Commentary / Wall Street: Always an insider's game
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Decades ago, while observing the vast yacht of Wall Street titan J.P. Morgan -- the largest in the world -- one investor muttered, "But where are the customers' yachts?" Recently, an academic who documented that corporate CEOs buy huge mansions by unloading large amounts of stock before their companies tank asked, "Where are the shareholders' mansions?"
One enduring criticism of the stock market is that it is an insider's game. Those on Wall Street or in executive suites make out like bandits. Investors from Main Street end up on the short end.
Of the many sins of high finance, insider trading is among the worst. It is a felony under federal law and has a long, dark history. It is nothing more than the privileged and well-positioned taking advantage of secret information to profit at the expense of ordinary investors. Names such as Ivan Boesky and Michael Milken come to mind.
To the extent the SEC shows any real muscle regarding insider trading, it focuses on Wall Street "tipping" in front on mergers and the like. Woe be unto the poor printing proofreader or law firm associate who pockets a few thousand or tips his wife or girlfriend. But the SEC is missing the forest for the trees. Billions -- literally billions -- of insider trading is going on by corporate executives. And they are getting away with it.
Corporate executives are uniquely positioned to use secret information to trade in their company's stock. In the wake of the stock market excesses of the 1920s, Congress prohibited fraud by corporate executives. Selling stock based on inside information was forbidden.
Congress also prohibited "short-swing" stock trades by creating a presumption that inside information had been used when any executive purchased and sold his corporation's stock in a six-month period. This law required re-payment of any short-swing trading profit. These prohibitions became potent weapons for shareholders to police corporate executives' insider trading. Corporate chieftains hated it.
So, several years ago, corporations got the SEC to issue a new rule. It allowed executives with stock options to exercise the option, immediately sell the stock and keep the profit. This obliterated the short-swing profit prohibition.
This SEC rule created the "stock option flip-trade." Executives could now bail out at the first whiff of bad news inside the company. They could exercise options, instantly sell the stock and pocket the profits, without putting up a penny or taking any market risk. Short-swing trading suits by shareholders disappeared. The explosive growth of executive stock options followed. Combined with the later illicit tactic of executives backdating their stock options, it became a license to steal.
As executive insider stock selling mushroomed, shareholders seeking damages or disgorgement began to allege that executives actually had used inside information when they sold stock. If proven, this put them outside the protection of the new SEC exemption. As these suits succeeded, corporations again pressed the SEC for help. Again, the SEC caved in to pressure from corporations. Again, the SEC changed the rules to protect insiders.
This time, the SEC adopted a new insider trading "safe harbor" rule that let corporate executives secretly set up pre-arranged stock sale programs. Now, even if the corporate insider actually has secret information and knows that the stock price is inflated, he could continue to unload stock. Even though the stock sales were supposed to be prearranged, the rule let the executive secretly "adjust" the amount of his stock sales up or down.
The potential for abuse is obvious. Corporate executives have their fingers on the corporate pulse and the benefit of sophisticated management information systems that provide almost instantaneous updates on internal trends. So, as soon as they see -- or even suspect -- performance shortfalls are coming, they can exercise options and flip trade, put stock sale plans in place or increase the shares they are selling -- all steps to profit by insider selling in advance of disclosure of the bad news and a stock drop. Several Enron fraudsters, including Mr. Lay and Mr. Skilling, used this safe harbor rule to sell off huge chunks of their Enron stock-option stock, pocketing hundreds of millions of dollars.
Despite Congress' stringent prohibitions against quick-flip stock trades or stock sales based on secret information, both have become the order of the day.
Recently, SEC Enforcement Director, Linda Thomsen, admitted to "seeing deliberate, calculated misconduct" -- "rampant" insider trading. She also voiced suspicion that executive stock sale plans were being abused. No wonder. Academic studies confirm that executives are twice as likely to put secret stock sale plans in place when corporate bad news is to follow and executives selling by such plans do much better than they would if the sales were random.
The financial world is filled with examples of executives selling huge amounts of shares in front of bad news that causes the stock to plunge. Here are a few suspicious instances.
Take Yahoo! -- a fallen darling that encountered long delays in launching its new internet ad placement technology. When the delay was finally revealed, Yahoo!'s stock collapsed from $44 to $22, inflicting $25 billion in losses on Yahoo!'s shareholders. While the top executives at Yahoo! were struggling with these undisclosed problems, they unloaded 33 million shares of their Yahoo! stock for more than a billion dollars -- most quick-flip stock option sales. Yahoo!'s CEO and CFO each sold 80 percent to 90 percent of their shares.
Look at Dell Computer. Dell disclosed serious product quality and customer service problems and restated years of prior financial reports to eliminate millions in profits. Dell stock fell from $42 to $19, inflicting $30 billion in losses on shareholders. Yet before this came out, Dell executives unloaded 98 million shares of stock for $3.3 billion. Dell's CEO and CFO, both ousted due to the scandal, sold 98 percent of their stock. Eight other executives sold more than 90 percent of theirs. Most were "quick flip" stock option sales.
Next came Countrywide Financial, the big subprime lender. As its lax lending practices and dubious accounting became public, its stock collapsed from $45 to $20, costing shareholders $13 billion. Yet, Countrywide's insiders had unloaded 21 million shares for $765 million before the bad news. More quick-flip stock option sales. The CEO, Angelo Mozilo sold millions of shares, pocketing $232 million while he monkeyed with his stock-sale plan to increase his sales before the stock collapsed.
At drug manufacturer, Forest Laboratories, the CEO sold off 3.8 million shares -- all stock-option shares -- for $221 million before studies linking its main drug to increased adolescent suicide came out. Then that stock collapsed from $78 to $36, costing shareholders $15 billion.
At home builder Toll Brothers, top insiders unloaded 14 million shares for $612 million, before revealing slowing demand and a decline in orders that caused that stock to plummet from $56 to $33, costing shareholders $3.5 billion.
Finally, there is AOL Time Warner, where the corporate insiders sold more than 22 million shares for more than $750 million, as they put together -- and watched fall apart -- the worst merger of the century causing huge losses and a stock drop from $59 to $9, inflicting $150 billion in losses on shareholders.
These numbers are mind-numbing. If an inner-city kid uses a toy gun to rob a convenience store of $250, he gets 10 years. His crime impacts one store in a negligible amount. In California, if he had a couple of prior shoplifting or joy riding convictions, he could get life as a "three-time loser."
Yet, corporate insiders regularly use secret information to profit by millions and millions with impunity -- even though insider trading is a felony and their misconduct harms hundreds of thousands of investors, including pension funds charged with investing the life savings of millions of Americans.
The SEC's mandate is to protect investors and police fraud in our securities markets. So it's fair to ask "why is this happening and what is the SEC doing about it?"
This insider selling is largely the SEC's fault. The agency whose mandate is to police the securities markets actually adopted rules that encourage insider trading, facilitating the very kind of fraud it is supposed to prevent. And, despite the SEC Enforcement Director's complaints about insider selling, the SEC is doing little about the current epidemic.
The New York Times reported the SEC is "terrifically understaffed and wildly underfunded" and does not use trading audits by the national stock exchanges to further insider trading investigations. Perhaps that's why the SEC seems so ineffective in fighting insider trading. But let me suggest a further reason. Years of industry-friendly appointments have transmogrified the SEC into an agency more interested in protecting corporate insiders than public investors. The current SEC chairman sure doesn't look like an investor champion to many.
In each of the above examples of insider bailouts, institutional investors brought securities class-action suits. But they all suffer from problems due to the SEC's protective insider-trading rules. As a result, corporate insiders virtually never pay up any of their insider-trading proceeds when such suits are settled and it is most unlikely the stockholders will succeed in disgorging the insiders' stock sale profits in these cases.
Criminal prosecutions just don't happen. This kind of stock profiteering by corporate insiders undermines investor confidence in the markets and the federal agency that is supposed to protect them. If investors lose confidence, they invest less and economic growth and prosperity are impaired.
Rather than engage in empty rhetoric about insider trading, the SEC should step up its enforcement efforts and vigorously police the markets like Congress intended it to. And the courts should take off the gloves and treat shareholder suits challenging executive insider trading more kindly.
First Published January 6, 2008 12:00 am