The SEC To Top Execs: Read The Fine Print

Its suit against Lay says trades or loans on company stock can be insider trading, too

In 2001, Enron Corp. was quietly lurching from crisis to crisis. Whatever he did or didn't know about Enron's woes at the time, Kenneth L. Lay rarely missed an opportunity to talk up the oil-and-gas trading concern with analysts and Enron employees. The ex-chairman and CEO even urged workers to follow his lead and buy stock. From August through October, 2001, Lay bought $4 million worth of Enron shares -- which he cites as proof that he had faith in the company.

But there's a hitch. Privately, Lay was dumping far more stock than he publicly acquired, according to criminal and civil charges filed against him on July 8. In the same three months, he sold $26 million of Enron shares. Altogether in 2001 he unloaded Enron stock for $90 million. But because those shares were sold back to Enron, Lay did not have to disclose the sales until 2002, thanks to a loophole -- since closed -- in Securities & Exchange Commission rules.

The difference between Lay's public statements and private actions is the foundation of the SEC's civil charges -- one of the more aggressive interpretations of insider-trading law in decades. Opening a new chapter in the SEC's pursuit of alleged corporate crooks, the agency, in effect, is putting all CEOs on warning: They now face the risk of violating insider-trading laws when they trade company stock or borrow against it.

For Lay, the civil suit may be more serious than it first appears. The SEC complaint could undermine his defense against his criminal indictment on charges of conspiring to defraud investors by portraying the company as financially sound despite knowing otherwise. Why? The SEC lays out a trading pattern in which Lay appears to be an eager seller of Enron shares, contrary to his public statements. Lay insists he did nothing wrong and has pleaded not guilty to all the government charges.


So how did Lay cash out while appearing to support the stock? In 2001, according to the suit, he borrowed a total of $77.5 million from Enron, spread out over 20 transactions, and repaid the loans entirely with Enron shares. The repayments often came within a few days. Such stock sales vastly outweighed purchases. In seven transactions from August, 2001 -- when he resumed the CEO job after Jeffrey K. Skilling's surprise resignation -- through October, 2001, he converted more than 918,000 shares into $26 million. "He was selling all the time," says Duke University law professor James D. Cox. "And the number of shares he sold is staggering."

Lay doesn't see it that way. In public he has said that he sold because he needed the funds. He had pledged his shares as collateral for some $100 million in personal loans from three commercial banks. When the value of his Enron stock declined, his bankers made margin calls or demands that he increase his collateral. In his trial, Lay is expected to claim that, with few other assets he could easily sell to satisfy those demands, he was forced to borrow from Enron, repay the Enron loans with stock, and use the proceeds to pay off the banks.

That argument appears to have warded off a criminal insider-trading count. Justice would have had to show beyond a reasonable doubt that Lay possessed important information the market lacked and that he intentionally traded to take advantage of that information. The SEC's burden of proof is lower. It need only show that the preponderance of evidence points to insider trading. The SEC complaint argues that Lay's trades reveal an effort to pump up the shares, dump his stock, and skirt disclosure rules that might tip off investors.

Under then-SEC rules, sales of stock back to the company did not have to be reported until 45 days after the close of the calendar year in which the trades occurred. So when Lay urged Enron employees to buy on Sept. 26, 2001, he knew there would be no record of his sales. SEC filings showed only that he had bought that $4 million worth of stock.

The SEC case, however, is equally significant for the new liabilities it could create for other execs. Agency officials believe it's relatively common for managers to try to have their cash and keep their shares, too, by borrowing against their stock. Doing so allows them to avoid sending bearish signals to investors while still monetizing their shares. The Lay case seems to show that the SEC views the practice as deceptive. "I think the SEC clearly is saying that you're going to have to disclose if you're borrowing against your stock because, in effect, that's a sale," says UCLA law professor Stephen M. Bainbridge.

The agency also is warning that execs may be setting themselves a trap if they use shares as collateral. Monetizing shares via loans could create a motive to pump up the stock and, as with Lay, subject execs to insider-trading charges if they later sell because of margin calls, says Cox.

The SEC is also resurrecting long-forgotten doctrines to remind insiders of their obligations. Indeed, says Cox, not since 1968 has the agency brought insider-trading charges against a corporate exec for trading in the company's securities while holding back crucial information. And the SEC appears to be dusting off an old legal principle that says officials can't tell half-truths. That is, they can't claim to be a buyer -- even if that's technically true -- if they're selling more than they're buying.

At the same time, the SEC is making it harder to defend against inside-trading charges. Like Lay, many execs have so-called program-trading plans, which telegraph stock-selling intentions in advance. SEC rules state that such plans, if filed with the agency, protect against insider-trading charges. Lay had two such plans that let him sell up to 2,000 shares a day. He amended them in February, 2001, just as he was stepping down as CEO, so that he could diversify his assets. The SEC will counter that its rules make it clear that the protective shield melts if plan changes occur when an insider has important information not available to the market. Until now, the agency has never brought a suit alleging that a trading plan was inoperable.


A combination of SEC rules and the Sarbanes-Oxley Act of 2002 closed many of the loopholes that allowed Lay to avoid full disclosure. Companies can no longer lend money to officers and directors. And new SEC rules require insiders to report stock sales back to the issuer within two days. But no law or regulation prevents higher-ups from taking out bank loans secured by shares of company stock.

Already, the SEC is investigating numerous cases of tech executives' use of another common ploy to avoid tipping off investors about stock sales. When the tech bubble was driving up share prices in the late '90s, many officials used sophisticated options contracts to cash in their shares while putting off delivery of the shares for several years. They deferred capital-gains taxes -- and avoided sending a sell signal. Now the SEC is making it clear that such transactions are the same as selling -- and insiders who avoided disclosing them could be subject to an SEC enforcement action.

The Ken Lay criminal indictment has overshadowed the parallel SEC civil lawsuit. But corporate insiders and their attorneys would be wise to give the SEC complaint a close read.

By Paula Dwyer in Washington

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