information private is not always clear. In one influential case in the 1980s, Barry Switzer, the University of Oklahoma football coach, was sued for buying stock in a company run by a team booster — a company that was acquired shortly after he invested. At trial, Switzer claimed that he was sunbathing in the stands when he innocently overheard the booster describing the deal. Since the leak was inadvertent, the court ruled that Switzer did not have a duty not to

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trade.One of the more contentious current cases also involves a sports mogul, Mark Cuban, the irreverent owner of the Dallas Mavericks basketball team. A few years ago, Cuban was a big shareholder in a Canadian search engine, Mamma.com, which needed to raise cash. The company decided to offer stock to large investors at a discounted price; so in June 2004, according to the S.E.C.’s complaint, the chief executive of Mamma.com called Cuban and asked if he would like to participate. The C.E.O. supposedly prefaced his offer by telling Cuban he was about to impart confidential information. Typically, when such private placements are disclosed, the market price falls — and for that reason, Cuban reacted angrily. At the end of the call, the S.E.C. claims, he snarled: “This means I’m screwed. I can’t sell.” But hours later, he phoned his broker; the next day, he dumped his stake. When the private offering was announced, the stock plunged; Cuban’s early sale saved him $750,000.Cuban’s behavior was exactly what the insider trading rules should prevent: a mogul profiting from privileged information. But it isn’t clear that the rules do prevent it, at least in this case. The difficult part centers on Cuban’s relationship with the Mamma.com chief executive. According to the S.E.C., at some point during their eight-minute phone call, Cuban acquired a duty not to trade. Cuban has denied that he agreed to keep the information about the offering private; even if he did agree, his lawyers argue, he would still have been free to trade, because he and the C.E.O. were not in a relationship of trust. A district court agreed and dismissed the complaint; on appeal, however, the decision was reversed. The case may now go to trial. Cuban, who has been fined nearly $1.7 million for yelling at basketball officials over the years, has, through his lawyers, cried foul against the S.E.C., which he accuses of “a transparent plan to expand the scope of insider trading liability.” The billionaire is said to be fuming and is considering making a movie about the case when it is done.What the Cuban case is to the question of “duty,” the S.E.C.’s suit against the consummately ordinary Steffes family is to the definition of “material.” Last year, the S.E.C. charged six family members with tipping or trading on tips in advance of the 2007 leveraged buyout of Florida East Coast Industries. Two defendants were employees: Gary Griffiths, a former trainman who had risen to the executive position of chief mechanical officer; and his trainman nephew, Cliff Steffes. The two supposedly tipped other relatives; collectively, the family purchased $1.6 million in stock and options. What makes the case unusual is that the S.E.C. is not charging that either man was given an explicit tip. Rather, the complaint charges that a procession of pinstriped bankers took minibus tours of company facilities, that the

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tours gave rise to rumors of a deal among railyard workers and that Griffiths was asked to arrange a private tour for one group. Such circumstantial evidence gave them to “know” that a deal was in the works, or so contends the S.E.C. Thomas Bishop, the lawyer for Griffiths — who, like Steffes, is fighting the charges — says: “This means anybody who works for a company possesses insider information. That’s past the frontier of what the security laws are intending.”The scale of the family’s investment does suggest that they knew something was up. Yet few Americans would have dreamed they could get into trouble for drawing an inference based on observations at work. And until recently, they might not have. But the Florida East Coast case is the third of its kind in recent years. Whether it will hold up in court is another matter. Khuzami has already had some embarrassing setbacks on insider trading cases — one against a Goldman director that was recently dropped and another, relating to credit-default swaps, that was dismissed by a federal judge. “What the S.E.C. is doing,” says Tom Gorman, a lawyer at Dorsey and Whitney, “is changing the law.”I met Khuzami on a Friday afternoon, when official Washington was heading out for the weekend. The son of ballroom dancers, he is 54, his hair tinged with gray, and has the kind of résumé you often see in Washington: successful prosecutor in his 30s for the Southern District of New York, then a well-paid lawyer for Deutsche Bank. His seven-year stint in the private sector coincided with the years in which securities regulation was, at least in retrospect, too lax. He returned to government in 2009, with a goal of restoring the S.E.C.’s reputation for vigilance. He has nurtured a close relationship with Preet Bharara, the United States attorney who prosecuted Rajaratnam. The S.E.C. has at times seemed out of its element while handling complex mortgage cases, though lately it has been stepping up activity in that area. But insider trading cases are closer to its ken.Khuzami scoffed at the notion, proposed to me by defense lawyers, that he is bringing “gray area” cases and noted that many of the S.E.C.’s targets took pains to hide their tracks. In other words, they knew they were doing wrong. “People claim it’s a trap for the unawares because they don’t know where the line is drawn,” Khuzami said. “From where I sit, it’s pretty clear. Insider trading requires intent.” The traders often rationalize that intent, of course, by telling themselves that cheating is normal and not really so serious. A smattering of free-marketers defend insider trading as aiding market efficiency; except in extreme cases, they question whether it should be a crime at all. Unlike with, say, Ponzi schemes, you can’t identify a victim who suffers a loss when someone profits from an illegal tip.

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On a little reflection, though, that rationalization doesn’t hold up. The American system of markets may get a lot wrong, but one thing it gets absolutely right is the principle of disclosure. This bedrock of U.S. markets was established in the 1933 Securities Act, and the S.E.C. was created, in 1934, largely to enforce a single proposition: that a corporation issuing securities to the public has to come clean about its financial results and outlook. Disclosure prevents corporations from duping investors. It’s worth noting that disclosure, though a technical term in the context of securities, expresses a broader and distinctly American ideal — that of openness. Governments and most institutions operate better in the sunlight; markets too. Since insiders have a duty of disclosure to people who buy their securities, the courts have ruled that executives who trade in their own stock while failing to disclose confidential information are committing fraud.The traditional theory of insider trading applies to corporate insiders and other fiduciaries (even to executives’ psychiatrists); it also covers traders who pay insiders for information or otherwise induce them to leak. Ivan Boesky, the arbitrageur who pleaded guilty to securities fraud in the 1980s, was the classic case. But the traditional theory doesn’t, by a long stretch, cover all of the behavior that the public would consider cheating. What happens, for instance, when a corporate outsider steals information? The law on that issue was, for years, unresolved. Then, in the ’90s, James O’Hagan, a partner in a Minneapolis law firm, learned that a client of the firm was planning a bid for Pillsbury. O’Hagan bought options on Pillsbury and made a quick $4 million. His conviction was reversed under the theory that since his firm had no obligation to Pillsbury, he hadn’t defrauded it. But in a 6-to-3 opinion written by Justice Ruth Bader Ginsburg in 1997, the Supreme Court reinstated it. Stealing information, the court reckoned, was just that: stealing. The decision validated “misappropriation theory,” which holds that outsiders are guilty of securities fraud when they misappropriate confidential information “in breach of a duty owed to the source of the information.” This seems the right result: whether an executive trades on a secret or a lawyer steals the secret and trades on it makes little difference.And without “misappropriation theory,” Khuzami’s crusade against hedge funds would scarcely be possible.Khuzami assured me he wasn’t intent on “slamming” hedge funds, but he clearly sees them as breeding grounds for potential cheaters. “People ask me, ‘Is there more inside trading going on?’ ” Khuzami said. “Developments in the market” — he meant the growth of hedge funds — “suggest there might be. People are looking for any advantage.” Hedge funds, he noted, command large sums of capital (in total, an estimated $2 trillion); many have contacts with well-

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placed Wall Street and corporate sources, and they operate hidden from public view (this will change somewhat as a result of the Dodd-Frank law, which will require medium- and large-size funds to register with the S.E.C.). Finally, the hedge fund business is immensely lucrative and fiercely competitive, which ratchets up managers’ incentives to cheat.In testimony to Congress, Khuzami said the S.E.C. was canvassing the industry for funds with “aberrational performance,” on the theory that above-average funds may be benefiting from tips. Khuzami went further at the hearing and declared that “anybody who is beating market indexes by 3 percent and doing it on a steady basis” could be a suspect. This pronouncement horrifies professional money managers, who rightly point out that there are plenty of ways of beating the market that don’t involve cheating.Khuzami and Bharara have advanced a theory that, for some minority of the hedge fund industry, trading on illegal tips has become a “business model” — a routine aspect of doing business. In effect, they view insider trading as a white-collar version of organized crime.This theory was years in the making. In 2005, the S.E.C. learned that, improbably, a retired seamstress in Croatia had bet big on Reebok stock just before the sneaker company announced a takeover. The seamstress turned out to be a front. The agency ultimately charged 17 people in a huge insider trading ring, prominently including Eugene Plotkin, a dashing ballroom dancer and Russian-born Goldman Sachs analyst. For Sanjay Wadhwa, a lawyer in the S.E.C.’s Manhattan bureau, the “seamstress case” was a new concept: inside trading as a group endeavor. It “whetted our appetite,” Wadhwa recalls.Then, in August 2006, the S.E.C. got a tip about a New York hedge fund, Sedna Capital Management. Wadhwa was assigned to this case, too. Sedna was a small fund, but its manager, Rengan Rajaratnam, was the younger brother of Raj Rajaratnam, the head of Galleon Group, a $7 billion fund. Born in Sri Lanka and educated at Wharton, the elder Rajaratnam kept an extensive network of business associates, many of whom were also South Asians. Since 2000, his fund outperformed its peers by a stunning eight percentage points a year. Wadhwa’s focus began to shift to Raj, a gregarious, daring trader who reminded him of Plotkin.When I met Wadhwa at a coffee bar near his office, he seemed upset by the agency’s bad press and, perhaps for that reason, eager to tell me how they caught Rajaratnam. In 2007, the S.E.C. began an examination of Galleon, issuing subpoenas for its trading, telephone and bank records, its appointment calendars and e-mail. Wadhwa’s interest was piqued by the cryptic tone of Rajaratnam’s instant messages with Roomy Khan, a former Intel employee with extensive

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contacts in Silicon Valley. One, from Khan to Rajaratnam, urged the hedge fund magnate not to buy Polycom stock until she got “guidance.” Sensing the potential for a criminal case, the agency briefed lawyers at the Southern District, who agreed the case looked promising. Then, in March 2007, the S.E.C. received an anonymous letter on plain white paper claiming that Galleon traded tips in exchange for prostitution and “other forms of illegal entertainment.” The author hurled a taunting challenge at the regulators: “It hurts my heart to see how these guys make monkeys out of individual investors, S.E.C. insider trading regulations and the attorney general’s office.”The S.E.C. could not identify the letter’s author, nor did prostitution figure in the eventual charges. But that June, Rajaratnam trooped downtown to the S.E.C. for a formal deposition. The agency’s lawyers asked about insider trading — which he denied. Less than a month later, Hilton Hotels revealed that it was being acquired; Finra promptly notified the S.E.C. that Galleon had invested in Hilton before the news broke. Wadhwa was stunned by Rajaratnam’s brass.Two weeks later, Rajaratnam did it again: Galleon sold Google just before it announced disappointing earnings. In November, an F.B.I. agent visited Khan and asked if she would be willing to talk about Rajaratnam. Khan replied, “What took you so long?” In a bid for a reduced sentence, she agreed to be a cooperating witness. In interviews with the S.E.C. and prosecutors, she divulged the identity of numerous tippers and sketched a broad map of inside traders. Armed with Khan’s proffer, prosecutors for the Southern District obtained the first of many wiretaps, which were crucial in winning convictions.The Rajaratnam case exposed some of the elite of American business: an Intel executive, a former McKinsey partner, a married senior vice president of I.B.M. who was tipping his lover. The trial transcripts suggest a Wall Street subculture that is, in a word, rotten. The tipped information was plainly material; much of it amounted to brazen cheating. But it’s unclear that Galleon is a template for the industry. The S.E.C. has yet to find another large hedge fund for which insider trading is a “business model.” It is known to be investigating SAC Capital Advisors, one of the country’s biggest and most successful hedge funds. Since its inception in 1992, SAC has returned 29 percent a year. Steven A. Cohen, the founder, told me that the fund comes by its results without cheating; as compared with other funds, he says, SAC has more analysts (900 traders and support staff) and more-effective incentives to discourage losses, and it has magnified its returns with leverage. This is plausible, although his returns remain eye-catching. SAC’s huge volume gives it privileged relationships with traders across Wall Street. At very least, it would

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be hard to argue that firms like SAC do not have an informational edge.At least three traders who worked at SAC have pleaded guilty to using inside information while employed at other hedge funds. One, Noah Freeman, a Harvard grad who traded computer-chip stocks, testified that he also cheated while at SAC. There is no evidence that SAC knew this, and in fact, Freeman testified that he took pains to circumvent SAC’s compliance policies. SAC eventually fired Freeman for poor performance.Hedge fund managers are plainly frightened of becoming the next target. McDermott, Will & Emery, an international law firm, has warned its clients, “Investment managers who outperform the market should be aware that the S.E.C. may soon come knocking.” Compliance staffs of hedge funds are warning their traders to report information sources that might be a problem. Though information is central to what they do, fund managers are becoming sensitized to thinking about whether the information gleaned by their traders is, in fact, too good to use. One New York investor, explaining why he took a loss rather than sell a stock on which he had borderline information, said, “The line on what is material is blurry.” If traders who were not engaged in illegal behavior have stepped back from the line, I sensed that that was O.K. with Khuzami.One sign of the S.E.C.’s impact is that hedge funds have sharply cut their use of so-called expert networks. These networks hire people with knowledge of specific industries to talk to traders. Networks serve a valid research function, but the potential for experts to cross the line into illegal tipping is plain. Six onetime employees at a Mountain View, Calif., network, Primary Global Research, have been indicted (Freeman was one of those). Since the scandal, business at networks is down by 40 percent, according to Integrity Research. No other network has been implicated, but if hedge funds and other traders have to be extra careful about how they do research — even if an occasional borderline trade is ruled off limits — it’s a reasonable price for ensuring that markets are fair.The real problem with the S.E.C.’s focusing on high-return funds is that it skates over the crucial distinction between short- and long-term investing. There are at least 8,000 hedge funds in the United States, and quite a few, like SAC, are engaged in rapid-fire trading — basically trying to outguess the competition with regard to disclosures that will become public in a week or two anyway. Freeman, for instance, was obsessed with trying to outguess the Wall Street “chatter” and the “whisper number” (the predisclosure estimate of earnings). Absent some tip regarding forthcoming news, he had no value added and no edge. For investors working longer horizons the

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picture is different. Skillful, long-term investors can make money without tips, by analyzing information that is already public. Indeed, to someone holding a stock for years, a quarterly earnings tip would be of little use.Society has an interest in genuine — hopefully intelligent — research, the kind that asks whether Google or Apple will be the more dominant business down the road or whether oil reserves will run short. But the sort of desperate hypertrading that was Freeman’s specialty does not add to economic output or jobs or anything that matters. What it does do is ratchet up market volatility, contributing to the mind-numbing daily swings that send ordinary investors to the sidelines. Lately, thanks in part to that feverish trading, triple-digit market moves have become routine. The marked increase in volatility complicates the S.E.C.’s job considerably. When stocks jump or plummet in reaction to news, the payoff for those who trade on tips ahead of the news rises as well. Ferreting out who is prescient and who is crooked becomes more important than ever.The Galleon case instilled fear in a lot of traders — just as the Boesky-era cases did — but the fear may have subsided somewhat. Especially in volatile markets, the temptation to cheat is fierce. A stiff sentence for Rajaratnam would reinvigorate the sense of a deterrent; on the other hand, a light penalty would make the lengthy, costly prosecution look like a waste. It would discourage future prosecutions and stoke the populist suspicion that no one on Wall Street ever really does time. The loser would be the public’s faith in market integrity. And, as Khuzami notes, “Who’s going to trade if they think the game is rigged?”Roger Lowenstein (elrogl@gmail.com), an outside director of the Sequoia Fund, is a contributing writer and the author of "The End of Wall Street."

Editor: Vera Titunik (v.titunik-MagGroup@nytimes.com)

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Insider trading has been a part of the U.S. market since William Duer used his post as assistant secretary of the Treasury to guide his bond purchases in the late 1700s. In this article, we will look at some landmark incidents of insider trading. (For more background info, check out What exactly is insider trading? and Uncovering Insider Trading.)

1. Albert H. Wiggin: The Market Crash MillionaireDuring the Roaring '20s, many Wall Street professionals, and even some of the general public, knew Wall Street was a rigged game run by powerful investing pools. Suffering from a lack of disclosure and an epidemic of manipulative rumors, people believed coattail investing and momentum investing were the only viable strategies for getting in on the profits. Unfortunately, many investors found that the coattails they were riding were actually smokescreens for hidden sell orders that left them holding the bag. Still, while the market kept going up and up, these setbacks were seen as a small price to pay in order to get in on the big game later on. In October, 1929, the big game was revealed to be yet another smokescreen.

After the crash, the public was hurt, angry, and hungry for vengeance. Albert H. Wiggin, the respected head of Chase National Bank, seemed an unlikely target

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until it was revealed that he shorted 40,000 shares of his own company. This is like a boxer betting on his opponent – a serious conflict of interest.

Using wholly-owned family corporations to hide the trades, Wiggin built up a position that gave him a vested interest in running his company into the ground. There were no specific rules against shorting your own company in 1929, so Wiggin legally made $4 million from the 1929 crash and the shakeout of Chase stock that followed. (Learn how to distinguish tops and bottoms in the equity market when short selling, read Finding Short Candidates With Technical Analysis.)

Not only was this legal at the time, but Wiggin had also accepted a $100,000 a year pension for life from the bank. He later declined the pension when the public outcry grew too loud to ignore. Wiggin was not alone in his immoral conduct, and similar revelations led to a 1934 revision of the 1933 Securities Act that was much sterner toward insider trading. It was appropriately nicknamed the "Wiggin Act".

2. Levine, Siegel, Boesky and Milken: The Precognition Rat Pack One of the most famous cases of insider trading made household names of Michael Milken, Dennis Levine, Martin Siegel and Ivan Boesky. Milken received the most attention because he was the biggest target for the Securities and Exchange Commission (SEC), but it was actually Boesky who was the spider in the center of the web.

Boesky was an arbitrageur in the mid-1980s with an uncanny ability to pick out potential takeover targets and invest before an offer was made. When the fated offer came, the target firm's stock would shoot up and Boesky would sell his shares for a profit. Sometimes, Boesky would buy mere days before an unsolicited bid was made public - a feat of precognition rivaling the mental powers of spoon bender Uri Geller. (Learn more in Tales From Wall Street's Crypt.)

Like Geller, Boesky's precognition turned out to be a fraud. Rather than keeping a running tabulation of all the publicly traded firms trading at enough of a discount to their true values to attract offers and investing in the most likely of the group, Boesky went straight to the source - the mergers and acquisitions arms of the major investment banks. Boesky paid Levine and Siegel for pre-takeover information that guided his prescient buys. When Boesky hit home runs on nearly every major deal in the 1980s - Getty Oil, Nabisco, Gulf Oil, Chevron (NYSE:CVX), Texaco - the people at the SEC became suspicious.

The SEC's break came when Merrill Lynch was tipped off that someone in the firm was leaking info and, as a result, Levine's Swiss bank account was uncovered. The SEC rolled Levine and he gave up Boesky's name. By watching Boesky - particularly during the Getty Oil fiasco - the SEC caught Siegel. With

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three in the bag, they went after Michael Milken. Surveillance of Boesky andMilken helped the SEC draw up a list of 98 charges worth 520 years in prison against the junk bond king. The SEC charges didn't all stick, but Boesky and Milken took the brunt with record fines and prison sentences. (For more on Milken, see 4 History-Making Wall Street Crooks.)

3. R. Foster Winans: The Corruptible ColumnistAlthough not high-ranking in terms of dollars, the case of Wall Street Journal columnist R. Foster Winans is a landmark case for its curious outcome. Winans wrote the  "Heard on the Street" column profiling a certain stock. The stocks featured in the column often went up or down according to Winans' opinion. Winans leaked the contents of his column to a group of stockbrokers, who used the tip to take up positions in the stock before the column was published. The brokers made easy profits and allegedly gave some of their illicit gains to Winans. (For more, see Why do stock prices change following news reports?)

Winans was caught by the SEC and put at the center of a very tricky court case. Because the column was the personal opinion of Winans rather than material insider information, the SEC was forced into a unique and dangerous strategy. The SEC charged that the info in the column belonged to the Wall Street Journal, not Winans. This meant that while Winans was convicted of a crime, the WSJ could theoretically engage in the same practice of trading on its content without any legal worries. (Find out how news can affect your stock in Trading On News Releases and Can Good News Be A Signal To Sell?.)

4. Martha Stewart: The Homemaking HoaxerIn December 2001, the Food and Drug Administration (FDA) announced that it was rejecting ImClone's new cancer drug, Erbitux. As the drug represented a major portion of ImClone's pipeline, the company's stock took a sharp dive. Many pharmaceutical investors were hurt by the drop, but the family and friends of CEO Samuel Waksal were, oddly enough, not among them. Among those with a preternatural knack for guessing the FDA's decision days before the announcement was homemaking guru Martha Stewart. She sold 4,000 shares when the stock was still trading in the high $50s and collected nearly $250,000 on the sale. The stock would plummet to just over $10 in the following months.

Stewart claimed to have a pre-existing sell order with her broker, but her story continued to unravel and public shame eventually forced her to resign as the CEO of her own company, Martha Stewart Living Omnimedia. Waksal was arrested and sentenced to more than seven years in prison and fined $4.3 million in 2003. In 2004, Stewart and her broker were also found guilty of insider trading. Stewart was sentenced to the minimum of five months in prison and fined $30,000.

ConclusionAlthough the cases in this article are glaring examples, insider trading is often

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difficult for the SEC to spot. Detecting it involves a lot of conjecture and consideration of probabilities. While it's possible that Boesky was that good at predicting takeovers, it was highly improbable.

Truth be told, the SEC has made mistakes and accused the innocent in cases

that are borderline, at best. This is one of the prices we pay to guard against

insiders trading on information that the public doesn't yet know. That said,

Stewart offers the best example of why it's best not to trade on material insider

information – leaving the moral aspect aside. If she had simply held her

ImClone stock, it would have hit the $70-$80 range during the Eli Lilly takeover, making her holdings worth around $60,000 more than what she sold out for. Instead, she was fined $30,000 and ended up in jail. The risks, in this case, definitely outweighed the returns.  

by Andrew BeattieAndrew Beattie is a former managing editor and longtime contributor at Investopedia.com. He operates the Wandering Wordsmith blog, and can be reached there.

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