Category Archives: Insider Trading

Public Trust

The current round of congressional hearings involving the secretarial appointments to the Trump administration appear to be raising numerous questions about conflicts of interest and as well as instances involving possible self-interested stock trading on the part of several of the wealthy candidates.  Issues involving self-interest are no less important for assurance professionals like CFE’s, auditors and public accountants than they are for presidential appointees.

The misuse of information for personal interest by an assurance professional can be detrimental to other stakeholders of the client or company involved. For example, the use of information by any professional before others have the right to use such information is unfair and considered unethical. This is the basic problem for anyone who is privy to inside information about a company by virtue of being its auditor or an employee, that is, an insider, to use that information personally or indirectly for any self-interested purpose. To ensure the basic fairness of stock markets so that the public and other non-insiders will wish to enter the market, regulatory bodies like the SEC require management insiders to wait until the information is released to the public before allowing insiders to trade, and then they must disclose these trades so the public will know what’s happened.

The prospect of a rigged game, in which insiders have an unfair advantage, would not be in the public interest or in the interest of the corporations using the market for fund raising in the long run. Insider trading rules also apply to the families of the insider, extending even to those who are not part of the immediate family but for or over whom the insider has an obvious ability to exert influence or extract gain. Some individuals with high-profile jobs in the public service go even further to avoid such conflicts of interest. To be entirely ethical, some politicians have placed their holdings, and those of their dependents, in so-called blind trusts, which are managed by someone else with instructions not to discuss trades or holdings with the politician. The situation for we auditors is somewhat different in that the ownership of shares or financial instruments of a client is forbidden based on the real or potential conflict of interest that would be created. Most auditing firms extend this ban in two ways. First, the ban is applied to the auditor’s family and to persons who would be considered significant dependents or subject to influence. Second, the ban may also apply to any client of the firm, even if that client is serviced through a wholly separate office (for international firms, even in another country) with which the individual professional does not have contact on a normally occurring basis.

Where the ban is relaxed on trading in shares of the firm’s clients for employees not directly involved in the client’s affairs, extreme care is taken through information barriers/firewalls and reporting/scrutiny mechanisms to manage the conflict of interest created. The extent of attention paid to the prevention of insider trading and even to the perception of it is indicative of the alarm with which most firms view its prospect. Confidentiality is the term used to describe keeping confidential information that is proprietary to a client or employer. The release of such information to the public, or to competitors, would have a detrimental effect on the interests of the client, and it would be contrary to the expectations of trust of any fiduciary relationship.

In the case of a fraud examiner, this expectation of trust and privacy is vital to the client’s willingness to discuss difficult issues, which are quite germane to the investigation, to get the opinion of the examiner on how they might be dealt with in court proceedings and even, eventually, in the public eye. In the case of auditors, how frank would the discussion of a contentious contingent liability be if there were a possibility the auditor would reveal the confidence? How could a contentious tax treatment be discussed thoroughly if there was the possibility of a voluntary or involuntary disclosure to the tax collection authorities? It’s therefore argued by the ACFE, the AICPA and others that the maintenance of client confidences is essential to the proper exercise of the audit function, and to the provision of the best advice based on full discussion of possibilities.

There are, however, limits to privacy that some professions have enshrined in their codes of conduct, or where these limits are spelled out in regulatory frameworks. Engineers, for example, must disclose to appropriate public officials when they believe a structure or mechanism is likely to be harmful to the users, as in the potential collapse of a building due to violations of the building code.  In most western countries, money laundering for drugs and terrorism must be reported to financial authorities by banking professionals. For auditors as well there appears to be an increasing focus on their public responsibility and an increasing expectation of action rather than silence. This trade-off between the interests of client, management, public, regulators, the profession, and management promises to be an ever growing conundrum for all professionals in the future. One issue that is not as well understood as is often thought is the consequence of a professional accountant observing strict confidentiality about the malfeasance of his or her employer, and being directed by the professional code to resign if the employer cannot be convinced to change their behavior. This would follow from the codes of conduct that require no disclosure of client/employer confidences except in a court of law or subject to a disciplinary hearing, and at the same time requiring resignation to avoid association with a misrepresentation. In the event of a resignation in silence, the ethical misdeed goes unrecognized by all stakeholders except the perpetrators and the silent professional. How does this protect the interests of the public, the shareholders, or the profession?

It has been suggested, as a topic for discussion, that strict confidentiality codes be modified to allow for the introduction of the possibility of consultation on such matters with officials of the professional’s certifying institute. Perhaps through such confidential dialogue, a means could be found to better judge what needs to be kept confidential, when and how disclosure ought to be made, and how the professional’s and the public’s interests can be protected. For an auditor, the situation is different. When an auditor is discharged, or replaced, the incoming auditor has the right to ask the outgoing auditor (and the client) what the circumstances were that led to the dismissal or resignation. In some jurisdictions, the removed auditor even has the right to address the shareholders at their annual meeting, or by mail, at the expense of the corporation involved.

CFE’s and other assurance professionals of all types are sophisticated enough to know that our professional codes don’t cover every ethical challenge and that investigations and engagements involving potential or suspected insider trading and conflicts of interest are no exception.  We must all, therefore, continue to develop judgement, values and character traits that embrace the public expectations inherent in emerging stakeholder oriented accountability and governance frameworks.

Empire Lost

marthastuart2Last week my wife and I were confronted with the challenge of  hosting a Christmas party for 24 of our relatives.  We thought we’d serve a standing prime rib roast to the guests and turned to a Martha Stewart Cooking School episode on PBS for preparation guidance.  Needless to say, the roast was delicious but seeing Stuart again after all this time got me thinking about her classic insider trading case of what now seems so long ago.

In June 2002, Martha Stewart began to wrestle with allegations that she had improperly used inside information to sell a failed personal stock investment to the unsuspecting investing public. That was when her personal friend Sam Waksal was defending himself against Securities and Exchange Commission (SEC) allegations that he had tipped off his family members so they could sell their shares of ImClone Systems Inc. just before other investors learned that ImClone’s stock was about to tank. Observers presumed that Stuart was also tipped off and, even though she proclaimed her innocence, the rumors would not go away. On daily TV as the reigning guru of homemaking, Ms. Stuart was the multimillionaire proprietor, president, and driving force of Martha Stewart Living Omnimedia Inc. (MSO), of which, on March 18, 2002, she owned 30,713,475 (62.6 percent) of the class A, and 30,619,375 {100 percent) of the class B shares.

On December 27, 2001, her class A and class B shares were worth approximately $17 each, so on paper her MSO class A shares alone were worth over $500 million. Class B shares were convertible into class A shares on a one to-one basis. What was not known was that Stewart had sold 3,928 shares of ImClone for $58 each on December 27, 2001.  This was not public until the information surfaced in June 2003.  The sale generated $227,824, and she avoided losing $45,673 when the stock price dropped the next day.  The whole sorry episode over this relatively small amount of money wound up causing her endless personal grief and humiliation, dealt a devastating blow to her reputation, and precipitated a punishing drop to $5.26 in the MSO share price.

As some of your probably remember, it turned out that Stuart had made an investment in ImClone, a company that was trying to get the approval of the U.S. Food and Drug Administration (FDA) to bring to market an anti-colon cancer drug called Erbitux. Samuel Waksal, then the CEO of ImClone and a friend of Stuart’s, was apparently warned on or close to December 25, 2001, that the FDA was going to refuse to review Erbitux. Per later SEC allegations, Waksal relayed the information to his family so they could dump their ImClone shares on the public before the official announcement. Martha claimed (and still claims) that she didn’t get any early inside information from Waksal, but regulators believed that she may have either gotten it from her broker or from her broker’s aide. The activities of several of Waksal’s friends, including Stuart all came under almost immediate investigation by the SEC.

Waksal was arrested on June 12, 2002, and charged with “nine criminal counts of conspiracy, securities fraud and perjury, and then freed on $10 million bail. In a related civil complaint, the SEC alleged that Waksal “tried to sell ImClone stock and tipped family members before ImClone’s official FDA announcement on Dec. 28.”  Per the SEC, two unidentified members of Waksal’s family sold about $10 million worth of ImClone stock in a two-day interval just before the announcement. Moreover, Waksal also tried for two days to sell nearly 80,000 ImClone shares for about $5 million, but two different brokers refused to process the trades. Stuart denied any wrongdoing. She was quoted as saying: “In placing my trade I had no improper information…. My transaction was entirely lawful.”  She admitted calling Waksal after selling her shares, but claimed: “I did not reach Mr. Waksal, and he did not return my call.”  She maintained that she had an agreement with her broker to sell her remaining ImClone shares “if the stock dropped below $60 per share.” Stuart’s viewing public, however, was skeptical. She was asked embarrassing questions when she appeared on TV for a cooking segment, and she declined to answer saying: “I am here to make my salad.”

Martha’s interactions with her broker, Peter Bacanovic, and his assistant, Douglas Faneuil, quickly came under scrutiny. Merrill Lynch & Co. suspended Bacanovic (who was also Sam Waksal’s broker) and Faneuil, with pay, in late June. Later, since all phone calls to brokerages are taped and emails kept, it appeared to be damning when Bacanovic initially refused to provide his cell phone records to the House Energy and Commerce Commission for their investigation. Then, on October 4, 2001, Faneuil “pleaded guilty to a charge that he accepted gifts from his superior in return for keeping quiet about circumstances surrounding Stewart’s controversial stock sale.”  Faneuil admitted that he received extra vacation time, including a free airline ticket from a Merrill Lynch employee in exchange for withholding information from SEC and FBI investigators.

Per court records:

“On the morning of Dec. 27, Faneuil received a telephone call from a Waksal family member who asked to sell 39,472 shares for almost $2.5 million. Waksal’s accountant also called Faneuil in an unsuccessful attempt to sell a large block of shares. Prosecutors allege that those orders “constituted material non-public information.” They also allege that Faneuil violated his duty to Merrill Lynch by calling a “tippee” to relate that Waksal family members were attempting to liquidate their holdings in ImClone. That person then sold “all the tippee’s shares of ImClone stock, approximately 3,928 shares, yielding proceeds of approximately $228,000.”

One day later, on October 5th, it was announced that Stuart had resigned from her post as a director of the New York Stock Exchange (a post she held only four months) and the price of MSO shares declined more than 7 percent to $6.32 in afternoon trading. From June 12th to October 12th, the share price of MSO declined by approximately 61 percent. Stuart’s future took a further interesting turn on October 15th, when Sam Waksal pleaded guilty to six counts of his indictment, including: bank fraud, securities fraud, conspiracy to obstruct justice, and perjury. But he did not agree to cooperate with prosecutors, and did not incriminate Stuart. Waksal’s sentencing was postponed until 2003 so his lawyers could exchange information with U.S. District Judge William Pauley concerning Waksal’s financial records.  After October 15th, the price of MSO shares rose, perhaps as the prospect of Stuart’s going to jail appeared to become more remote, and/or people began to consider MSO to be more than Stuart and her reputation. The recovery from the low point of the MSO share price in October to December 9, 2002, was about 40 percent.

Stuart still had a lot to think about, however. Apparently, the SEC gave Stuart notice in September of its intent to file civil securities fraud charges against her. Stuart’s lawyers responded and the SEC deliberated. Even if Martha were to get off with a fine, prosecutors could still bring a criminal case against her in the future. It is an interesting legal question, however, that if Stuart had simply pled guilty to the civil charges, would she have avoided criminal liability completely? On June 4, 2003, Stewart was indicted on charges of obstructing justice and securities fraud. She then quit as Chairman and CEO of her company, but stayed on the Board and served as Chief Creative Officer. She appeared in court on January 20, 2004, and watched the proceedings throughout her trial. In addition to the testimony of Mr. Faneuil, Stewart’s friend Mariana Pasternak testified that Stewart told her Waksal was trying to dump his shares shortly after selling her ImClone stock. Ultimately, the jury did not believe the counterclaim by her broker, Peter Bacanovic, that he and Stuart had a prior agreement to sell ImClone if it went below $60. Although the judge dismissed the charge of securities fraud for insider trading, on March 5, 2004, the jury found Stewart guilty on one charge of conspiracy, one of obstruction of justice, and two of making false statements to investigators.

The announcement caused the share price of her company to sink by $2.77 to $11.26 on the NYSE. Stuart immediately posted the following on her website:

“I am obviously distressed by the jury’s verdict, but I continue to take comfort in knowing that I have done nothing wrong and that I have the enduring support of my family and friends. I will appeal the verdict and continue to fight to clear my name. I believe in the fairness of the judicial system and remain confident that I will ultimately prevail.”

Stuart was subsequently sentenced to 5 months in prison and 5 months of home detention-a lower than maximum sentence under the U.S. Sentencing Guidelines-and she did appeal. Although she could have remained free during the appeal, on September 15, 2004, she asked for her sentence to start immediately so she could be at home in time for the spring planting season. Martha’s appeal cited “prosecutorial misconduct, extraneous influences on the jury and erroneous evidentiary rulings and jury instructions” but on January 6, 2006, her conviction was upheld.

Stuart may continue to disagree with the verdict to this day but there is little doubt that the allegations and her subsequent convictions had a major impact on her personally, and on the fortunes of MSO and the shareholders that had faith in her and in her company. Assuming a value per share of $13.50 on June 12th, the decline to a low of $5.26 in early October 2003 represents a loss of market capitalization (reputation capital) of approximately $250 million, or 61 percent. The value of MSO’s shares did return to close at $35.51 on February 7, 2005, but fell off to under $20 in early 2006. Per a New York brand-rating company, the Martha Stewart brand reached a peak of 120 (the baseline is 100) in May 2002, and sank to a low of 63 in March 2004.

As my wife and I can attest, Stuart has returned to TV with a version of her usual homemaking and design shows, her new Martha Stewart Cooking School and related books.  Her products and magazines continue to be sold.  Still, what a catastrophe for so many to save just $45,000.