Insider Trading

There comes a time in the life of every independent oilman when he decides to leave his wells behind. For Harry C. Johnson, that time was last summer. Having lost out on bids for two energy companies, the chairman and president of Red Eagle Resources Corp. decided his outfit was too small to compete against better-heeled rivals. So on Aug. 30, Johnson announced that he would sell the Oklahoma City oil and gas producer he had founded in 1977 to competitor Lomak Petroleum Inc. for $38.3 million. "It was a shock to everyone who knew me that I parted with my baby," says the laconic 62-year-old former roughneck.

Well, maybe dot everyone. Red Eagle's stock shot up 16%, to $5.50, the day before the $7.94-a-share deal was made public. And trading volume in the stock on Aug. 29--16,500 shares--was more than triple the norm. The American Stock Exchange promptly launched an inquiry. "Where there are a lot of people involved in a deal," Johnson sighs, "you have to believe in the tooth fairy to think there isn't leakage."

Insider trading. The term conjures up images and people of the 1980s: Investment bankers in handcuffs, arbitrageurs in hot water, a beardless Ivan F. Boesky, a defiant Michael R. Milken, an uncontrite Dennis B. Levine, and a fire-eating latter-day Thomas E. Dewey, Rudolph W. Giuliani. But even as most of those fabled characters fade into history and the legacy of tough enforcement lives on, insider trading is alive and well--and growing.

The motive, greed, is the same. So, too, is the renewed merger mania that is, again, going hand in glove with insider trading. But the cast of characters is different. Today, even as regulators keep a sharp eye on Wall Street, most of the action has been on Main Street. It seems plain that beefed-up regulatory surveillance and stiffer sanctions have done little to stem the tide. A BUSINESS WEEK investigation, which included a detailed examination of the trading surrounding every large bid this year, reveals that the paw-prints of insider trading--unexplained runups in stock prices and/or trading volume--accompanied a startling number of the largest deals of 1994 (pages 72-76).

One of the biggest contrasts from the 1980s is that insider trading has gone Middle American. Corporate executives, their friends and relatives, their lawyers and their consultants, are taking up the slack from brokerages and investment banks. For Wall Street pros, memories of colleagues being hauled off to jail and subjected to costly legal onslaughts are all too fresh. But in corporate boardrooms, the lure of making a quick buck is often too strong to resist--and ignorance of the regulators' trade-watching acumen is rife. "There are surveillance cameras in banks, and people still rob them. There's just too much temptation," shrugs James M. Cangiano, head of market surveillance for the NASDAQ over-the-counter market.

ROGUE RUNUPS. Government numbers only hint at the pervasiveness of insider trading. In the fiscal year that ended on Sept. 30, the Securities & Exchange Commission brought a record 45 insider-trading cases, up from 34 last year and exceeding the previous peak of 43 brought in 1989. And the ground is being laid for even larger numbers in coming years. Referrals of suspected insider trading to the SEC by the New York Stock Exchange and the National Association of Securities Dealers (NASD), which monitors trading on the NASDAQ market, are rising (chart).

A far more chilling picture emerges from the playpen of the insider traders, the market itself. BUSINESS WEEK analyzed the stock trading activity that took place before each of the 100 largest deals of 1994. The conclusion was stunning: One out of every three of the merger deals or tender offers uas preceded by stock-price runups or abnormal volume that couldn't be satisfactorily explained by publicly available information. Some of the deals were preceded by suspiciously heavy trading, others by unexplained price runups--and some by both price and volume surges, such as the largest takeover bid, American Home Products' bid for American Cyanamid. Some of the companies --notably Monk-Austin and Associated Natural Gas-- saw the trading surge at the time and were alarmed by it.

True, companies involved in deals often cite favorable market sentiment, takeover speculation, or other rumors for such trading flurries. But SEC officials are skeptical. Where there's smoke--runups--too often there's the inferno of insider trading. "We believe generally if there is a price and volume runup, somebody somewhere knew" about undisclosed news, says SEC Enforcement Chief William R. McLucas.

Insider trading has long raised troubling questions about the fairness of the markets, and this latest wave is no different. It could encourage the belief that the market is rigged against small investors. "Misuse of insider information makes the markets unfair," says Stephen L. Hammerman, vice-chairman and general counsel of Merrill Lynch & Co.

To be sure, insider trading never disappeared altogether. Before the current merger boom, corporate officials or the friends and family members they tipped off kept the SEC busy, mostly in cases involving the sale of stakes in companies ahead of bad-news announcements. In May, for instance, the SEC charged Oded Aboodi, an informal financial adviser to Time Warner Inc., with selling 20,000 Time Warner common shares and buying preferred shares in 1991 before the company announced a poorly received shareholder stock-rights plan. Aboodi settled charges that he avoided $413,700 in losses by agreeing to pay $931,000 in penalties and interest without admitting or denying wrongdoing. His attorney says Aboodi declines to comment on the case.

BUSY MORNING. However, these days, the enforcement focus is on 1980s-style insider trading--the pre-merger kind--where runups preceding deals are often a tipoff to illegal profiteering. A good example is the suspiciously propitious climb in Brock Candy Co. stock. Late on Aug. 29, trading was halted in Brock's stock, and the company disclosed that it was negotiating the possible sale of the company. The trading halt came after an unexplained runup of 14% from the previous day's closing price. A spokesperson for the combined company, Brach & Brock Confections Inc., confirms that the SEC has inquired into the trading, but declines to comment further.

One intriguing subplot of the Brach-Brock wedlock is that Robinson-Humphrey Co., an Atlanta brokerage that was advising Brock on the possible deal, also was handling a significant amount of the preannouncement trading. Robinson-Humphrey filed data with AutEx, a unit of Thomson Financial Services used by traders to advertise their presence in the market, that showed it handled 55,000 shares that morning. David C. Prince, Robinson-Humphrey's general counsel, says the firm has examined its trading in Brock, and "we don't feel any improprieties have occurred."

Even when corporate execs move heaven and earth to keep merger talks quiet, news sometimes dribbles out. When modem manufacturer Megahertz Corp. was negotiating with U.S. Robotics Inc. earlier this year, discussions were held either in hotel rooms near O'Hare International Airport or in conference rooms at Megahertz' Salt Lake City headquarters. Visiting U.S. Robotics executives even left their suits at home so they wouldn't stand out among Megahertz' casually clad employees.

Still, the stock turned up in BUSINESS WEEK 's review of deals with hefty stock moves before a deal announcement. On Oct. 18, the day before the transaction was made public, trading in Megahertz stock surged to more than double its daily average, and the stock price moved up more than 10%. Megahertz Finance Vice-President Karl S. Ryser Jr. says some recent good news may have been a factor but adds that the company can't fully explain the activity. "I am very concerned that it may have leaked," he says. U.S. Robotics won't comment on the price movement.

For the leakees, insider trading is not always a sure path to riches. Some deals fall through, and in others, the pricing of the deal is not known until the very end. Take MidSouth Corp., a railroad operator that was bought by Kansas City Southern Industries Inc. in 1992. Mark M. Levin, former chairman and chief executive of the company, recalls that he was at loggerheads with KCS over the value of his company for weeks. KCS eventually bought MidSouth for $219 million in 1992, but "no one knew until the very last moment that we had an agreement on price."

Still, the SEC believes that there was insider trading in MidSouth stock. In June, the commission charged a former Kansas City Southern lobbyist and two of her longtime friends with insider trading. The agency alleged that the three, plus two other investors who weren't named, made relatively paltry profits of $35,000. The lobbyist settled without admitting or denying wrongdoing, while her friends are fighting the charges. The SEC acknowledges that its investigation is continuing, and Levin says a relative of someone with links to MidSouth and two others have received subpoenas from the commission. Both deny any wrongdoing, according to Levin. All the same, he says he's "really angry." He adds: "It's so embarrassing to the company. It's outrageous."

Regulators have poured enormous resources into tracking down miscreants. The self-regulatory organizations, such as the New York Stock Exchange, the American Stock Exchange, and the NASD now use statistical models to uncover potential insider activity. Those models flag a stock anytime the price or volume breaks mut of historical parameters. Increasingly, they can factor in how the market in general is moving or what news has been announced to narrow down the cases that warrant scrutiny.

SLEUTHING SOFTWARE. Frequently, insiders tip neighbors and friends, so the exchanges and NASD can run an electronic search that produces a list of everyone from a certain zip code who traded in the stock in question. The hunt may turn up an unusually long list of lucky traders from the same block. Regulators and self-regulatory organizations also share a database that lists anyone whose name has turned up in connection with suspicious trading in the past. So if a name turns up several times, investigators can zero in on that individual. "If somebody had been doing that in the Boesky and Levine days, they would have seen the same account showing up [as suspicious] 15 different times," says Cameron K. Funkhouser, assistant director of NASDAQ's surveillance team.

Eugene and Bruce E. Dines learned the hard way how effective the stepped-up surveillance has become. Shortly after a Minnesota bank made a bid for Colorado National Bankshares Inc. in November 1992, a NASDAQ team began a routine review of the deal. The team traced some suspicious transactions--30,000 shares bought in the three weeks of deal negotiations--to a broker in La Jolla, Calif., who identified her client as a wealthy local retiree, 71-year-old Eugene Dines.

Tipped by NASDAQ, the SEC picked up the case and learned that Dines's brother, Bruce, was a CNB director. Before long, they ascertained through phone and trading records that the brothers had been in touch throughout the merger negotiations. The SEC filed charges in U.S. District Court in San Diego, accusing Bruce Dines of breaching his fiduciary duty by tipping his brother to the deal. The commission charged Eugene with earning illegal insider-trading profits.

Without admitting or denying guilt, the Dines brothers agreed to pay a total of $655,000 in civil penalties. But the price has been more than just a financial one. Eugene Dines, whose great-grandfather was a Colorado governor, says the incident has been humiliating for his family. "It was a very naive thing," he says now. "I'll regret it the rest of my life." Bruce Dines declined comment.

The Dines case is a far cry from the Roaring Eighties, when high-profile insider-trading cases roared through the Street. One reason is a 1988 law that made brokerages potentially liable for their employees' insider trading. That forced firms to monitor their employees more closely. "People are more careful than they've ever been. They don't want to risk everything by doing something stupid," says Robert C. Doll Jr., head of equity investments at Oppenheimer Management Co.

But the SEC isn't convinced that the Street has been scared witless by its sharply honed statutes. While a return to 1980s-style prosecutions is unlikely, Wall Street may yet feel the sting of insider prosecutions. "I can't say I'd be surprised if we come up with somebody at an investment-banking firm who thought they could fly under the radar and get away with it," says McLucas.

But lawmakers haven't imposed a similar oversight burden on law firms and other professionals. So, not surprisingly, cases against such people are more common. In September, the SEC brought charges against the former executive director of San Francisco-based law firm Brobeck, Phleger & Harrison. In the complaint, the SEC charged that in January of this year, Joseph F. Hamilton learned of a pending merger between IVAX Corp., a Miami chemical company, and McGaw Inc., a medical products company in Irvine, Calif. The agency contended Hamilton learned ef the deal in a hotel bar in Newport Beach, Calif., where he was meeting with two of the firm's senior lawyers representing McGaw and a McGaw officer. The SEC contended that Hamilton bought McGaw stock and netted a profit of nearly $31,000. He settled the case for more than $62,000 without admitting or denying the allegations. A spokeswoman for Brobeck says the SEC reviewed the firm's policies and procedures and found them to be adequate. The firm was not named in the action.

LOVE HURTS. Most insiders make some kind of effort to hide their tracks. Take the case of Thomas J. Blair. In 1992, the

twentysomething accountant at First Union Corp. was part of a team working on a possible bid for DF Southeastern Inc. According to the SEC complaint, Blair asked his fiancee to buy 700 Southeastern shares and paid for the investment himself. His fiancee, who worked at a brokerage firm, bought the shares within a few weeks of the June 29 deal announcement.

It didn't take long for the trades to come under scrutiny. After the deal was announced, NASDAQ's insider-trading sleuths began a routine inquiry that turned up trades in Charlotte, N.C., where First Union is headquartered. First Union, provided with a list of those who had traded before the deal announcement, identified the woman as the fiancee of one of their employees. Asked about Blair, she responded that the two had never discussed business. By the time NASDAQ gumshoes requested her phone records in late September, Blair's fiancee was becoming increasingly anxious. On Sept. 25, Blair showed up in the lobby of NASDAQ's Rockville (Md.) headquarter, ready to spill the beans. NASDAQ officials taped his story and put Blair in a cab bound for the SEC. Blair turned over about $7,000 in profits in a settlement without admitting or denying guilt, and he left First Union. The bank declines to comment on the terms of his departure. The fiancee, who was never identified by the SEC, was not charged in the case.

Confessions are rare, of course. Cases are usually the product of painful and lengthy legwork. And the starting point often isn't the stock market at all but rather the freewheeling options markets. Options--which give purchasers the right to buy or sell securities at a set price by a specified date--are far cheaper than the actual stock but yield a proportionally greater profit or loss when the stock price changes significantly.

CORPORATE BOMBSHELL. Indeed, options trading is being scrutinized in one of the biggest recent manifestations of merger mania. Shortly after Hilton Hotels Corp.'s disclosure Nov. 17 that it was considering putting itself on the block, the Pacific Stock Exchange notified the SEC of some suspicious trades in Hilton options and requested that the government freeze the account in question. On Nov. 23, the SEC lodged charges against Jeffrey C. Morris, a British citizen, for allegedly trading stock and options before the announcement. In its complaint, the SEC contends Morris told his broker he had "gotten a tip from a friend." The SEC alleges that Morris made more than $425,000 in profits by trading Hilton stock and options ahead of the Nov. 17 announcement. A judge granted the SEC's request to temporarily freeze all of Morris' assets both in the U.S. and abroad. An attorney representing Morris declined comment.

Options trading was also at issue in a case the SEC brought last August involving electronic-equipment maker Comptronix Corp. In 1992, the company dropped a bombshell: Three Comptronix officers had improperly inflated the company's earnings. After the Nov. 25 announcement, the stock plummeted from $22 a share to about $6. But the agency noted that options activity had been unusually heavy in the days leading up to the disclosure.

In its complaint, the SEC contended that the options trading was the result of a tip from Comptronix director Richard F. Adler. According to the SEC, Adler learned of Comptronix' overstated earnings during a Nov. 15 board meeting in which he participated via telephone from his Taiwan office. The federal regulators contend that Adler then tipped off a friend and business associate. (Adler, who is no longer a member of the board, could not be reached for comment.)

Eventually, two other business associates learned of the news, the SEC says, and one of them, Domer L. Ishler, bought 300 put options on 30,000 shares the day before the announcement was made. In the entire month preceding the transaction, only 10 put options had been traded. The options, which gave Ishler the right to sell Comptronix stock at $20 a share, netted him close to $370,000, the commission says. Reached at his home, Ishler says that the case against him has no merit and that he has no plans to settle the charges.

CRUEL SEESAW. What's often forgotten in insider-trading cases is the people on the other side of the trades. But in options markets in particular, market makers can feel the impact of insider trading quite dramatically. Last March, for instance, Stephen S. Taylor, a market maker at the Chicago Board Options Exchange (CBOE), suffered hefty losses on Grumman Corp. call options, which gave buyers the right to buy the stock. After the company received a bid from Martin Marietta Corp., Taylor and other Grumman market makers were forced to sell Grumman stock to the options holders at below-market prices.

The Grumman options imbroglio may end up in court. Taylor is part of a group of market makers that filed a report with the CBOE on the trading and is threatening to file a lawsuit to recoup the losses of its members. While Taylor declined to provide details on who is potentially liable, his group is awaiting the outcome of an SEC probe of trading in Grumman before deciding whether to take legal action. The CBOE declined comment.

Unfortunately for the SEC, even when there's no clear explanation for prescient trading, it doesn't mean that the agency can slam down its hobnail boots. Most SEC cases are based on circumstantial evidence--trading records, phone bills, or credit-card receipts. And it's tough to prove that suspects not only received inside information but knew they shouldn't trade on it.

In fact, earlier this year, a federal appeals court upheld a jury's decision to toss out an SEC case involving trading in Revco D.S. Inc. stock and options. The case, originally filed in 1991, charged that Marc J. Dworkin, an executive vice-president of the drugstore chain and the son of Revco's chairman and CEO, tipped his financially troubled brother-in-law in the fall of 1985 about a pending leveraged buyout of Revco. But after an eight-day trial, a jury found in favor of Dworkin. "Insider-trading cases are difficult to prove," notes securities lawyer John F. Olson. "Often, you just don't have a smoking gun."

Even in cases where the wrongdoing is blatant, the SEC can have a tough time recovering the money. That's because international cooperation sometimes is essential. And while the situation has improved over time, glitches remain. The SEC, for instance, has been struggling since 1990 to get its hands on money stolen by Eddie Antar, the infamous founder of the defunct Crazy Eddie Inc. chain of consumer-electronics stores. Agreements signed over the past several years with such countries as Canada, Luxembourg, and France have helped the SEC recover more than $58 million from Antar. However, the commission is still trying to seize an additional $10 million in frozen assets that Antar had stashed in various places such as Switzerland and Britain. "We've locked the money up," says the SEC's McLucas. "Now, we've got to get it back here."

FAMILIAR NAME. Many cases never get that far, of course. Often the trading trail comes to a dead end or the circumstantial evidence just isn't strong enough to bring a solid case. What's more, as merger-and-acquisition activity continues, putting ever more strain on the SEC's enforcement staff, it could take years to get to the bottom of cases.

So for former oilman Harry C. Johnson, finding the cause of that worrisome Red Eagle runup may be a long time coming. As part of its inquiry, the American Stock Exchange sent him a list of those who invested on Aug. 29 to see if he recognized anyone. Lo and behold, he spotted a familiar name--a former business associate who is now a stockbroker at a major brokerage house. Johnson says he spoke with his friend, a longtime investor in Red Eagle, about a week before the announcement but never mentioned a pending deal.

Still, he wonders about that runup. There was no explanation for it. "It may have been a leak," Johnson muses. "Or it may be a coincidence." Maybe. But perhaps Voltaire put it best. "Chance," he wrote, "is a word void of sense. Nothing can exist without a cause." Until Corporate America learns the lesson that Wall Street digested so painfully in the 1980s, the stock tables will continue to resonate with more and more "coincidences."


BUSINESS WEEK examined the 100 largest mergers so far this year. Of the 100 target companies, 34 showed runups in either price or volume--or both--that can't be satisfactorily explained. Each of the 34 companies was contacted by BW. Their explanation or comment, if any, is below:



Stock in the target rose from 60 5/8 to 63 in heavy trading on the day before American Home launched its hostile $95-a-share bid.


Takeover rumors were rife before Sandoz launched its $53-a-share bid for Gerber on May 23. Volume was huge--over a million shares on May 6--before the rumors hit the media.


Massive trading in Grumman shares and options preceded Northrop's bid for the company on Mar. 10. Trading in Grumman was also heavy prior to the Mar. 7 bid from Martin Marietta.


A day before the ill-fated merger agreement on Aug. 30, volume in Reliance stock reached 180,000 shares--twice the usual level. Reliance's director of investor relations, Steven Van Oss, says the company did not detect any "unusual stock trading patterns" on that day.


The deal was announced officially on Oct.13, but the action began days before. Intuit shares rose from 403/4 to 42 on Oct. 7, in heavy volume, for no apparent reason. Share prices rose, under heavy volume, even before a trade publication, InfoWorld, reported the impending deal on Oct. 10. Company officials cannot explain the predeal trading.


Shares of SynOptics rose from 13 5/8 to 15 1/4 in heavy trading on the trading day before the merger was announced on July 5.


Trading in both the stock and options of Neutrogena was unusually brisk in advance of the company's Aug. 10 disclosure that it was in talks regarding possible sale of the company. A shareholder suit alleges insider trading. Citing the suit, Neutrogena declines comment.


SciMed stock rose from 471/4 to 481/2 in heavy volume-1.5 million shares-shortly before the stock swap with Boston Scientific was announced at the end of the trading day on Aug. 8.


In the days before the merger was announced, on Oct. 10, Associated stock climbed 10% in huge trading. Harold Logan, a spokesman for Associated, says the runup "concerned us greatly. We don't know what caused it."


A poor earnings report pummeled Dial Page shares on July 25. But the shares came roaring back in the days before the merger was announced on Aug. 5.


The target company's shares rose in heavy trading on the day before the merger announcement on Apr. 4.


Trading volume was heavy on Sept. 9, the trading day preceding the Sept. 12 merger announcement. Trading was also heavy, and share prices rose 14%, in the two weeks before GenCare announced that it was in "conversations with other companies to explore a variety of business combinations." The company knows of no reason for the heavy trading.


Citizens shares rose in heavy volume--641,000 shares--the trading day before the merger was announced on Mar. 21. Lawrence Nichols, a spokesman for Citizens, says that the volume increase was noticed by the company at the time and that the company could not explain the rise in trading activity.


The company's shares rose from 24 1/2 to 26 1/4 in the three days before the merger pact was announced late on Mar. 15. A spokesman says the company didn't note any unusual stock activity before the announcement. Options trading volume was also heavy, leading to scrutiny by the Pacific Stock Exchange.


NBB stock climbed from 42 to 48, in trading that was at times very heavy, in the two weeks before the merger was announced on May 9.


Shares in the target company rose from 13 3/4 to 15 5/8 in unusually heavy trading the two trading days before the merger was announced on Oct. 23. "I think management here attributed it to speculation in the industry. We certainly hope it was speculation," says Paul Steelman, financial reporting manager at Monk-Austin. He calls the trading "alarming."


In the days before the merger was announced on Aug. 30, there was substantial trading in the usually thinly-traded Union Counties. Alice Cadby, head of investor relations at United, says the company was aware of the surge in volume but has no explanation for it.


Shares prices in Margaretten rose from 20 7/8 to 22 7/8 in the two days before the acquisition was announced on May 12.


Heavy volume and a jump in price--from 12 1/2 to 14 1/2 during two trading days--preceded the announcement that Statesman would be acquired by Conseco.


In the week before this long-pending merger was finalized on Mar. 21, share prices climbed from 16 1/2 to 18, in heavy volume.


Shares in this company soared almost 20% in the two weeks before the merger was announced, with an 11% gain on Aug. 8--the day before the takeover was announced.


Huge volume was sustained in the stock on May 31, one day before the acquisition by Corning was announced. Executives at Nichols noticed the volume at the time but had no explanation for it, a Corning spokesman says.


Mediplex rose from 26 to 29 in the week before the Jan. 4 deal announcement. "The general consensus [at Mediplex] was that it was a normal market thing," says a spokesman. However, health-care stocks hardly budged during that period.


In the two days before the merger was announced, there was unusually heavy volume in Colonial stock. A spokesman says that there were "tons of rumors out there for a while" but says that the company has no explanation for the activity in the stock.


Puritan shares climbed from 16 3/4 to 18 in the hours before the Thermo tender offer was announced late on Oct. 6. The company says part of the runup may be attributable to the announcement of new products. Still, the SEC has inquired about who had knowledge of the negotiations.


High volume and a jump in share prices--from 27 1/8 to 31 in the space of a week--preceded the acquisition announcement on June 30. Jim Vaccaro, executive vice-president, says: "We recognize there was heightened price and volume activity [before the merger announcement]," and that bank officials know of no reason for the trading frenzy.


Stock in Germantown sustained unusually heavy volume on Mar. 7, the day before the acquisition by CoreStates was announced.


Unusually heavy trading and a surge in price--from 40 to 48 1/2--preceded the Apr. 15 announcement of Surburban's acquisition by Bank of Montreal. A spokesman for Suburban says: "No one here has any knowledge of the reason for the trading activity" before the announcement.


One of the largest predeal runups of the year was sustained by Allied Clinical stock, which climbed from 123/4 to 171/4 in the four days before the merger, which was announced on May 4.


Trading in Great Lakes abruptly surged in the days before the takeover announcement on Sept. 9. Takeover speculation was rife the day before as share prices rose from 24 to 24 3/4 in heavy trading.


Shares of Northeast climbed from 9 5/8 to 10 1/8 in the three days before the acquisition was announced on June 13.


Share prices climbed from 60 on Nov. 3 to 66 on Nov. 4, then fell to 61 on Nov. 7, the day before the merger announcement. Notes Trico Treasurer Marshall J. Morris: "It was a very strong quarter. If there was any cause and effect, that may have had some support."


Before trading was halted in the stock on Aug. 29, the day the merger was announced, Brock stock had climbed to 11 1/8--a 14% surge over the day before.


Four days before the Carson tender offer on Oct. 28, Younkers shares fell from 15 to 13 3/4 because of worse-than-expected earnings. But then, the stock surged, climbing some 15% in the days before the offer. CFO Alan Raxter says that "was just normal calming down of the market."

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