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SCHADENFREUDE AND MARTHA STEWART
Professor Douglas Branson
University of Pittsburgh School of Law
JURIST Guest Columnist

Well, the other shoe has dropped (two of them, as a matter of fact). Wednesday, on a rainy day in Manhattan, the SEC filed a civil suit, seeking penalties from Martha Stewart for insider trading in shares of ImClone. The U.S. Attorney痴 office obtained an indictment of Stewart for securities fraud and for obstruction of justice. Stewart appeared at Foley Square, where the federal courts are located, to enter her plea of 渡ot guilty to the criminal charges. To one trained eye (mine), both cases seem a stretch. The SEC痴 motive in all of this is questionable as well.

Martha Stewart traded on the basis of knowledge, communicated to her by her stockbroker痴 assistant, that the ImClone CEO (Samuel Waksal) was attempting to sell the ImClone shares held in his Merrill Lynch account. Based upon her knowledge, Stewart sold 3,928 shares, thus averting a $46,000 loss that would have eventuated after ImClone announced, on the very next day, its failure to obtain FDA approval for its Erbitux cancer drug.

The broker痴 assistant (Douglas Franeuil) did not tip Stewart that the company had failed to win FDA approval, as many news sources have reported. If that had happened, Stewart would have been a tippee, or remote tippee (the tippee being Peter Bacanovic, the Merrill broker). Because she would have possessed information intended to be available only for corporate purposes, and the ultimate source of that information (Samuel Waksal) was a person bound by a fiduciary or similar duty to preserve trusts and confidences, she would have engaged in an illicit insider trade. She would have possessed classic insider information.

But that is not the case. Instead, the broker, and his assistant, communicated to Stewart 杜arket information, information about the market for the company痴 shares rather than information about the company痴 products, profits, or prospects, with a source inside the company itself. Other than in the area of control transactions (news of impending takeover bids and such), trading on market information is an undeveloped area of the law of insider trading. We can note, however, that investors trade on that type of 杜arket information all of the time.

If mutual fund A learns that mutual funds B and C have placed sell orders for their company X stock, fund A痴 traders might surmise that 都omething is up. They might consider a sale, or cancellation of a buy order they had placed earlier, in company X stock. The information may be non-public but it is not insider information. Fund A痴 traders are free to trade. Happens all the time.

Stewart received news not only of sell orders but also of the insider identity of the ersatz seller. Does that change anything? I think not. Millions of investors adhere to the school of thought that a smart strategy is to 電o what the insiders do. So gargantuan efforts are undertaken to find out what, indeed, the insiders are doing, and to do so at the earliest possible moment. Many investors track section 16(a) reports filed with the SEC, filed by insiders at the end of any month in which they have traded. Soon, under the Sarbanes-Oxley legislation, those reports will be filed, and available on company web sites, in near real time (2-3 days after the insider traded).

Nonetheless, even before Sarbanes-Oxley, some investors, through one stratagem or another, find out sooner than the public reports what insiders are doing. They trade on that basis. No one has suggested prosecuting them.

So, in Stewart痴 case, the SEC had to develop a new theory, or extend an existing (but relatively new) theory. The SEC alleges that Peter Bacanovic 都tole (杜isappropriated in polite terms) 杜arket (not inside) information (the Waksal sales attempts). He stole it not from the company (ImClone) but from his employer, Merrill Lynch. He tipped a client (Stewart) to trade on the basis of confidential information that belonged to Merrill and to Merrill alone. His tip is an illicit one because in communicating he breached a fiduciary duty to his employer.

So the SEC has cobbled together tried and true, relatively new, and undeveloped concepts, namely, tippee liability (tried and true), misappropriation (approved by the Supreme Court only in 1998, relatively new and still somewhat controversial), and market information (undeveloped and unexplored). In technical terms, the case is a civil penalty proceeding against a tippee of a misappropriator of market information in a non control situation. I think it is a first. No wonder the SEC put its toes in the water with only a civil proceeding.

The securities fraud case seems a much greater stretch. The U.S. Attorney has alleged that by denying the reports of insider trading, and by her company痴 press releases, denying that she had traded on classical insider information, Ms. Stewart engaged in securities fraud. The gist of the case is that she issued false public statements that were intended to impede the decline in price of Martha Stewart Living Omnimedia shares. Price declines, I guess the theory goes, were inevitable because the company痴 alter ego (Stewart) had become entangled in the insider trading imbroglio. Scrapped bare, the case alleges stock price manipulation by means of press release.

The U.S. Attorney痴 theory is fraught with theoretical glitches. Moreover, the practical consequence of a victory for the United States may be one few us wish.

The U.S. Attorney (and the SEC) have confused motive with intent. Intent is intending, or having the purpose or resolve, to do the act. Motive is possessing the 菟urpose or inducement which incites or stimulates a person to do the act. Intent is an essential element of most crimes. Motive is not. The SEC may have motive (although that may largely be guess work). It does not have intent. Let me explain.

In stock price manipulation cases, defendants have placed false orders, engaged in wash sales and matched orders, and done other intentional acts to create appearances in the market that are unrelated to the underlying economic reality. They inflate the price of a stock (a "bubble) and create the appearance of real trading when there has been little or none. They do the acts (the trades) purposely and knowingly, and not while sleep walking, or negligently.

Stewart has done none of these things. Instead, she denied wrongdoing, in the shares of another company (not Omnimedia), and explained why. Omnimedia investors traded or did not trade. The SEC case is that they did not trade and thus the stock did not fall as far as it should have. How do we know that? Or how does the SEC know that the stock price should have fallen further? The SEC痴 case seems to be that she made a false or misleading statement in connection with a non-trade and hence the stock did not fall as far as it might have which, under existing precedents, states no case at all.

Without reading Stewart痴 mind, the U.S. Attorney also cannot fathom her motive. Did she have the base motive of influencing securities prices, or the quite understandable one of attempting to preserve her good name? Was she trying to prevent her shareholders from selling, or defending herself so that she would not go to jail?

Where is the causal connection? Can the SEC demonstrate that investors did not sell because they believed Stewart in her statements that she had done nothing wrong? Maybe investors judged her denials as implausible. Then the result would have been that more investors would have sold, not less, than otherwise would have been the case. The share price fell too far.

The practical ramification is that corporate executives no longer are entitled to defend themselves. Any corporate executive charged with an allegedly questionable act who undertakes to defend himself may be charged with stock price manipulation and securities fraud. Their defense of themselves is an illicit attempt to retard any share price drop occasioned by the allegation of wrongdoing. It all seems un-American.

Apparently, the SEC wishes corporate executives and celebrities (Stewart is both), when accused of wrongdoing, to drop down, admit their fault, and then 努allow in their shame. The Commission thus has taken on a whole new mission beyond investor protection. The SEC痴 motive is production of schadenfreude.

Now the citizenry may take great pleasure in the trials and tribulations, and the immense shame, brought on by the admissions of the rich and famous. Admittedly, with Enron, WorldCom, Global Crossing, Adelphia Communications, and on and on, a good measure of schadenfreude is in order. To me at least, though, the Martha Stewart criminal securities fraud prosecution goes too far. As with any other commodity, there is an optimal output of schadenfreude and prosecuting not one, but two, suits against Martha Stewart exceeds that point.


Douglas Branson holds the W. Edward Sell Chair in Business Law at the University of Pittsburgh and is the author of Corporate Governance (Lexis Law. Pub. 1993).

June 6, 2003

GUEST COLUMNIST

JURIST Guest Columnist Douglas Branson holds the W. Edward Sell Chair in Business Law at the University of Pittsburgh School of Law, where he teaches Corporations and Corporate Governance. Considered one of the top corporate law experts in the country, he is a prolific writer whose work has been described as the best "traditional" corporate scholarship currently being done. The most recent book on his impressive bibliography is the widely and favorably reviewed 1993 treatise, Corporate Governance.

Professor Branson's reputation as one of the country's most productive and thoughtful business law scholars has earned him an especially influential role in framing the highly prestigious American Law Institute's recommendations for corporate governance. In addition, he is considered the world's leading expert on the corporate law aspects of Alaska native corporations.

Professor Branson is a graduate of the University of Notre Dame, Northwestern University School of Law and the University of Virginia School of Law.