Read the case below and answer the 3 following questions

Insider Trading: Have I Got a Stock Tip for You!

Everyone would like to get a stock tip that will yield a huge return on a small investment. That's human nature. But stock tips can be mixed blessings. Consider the following example: Dr. Sam Waksal developed a promising cancer drug called Erbitux. As the CEO of ImClone, Waksal was an entrepreneur as well as an immunologist. Waksal sold an interest in Erbitux to the pharmaceutical company Bristol Myers for $42 million.

It was a Bristol Myers executive who informed Waksal that the Federal Drug Administration (FDA) was not going to approve the drug because there were insufficient data to determine its effectiveness; thus, new clinical trials were needed. Investors had expected approval, and once the FDA decision was made public, ImClone stock was certain to face a sharp decline in price. At least in the short term, some people were going to lose a lot of money.

One of those people was, of course, Waksal himself. He had millions of shares of ImClone. So did his family. Waksal told his daughter and father to sell their shares. In addition, Waksal transferred 79,000 of his own shares to his daughter to sell. Waksal knew that it was illegal under federal law for him or his family members to trade on inside information. And in the end, all three were indicted and later convicted of violating federal security laws.

Waksal was guilty of insider trading. As we pointed out in Chapter1, insider trading results from information asymmetry, which arises when one party in a business transaction has information that is unavailable to the other parties in the transaction. To be legally actionable, insider trading must involve information that has not been publicly announced, as you might expect. In addition, the information must be material.Materialmeans that the information will cause a significant change in the stock pricethe price will go either up or down as a result of the event the information concerns. Examples of material corporate events include the introduction of a new product line, an acquisition, a divestiture, a key executive appointment, and the failure or success of a product under development.

Martha Stewart Enters the Picture

Waksal's conviction is not the only part of this story. Waksal was friends with the celebrity Martha Stewart, who also owned ImClone stock. On the day before the negative FDA announcement, Stewart sold 4,000 shares of ImClone worth $230,000. Did Stewart sell her shares on the basis of inside information regarding the FDA decision? Stewart's sale certainly looked suspicious, and the Securities and Exchange Commission (SEC) started an investigation and asked her to explain her sale. In her discussions with the SEC, Stewart did not admit to insider trading.

Stewart claimed that she had a prearranged order in place to sell her ImClone stock when it dipped below $60 per share. The stock did dip below $60 the day before the FDA announcement. Federal prosecutors, however, alleged that she and her broker, Peter Bacanovic, had doctored stock transaction records to support her story. In the SEC indictment, it was clear that they did not believe her explanation.

It is also interesting to note that Stewart is not alleged to have received a tip from Waksal himself. Indeed, she contacted Waksal only after the sale, when she called him to ask what was happening to the company. However, it is alleged that her broker, Bacanovic, received a tip that Waksal and his daughter had placed orders to sell shares of ImClone.

Martha Stewart was eventually convicted in a criminal trial, but convicted of what? The most serious charges, which involved securities fraud and insider trading, were thrown out of court. She was convicted only of lying to investigators. However, Stewart was also charged in a civil suit, and in that suit the insider trading charge would have been allowed in court. After serving a jail term, Stewart eventually reached an agreement with the SEC to settle the insider trading accusations. Under the agreement, she had to pay $195,000, covering her gains from the trading and penalties, although she did not admit to any wrongdoing.

Conclusions

What can we conclude about insider trading? The ethical issues can be analyzed at two levels: At the institutional level, we can ask whether the insider trading laws are ethical. At the individual level, we can ask why a person would engage in this illegal behavior.

Institutional Level.

Fairness is the ethical basis of the insider trading laws. If the competitive system is to work, it must operate on an even playing field. If insiders have material financial information not available to the public, then the playing field is not level. Note what the SEC said in its press release: "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 and give her an illegal tip. It's worse still when the individual engaging in the insider trading is the Chairman and CEO of a public company." However, not everyone is convinced by this argument. Using a utilitarian framework, others argue that persons acting on insider information bring information to the market more quickly and thus make the market more efficient for the benefit of all.

Both sides have a point. One of the keystone propositions of efficient financial markets is that no participant should possess a significantunfairadvantage over others. If you believe that the deck of cards is stacked against you and that some people who trade have access to inside information, you will collect your money and invest it elsewhere. Conversely, without inside information, there would be little reason for trading securities. Unless you know some information that affects securities' prices that others do not know, why trade? Furthermore, how would information relevant to security prices be released to the market unless some traded on that information?

The bottom line is that too much or too little inside information trading seems to be detrimental to financial markets. The critical question is how much inside information is optimal. There is no consensus among economists on an answer.

Individual Level.

At the individual level, we must evaluate the motivation of the inside traders. Waksal, for example, knew that insider trading was illegal. Why did he do it? In an interview on CBS's 60Minutes, Waksal admitted that he did not think that he would get caught. Investigation showed that Waksal had been guilty of a number of ethical lapses in his life. He had been dismissed from a number of academic and research positions for questionable conduct. Aristotle would say he had a weak character. If Stewart had not tried to obscure what she did and simply told the truth to investigators, most legal experts are convinced she would not have been convicted of anything.

1.Discuss whether it would be unethical to buy a stock based on some information you found in the trash that had been thrown away by mistake.

2.Suppose you are the printer who has been given the job of preparing the official announcement of the FDA report. Can you use that information for personal gain? Why or why not?

3.Some argue that insider trading brings information to the market more quickly and thus is morally acceptable on the grounds of efficiency. Do you agree with that argument? Why or why not?