St. Martha: why Martha Stewart should go to heaven and the SEC should go to hell.

June did not bring much sunshine for New York City or good news for Martha Stewart. After twisting in the wind for nearly a year and a half, the Diva of Domesticity was sued for insider trading by the Securities and Exchange Commission (SEC) and indicted for securities fraud and obstruction of justice by the Department of Justice.

Those who are salivating over Stewart's demise should put down their forks. In early 2002, when she was first questioned by the reds, all the news outlets reported speculation, based on anonymous government sources, that she had sold the last remnant of her ImClone stock on December 27, 2001, because her buddy, ImClone founder and CEO Sam Waksal, had told her that the Food and Drug Administration was about to reject an application for Erbitux, the company's highly touted cancer drug. The news reports also suggested that she had lied to the feds about Waksal's tip. But as the government now tacitly admits, neither of these allegations is true. That fact helps explain why the feds waited until June 2003 to bring charges: They had trouble finding anything to pin on Stewart.

The most serious criminal charge against her is not perjury or insider trading but securities fraud, based on the fact that she denied to the press, personally and through her lawyers, that she had engaged in insider trading. This was done, the feds say, not for the purpose of clearing her name, but only to prop up the stock price of her own publicly traded company, Martha Stewart Living Omnimedia. In other words, her crime is claiming to be innocent of a crime with which she was never charged.

As for the SEC's civil case, it hinges on an elastic understanding of insider trading, an offense Congress has never defined. The justification for the ban on insider trading, which makes little economic or legal sense, is just as murky as the behavior covered by it. Given the difficulty of figuring out exactly what constitutes insider trading (let alone why it's illegal), it is entirely possible that Stewart and her lawyers weren't sure whether she had broken the rules. In any event under existing case law, it's clear that she didn't.

What Did She Know?

All Stewart knew when she ordered the sale of her 3,928 ImClone shares was that, according to her broker; the price of the company's stock had dropped from $64 at opening to $58 under heavy selling (7.7 million shares vs. the daily average of 1.1 million), and that his clients, Sam Waksal, and his daughter, Aliza, also had been selling. The SEC charged Stewart with insider trading because her broker told her the Waksals were selling, and the Department of Justice indicted her because she denied any culpability for insider trading.

Stewart was not the only investor connected to Waksal who joined the selling mob that day. She just received the most scrutiny. There was Martha's friend, Mariana Pasternak, who was on vacation with her when all this happened and whose ex-husband coincidentally sold more than 10,000 shares of ImClone that day. He wasn't charged with insider trading. Then there were the two unnamed friends of Waksal described by The New York Times: One sold $600,000 of ImClone stock on December 27, while another sold ImClone stock worth $30 million on December 27 and 28. Phone records show the sales took place "almost immediately" after contact between Waksal and the sellers. The government has refused to identify these anonymous investors and so far has declined to indict or sue them for insider trading.

Finally, there were Waksal's daughter, Aliza Waksal, a 29-year-old actress, and his octogenarian father, Jack Waksal. On December 27, Sam Waksal telephoned Aliza at the ski resort where she was vacationing and told her to sell all her ImClone shares (40,000 for $2.5 million). Before government investigators questioned Aliza, Waksal told her to conceal their conversations, using the cover story that she needed the proceeds to buy an apartment (which she didn't do until seven months later, spending $1.4 million to buy it from her daddy's development company). After talking to his son, Jack Waksal sold more than 136,000 shares on December 27 and 28 for more than $8 million. Jack Waksal also lied to the government, denying that he spoke to Sam Waksal prior to selling his ImClone stock. This was before prosecutors produced phone records showing that calls between them all had taken place before the trades were made. Neither Aliza Waksal nor her grandfather has been indicted or sued for insider trading or lying to the government.

The disparate treatment of Stewart and the other ImClone investors is especially troubling when you consider the government's definition of insider trading and rationale for prohibiting it. The government says insider trading occurs when someone buys or sells stock based on material, non-public information received from an insider. While Aliza Waksal spoke directly with her father prior to her sale, Stewart knew the Waksals were selling (arguably not material information, since insider sales are not always reliable predictors of a stock's movements) only because her broker (not a true corporate insider) told her so. Although Martha tried to speak to Waksal, she was unable to get hold of him before selling her stock.

Likewise, the government says insider trading is illegal because it does "economic harm" to the market. Therefore the size of the trade must matter. Aliza Waksal avoided $630,295 in losses and her grandfather three times that, while Stewart saved only $45,000. By this measure, Aliza Waksal's sale and her grandfather's did more "economic harm."

Suppose we stretch the definition of insider trading beyond economic harm caused by the use of material, non-public information, and instead use the SEC's long discredited "fairness" or "level playing field" theory. According to this view, it was not fair that Martha knew the Waksals were selling before the rest of the market knew. That standard still wouldn't explain why Aliza Waksal's trade was legitimate. Stewart's excuse was that she had already told her broker she wanted to sell when the ImClone share price fell below $60, which is what happened on December 27. Aliza Waksal's excuse was that although she's an adult, she is still financially dependent on her father, so she had no choice but to do as he instructed, which included selling the stock and lying to government investigators. Which explanation sounds more plausible?

When Waksal worked out a settlement with the government, it reworded the language regarding Aliza Waksal's sale. The settlement now says Waksal "directed Aliza to sell all of her ImClone shares" and Waksal "benefited because he was her entire means of financial support. "Thus Sam Waksal is guilty of his adult daughter's insider trading because if she hadn't sold, he would have ended up paying more of her bills. She didn't benefit from the trade, according to the government; he did.

Birth of a Crime

As the treatment of Aliza Waksal and other lucky ImClone investors suggests, the prosecution of insider trading has nothing to do with supposed economic harm or even "unfair" tips, let alone lying to the government. Instead it's about bringing down the biggest and best-known targets to make it look like the laws against insider trading are accomplishing something.

Such publicity stunts are necessary because the insider trading ban is bad economics and worse law. Although there's a broad consensus, among Wall Street executives as well as Washington policy makers, that trading on inside information is harmful to investors and the market, this consensus has never been supported by solid evidence. Yet during the last four decades the SEC has waged a campaign to maintain and expand the scope of the insider trading ban, perpetuating the myth that scores of insiders are secretly enriching themselves at the expense of the investing public.

It has been, in many respects, a successful campaign. In a June survey by the Sienna Research Institute, 60 percent of those polled thought Martha Stewart was guilty of insider trading, and 51 percent thought she was guilty of obstruction of justice. Many people think Stewart "should have known better" because she used to be a stockbroker. But when it comes to insider trading, the SEC and the Justice Department don't want anyone to know better. If they did, They would have long since asked Congress to clearly define the offense. Instead, as Barron's Editor Thomas G. Donlan wrote in June, "The government prefers to define [insider trading] case by case. 'He did what? Oh, that should be illegal.' So it is."

Insider trading was not a crime until passage of the Securities and Exchange Act of 1934, Section 10(b), which prohibits "fraud" in the sale of securities. This offense was intended by Congress to cover stock trades by a corporate officer, director, or major shareholder--someone with a fiduciary responsibility to a company's stockholders--based on non-public, material, "inside" information. In 1961 the SEC for the first time claimed that Section 10(b) and its SEC-promulgated companion, Rule 10(b)(5), extended beyond people traditionally considered to be corporate insiders. The case involved a Cady, Roberts & Co. broker who learned from a director of Curtis-Wright Corp. that the company was going to reduce its dividend. Before the reduction became public knowledge, the broker sold Curtis-Wright shares owned by his wife and clients.

Although the broker was not a traditional insider and did not have a fiduciary duty to Curtis-Wright or its stockholders, the SEC charged Cady, Roberts with insider trading. It argued that Section 10(b) was "designed to encompass the infinite variety of devices by which undue advantage may be taken of investors and others." The SEC thought it was inherently "unfair" for the broker to sell shares when he knew that the people buying them did not have the same information he had. The SEC ignored the fact that all trades on impersonal stock exchanges involve the potential for asymmetric information; one party frequently will know something the other does not. That is how markets work. It's why two people can simultaneously think XYZ stock is a buy and a sell at $2.

Yet the SEC is still using the same "fairness" rationale today. Commenting on the insider trading case against Martha Stewart, SEC enforcement director Stephen M. Cutler told The Washington Post, "It is fundamentally unfair for someone to have an edge on the market just because she has a stockbroker who is willing to break the rules."

Bad Economics

That position makes no economic sense. In his classic 1966 book Insider Trading and the Stock Market, Henry Manne of George Mason University Law School demonstrated that inside information makes stock markets more efficient. Stock market efficiency depends on the speed and the accuracy with which new information is assessed by the market and reflected in share prices. When insiders trade on their knowledge, that information is immediately reflected in stock prices, thereby conveying this "inside" information to the market. The more information available, the more accurate the stock prices and the more efficient the allocation of capital.

What's more, there is no evidence that insider trading harms the market. The SEC says insider trading has to be prevented because it would cause the public to lose confidence in the market and abandon it. Yet such flight does not seem to have occurred in the years before 1934, when insider trading was still legal, and scholars such as Manne point out that the 1929 stock market crash was not caused by insider trading.

A 1987 study by the SEC's own economists casts further doubt on the commission's view of insider trading. The study, which looked at the effect of corporate takeovers on stock prices during the 1980S, determined that, on average, nearly 40 percent of the increase in a target company's stock price occurred before the takeover announcement. Yet the economists found that insider trading did not cause the pre-bid rise, which was entirely the result of speculation in the media, how much stock the acquirer bought before announcing the takeover bid, and whether the bid was hostile or friendly.

A footnote to the report questioned the assumption that inside traders profit at the expense of less-informed investors. "Those selling into the market when the better informed are buying probably would not have sold had they possessed the same valuable information," the economists noted. "However, they still would have sold if the information specialist had refrained from buying, especially if the trading of the specialist did not affect significantly the stock price. This holds true whether the trading is based on insider information or on careful analysis and successful anticipation of the event."

An insider, by definition, has better information than an outsider. So does a market professional. Market professionals sometimes track insiders' buying and selling of their company's positions, which are available through public filings. Whether the trader with better information acquired it from an inside tip or simply through diligence and hard work, the SEC economists reasoned, does not change the effect on either the market or the other party to the trade.

Bad law

Not only is the SEC's "level playing field" theory bad economics, the U.S. Supreme Court has held that it is bad law. The Court first rejected the theory in a 1980 case involving Vincent Chiarella, who worked in the composing room of a financial printing company, Pandrick Press. Chiarella handled the announcements of five corporate takeover offers. Despite Pandrick's use of code names for the companies, Chiarella was able to deduce their identities. Armed with this knowledge, he bought modest amounts of the target companies' stock before the takeover announcements and sold it immediately afterward. The SEC investigated, confronted Chiarella, and not only made him give up his profits (about $30,000) but referred the case to the U.S. attorney for criminal prosecution. Based on the SEC's level playing field theory, Chiarella was indicted for securities fraud, brought to trial before a jury, and convicted. The always SEC-friendly U.S. Court of Appeals for the 2nd Circuit rubber-stamped the verdict.

On appeal, however, the Supreme Court ruled that Chiarella could not have been guilty of securities fraud. His employer worked for the corporate raider, not the target. Chiarella therefore had no duty to shareholders of the target corporation. "Section 10(b) is aptly described as a catchall provision," Justice Lewis Powell wrote for the majority, "but what it catches must be fraud. When an allegation of fraud is based upon non-disclosure, there can be no fraud absent a duty to speak." Chiarella had no such duty, unless the law required all market participants to disclose what they know or to refrain from trading on such information. As Powell noted, "Neither the Congress nor the Commission ever has adopted a parity-of-information rule."

The second defeat for the SEC's level playing field theory involved an investment analyst, Ray Dirks, who specialized in the insurance industry. Two employees of Equity Funding Corp. of America gave Dirks information that enabled him to uncover a shocking and pervasive insurance scandal. Dirks learned that Equity Funding had invented records of policies that never existed to bolster sales figures, intimidated employees who threatened to expose the fraud, and falsified other corporate records to paint a picture of fiscal health. The corporation's executives knew all this was taking place.

Upon learning the extent of the scandal, Dirks told his clients, who promptly sold their Equity Funding stock. Then he told the SEC and The WallStreet Journal Instead of praising Dirks for uncovering the scandal, the SEC hauled him into court. As punishment for giving his clients the "inside information" on Equity Funding, Dirks was prohibited for six months from trading or associating with a registered broker/dealer.

The U.S. Court of Appeals for the District of Columbia Circuit upheld the SEC'S action. In a decision that can charitably be described as confused, the D.C. Circuit ruled that the Supreme Court really did not mean what it said in Chiarella. Even though Dirks had no fiduciary responsibility to Equity Funding, the appeals court said, he had an overriding obligation to the SEC and the trading public to disclose the fraud or to refrain from trading.

The Supreme Court, which ruled on Dirks' appeal in 1983, was not pleased. In unusually blunt language, Justice Powell wrote: "We were explicit in Chiarella in saying that there can be no duty to disclose where the person who had traded on inside information was not [the corporation's] agent ... was not a fiduciary, [and] was not a person in whom the sellers [of the securities] had placed their trust and confidence."

The Supreme Court's message to the SEC in Dirks was as clear as it was in Chiarella: If you want a level playing field, go see Congress, not us. Section 10(b) is about fraud, not fairness. The Court also went out of its way to chastise the SEC for its inconsistency in insider trading enforcement. Suggesting that it was "hazardous" to deal with the SEC, the Court accused the commission of bringing "test cases" that contradicted its stated enforcement policies. In his opinion, Powell quoted from a speech by a former SEC chairman who said the commission "does not contemplate suing everyone who may have come across inside information" and specifically listed as people who would not be sued "persons outside the company such as the analyst or reporter who learns of inside information"--in other words, people like Ray Dirks.

Misappropriated Logic

When Powell retired from the Supreme Court, the SEC got the opportunity to try out a new version of the level playing field theory based on the concept of "misappropriation." It's best illustrated by Wall Street Journal reporter Poster Winans, who was one of the writers of the Journal's "Heard on the Street" columns, which frequently affected stock prices. Perhaps comforted by that SEC chairman's assurances that reporters wouldn't be sued, Winans agreed to disclose the subject of the next day's column to a broker who sometimes traded on that information, giving Winans a small portion of his profit.

Like Chiarella, Winans was hit with both civil and criminal charges even though he had no fiduciary obligations to either the buyers or the sellers of the stocks traded. The only party he defrauded was his employer, The Wall Street Journal (which fired him but did not pursue criminal charges). The only basis for the insider trading charges against Winans was the level playing field theory, i.e., the idea that selling advance information about the column wasn't "fair" to the market. Yet the SEC argued that because he had committed a fraud on his employer, The Wall Street Journal, by "misappropriating" information that belonged to it, Winans was guilty of securities fraud under Section 10(b), even though the entity he defrauded, The Wall Street Journal, had no connection with any securities trade. Winans was convicted of insider trading as well as federal mail and wire fraud, and the and Circuit upheld his conviction. The Supreme Court affirmed Winans' mail and wire fraud conviction but split 4-4 on the insider trading conviction and issued no opinion. Powell, who had retired a few months earlier, would have been the deciding vote.

It wasn't until 1997, in United States v. O'Hagan, that the Supreme Court approved die misappropriation theory. O'Hagan was a lawyer whose firm represented a company that intended to make a tender offer for Pillsbury. O'Hagan "misappropriated" this information without his client's knowledge or consent by buying call options in Pillsbury stock, which became very valuable when the tender offer was announced. O'Hagan took home a tidy $4.3 million in profits. As with Chiarella, Dirks, and Winans, no one in the market was hurt by this action, not even O'Hagan's client. The government, under the same misappropriation theory it had used with Winans, secured a conviction. The U.S. Court of Appeals for the 8th Circuit reversed on the grounds that the misappropriation theory was beyond the scope of Rule 10(b)(5) and did not involve fraud directed toward a buyer or seller of securities. The 8th Circuit also reversed O'Hagan's mail fraud and money laundering convictions, concluding that they rested on violations of the securities laws that had not been proven.

There was no way the Supreme Court could let a lawyer get away with making millions of dollars by stealing confidential client information, so it reinstated the conviction and approved the misappropriation theory. But the Court said its decision was not based on fairness or protecting the trading public. The Court in its decision and the government in oral argument agreed that it would have been perfectly legal for O'Hagan or Foster Winans to trade on their inside information had they privately disclosed to their client and employer, respectively, what they were doing, notwithstanding the "unfairness" to the market. No deception, no foul.

Although the misappropriation theory narrows the definition of insider trading, the SEC continues to believe in the level playing field and to look for ways to broaden its approach. In O'Hagan the government argued that "the very aim of [section 10(b)(5)] was to pick up unforeseen, cunning, deceptive devices that people might cleverly use in the securities markets." Justice Clarence Thomas quoted this claim in his dissent, along with the dry response of one of his colleagues: "That's rather unusual for a criminal statute to be that open-ended, isn't it.?" Yes, it is. But open-endedness has its advantages. It allows the SEC to ignore, condone, or even facilitate insider trading when it chooses and then go after a juicy target like Martha Stewart, whose alleged insider trading is well outside anything recognized as such by the Supreme Court.

Ivan the Not-So-Terrible

In its heart of hearts, even the SEC knows insider trading doesn't hurt the market. Remember the financier Ivan Boesky? Back in the 1980s, Boesky agreed to pay a record $100 million in penalties for trading on inside information purchased from the Drexel Burnham Lambert investment banker Dennis Levine. The Wall Street Journal estimated that Boesky had made more than $200 million in profit from Levine's information. By cutting a deal the SEC let Boesky keep half of his illicit profits.

But wait, it gets better. Before the SEC announced the settlement, it allowed Boesky to cut his trading partnership's liabilities by $1.3 billion through a series of government-sanctioned insider trades. SEC Chairman John Shad later told a House committee that the market wasn't hurt by those trades because it bounced back after a one-day loss. So keeping $100 million in ill-gotten gains and executing insider trades totaling more than $1 billion are both OK if the SEC says so.

Yet Martha Stewart got nailed for saving $45,000 without breaching a fiduciary duty to anyone. The initial trading case against her centered on whether she knew that Sam Waksal was selling his ImClone stock because of the FDA's impending rejection of the company's anti-cancer drug. The feds interviewed Stewart about the sale and claim that during the interview she lied to cover up her wrongdoing and then issued false claims of innocence when anonymous government sources leaked these unproven accusations against her, allegedly doing so to support her own company's stock price.

The government now admits Stewart never had inside information from Waksal. Here are the facts patched together from various pleadings and other public accounts:

On December 27, Stewart and her friend, Mariana Pasternak, were flying in Stewart's private jet to San Jose del Cabo, Mexico, for a vacation at a resort. The plane stopped to refuel in San Antonio, where Stewart called her office on her cell phone and learned that her Merrill Lynch broker (and friend), Peter Bacanovic, had telephoned. Bacanovic, who was also a broker for Waksal and his daughter, Aliza, was in Miami at the time and didn't connect with Stewart when she returned his call at Merrill.

According to the SEC, Douglas Faneuil Bacanovic's assistant, who copped a plea in exchange for a misdemeanor slap on the wrist, advised Stewart, at the behest of Bacanovic, that the Waksals were selling their ImClone stock. In doing so, Faneuil (and allegedly Bacanovic) broke Merrill Lynch's customer confidentiality rule. Stewart asked Faneuil where the stock was trading. Faneuil said $58, and Stewart told Faneuil to sell her remaining ImClone shares (3,928 shares for close to $230,000). Stewart then left a message for Waksal at his office, subsequently summarized in a note from Waksal's secretary: "Martha Stewart. Something is going on with ImClone and she wants to know what."

The SEC started investigating ImClone within days of the FDA announcement on December 28, 2001. It first interviewed Bacanovic on January 7, 2002, and Stewart on February 4. Stewart and Bacanovic each tom investigators that she unloaded her shares because of an oral arrangement they had to sell her ImClone shares at $60. Faneuil initially backed them up but later recanted, telling prosecutors there was no agreement. He said Bacanovic pressured and bribed him (with extra vacation and free airline tickets) to lie. As further proof of this cover-up, the Justice Department's indictment cites the fact that Bacanovic marked "@60" near the listing for Stewart's ImClone holdings in a blue ink different from the blue ink he used on a spreadsheet where he wrote down portfolio decisions for Martha's various holdings on December 20.The feds claim the different ink proves that he made the notation after December 27. Forensic experts say there is no way to tell when the "@60" notation was made.

The SEC also charges that prior to the initial February interview, Stewart temporarily changed an entry in her telephone log from "Peter Bacanovic thinks ImClone is going to start trading downward" to "Peter Bacanovic re: ImClone." Then she had second thoughts and changed the log back to its original form. This aborted tampering with evidence does not prove Stewart was guilty, but it does illustrate the uncertainty created by the government's murky inside trading rules.

The Real Insiders

A better approach would focus on actual wrongdoing rather than the perceived unfairness of unevenly distributed information. Insider trading should be regulated by existing criminal laws that prohibit industrial espionage and the theft of trade secrets and sensitive commercial information. Dennis Levine, for instance, could have been prosecuted for stealing proprietary information from his employer and selling it to Boesky. Ditto O'Hagan. At most Foster Winans and Peter Bacanovic should have been fired for violating their employers' internal policies, not prosecuted or sued for insider trading.

Anything more should be left to the public companies and the stock exchanges on which their shares are traded. If companies want to permit or prohibit insider trading by their executives, let them say so publicly and let investor decide if they want to buy shares based on that policy. If a stock exchange believes insider trading damages investor confidence, it should require companies whose shares trade on the exchange to have rules against it.

The SEC does not want this to happen. Its prosecution of Ray Dirks for saving his clients from the Equity Funding fraud and its failure to sue Sam Waksal's daughter, father, and anonymous friends for their insider trading suggest why. The SEC does not care about protecting individual investors; insider trading has no effect on them anyway. It does not care about the integrity of the market or capital formation; insider trading has no effect on them either. The only people protected by SEC prosecution of the nebulous "crime" of insider trading are SEC lawyers and their allies, who can keep on inventing new definitions of the offense as they go along. Before suing Stewart, the SEE had never gone after the customer of a broker who offered his knowledge of what another customer had done as a reason to make a trade.

The Justice Department and the SEC don't care about the "fairness, efficiency, and integrity" of our capital markets. Letting Aliza Waksal keep her profits from insider trades proves that. The government lawyers want to enhance their own power and prestige. They don't care who they hurt in the process, such as the shareholders of Martha Stewart Living Omnimedia, who saw the company's value drop by over $400 million between December 2002 and August 2003.

What's worse, these government lawyers don't seriously expect to prevail at trial. Without a credible claim of insider trading against Stewart, the securities fraud charge based on her public (and truthful) denials of the government-leaked claims that she was guilty of insider trading will collapse. Martha will walk, and it will be a good thing. But she and her shareholders will have paid an unnecessary price. That's not a good thing. It's a disgrace. And a damn shame.

Contributing Editor Michael McMenamin (mtm@ walterhav.com) is a lawyer in Cleveland.