St. Martha

June did not bring much sunshine for New York City or good news for Martha Stewart. After twisting in the wind for nearly a year and a half, the Diva of Domesticity was sued for insider trading by the Securities and Exchange Commission (SEC) and indicted for securities fraud and obstruction of justice by the Department of Justice.

Those who are salivating over Stewart's demise should put down their forks. In early 2002, when she was first questioned by the feds, all the news outlets reported speculation, based on anonymous government sources, that she had sold the last remnant of her ImClone stock on December 27, 2001, because her buddy, ImClone founder and CEO Sam Waksal, had told her that the Food and Drug Administration was about to reject an application for Erbitux, the company's highly touted cancer drug. The news reports also suggested that she had lied to the feds about Waksal's tip. But as the government now tacitly admits, neither of these allegations is true. That fact helps explain why the feds waited until June 2003 to bring charges: They had trouble finding anything to pin on Stewart.

The most serious criminal charge against her is not perjury or insider trading but securities fraud, based on the fact that she denied to the press, personally and through her lawyers, that she had engaged in insider trading. This was done, the feds say, not for the purpose of clearing her name, but only to prop up the stock price of her own publicly traded company, Martha Stewart Living Omnimedia. In other words, her crime is claiming to be innocent of a crime with which she was never charged.

As for the SEC's civil case, it hinges on an elastic understanding of insider trading, an offense Congress has never defined. The justification for the ban on insider trading, which makes little economic or legal sense, is just as murky as the behavior covered by it. Given the difficulty of figuring out exactly what constitutes insider trading (let alone why it's illegal), it is entirely possible that Stewart and her lawyers weren't sure whether she had broken the rules. In any event, under existing case law, it's clear that she didn't.

What Did She Know?

All Stewart knew when she ordered the sale of her 3,928 ImClone shares was that, according to her broker, the price of the company's stock had dropped from $64 at opening to $58 under heavy selling (7.7 million shares vs. the daily average of 1.1 million), and that his clients, Sam Waksal, and his daughter, Aliza, also had been selling. The SEC charged Stewart with insider trading because her broker told her the Waksals were selling, and the Department of Justice indicted her because she denied any culpability for insider trading.

Stewart was not the only investor connected to Waksal who joined the selling mob that day. She just received the most scrutiny. There was Martha's friend, Mariana Pasternak, who was on vacation with her when all this happened and whose ex-husband coincidentally sold more than 10,000 shares of ImClone that day. He wasn't charged with insider trading. Then there were the two unnamed friends of Waksal described by The New York Times: One sold $600,000 of ImClone stock on December 27, while another sold ImClone stock worth $30 million on December 27 and 28. Phone records show the sales took place "almost immediately" after contact between Waksal and the sellers. The government has refused to identify these anonymous investors and so far has declined to indict or sue them for insider trading.

Finally, there were Waksal's daughter, Aliza Waksal, a 29-year-old actress, and his octogenarian father, Jack Waksal. On December 27, Sam Waksal telephoned Aliza at the ski resort where she was vacationing and told her to sell all her ImClone shares (40,000 for $2.5 million). Before government investigators questioned Aliza, Waksal told her to conceal their conversations, using the cover story that she needed the proceeds to buy an apartment (which she didn't do until seven months later, spending $1.4 million to buy it from her daddy's development company). After talking to his son, Jack Waksal sold more than 136,000 shares on December 27 and 28 for more than $8 million. Jack Waksal also lied to the government, denying that he spoke to Sam Waksal prior to selling his ImClone stock. This was before prosecutors produced phone records showing that calls between them all had taken place before the trades were made. Neither Aliza Waksal nor her grandfather has been indicted or sued for insider trading or lying to the government.

The disparate treatment of Stewart and the other ImClone investors is especially troubling when you consider the government's definition of insider trading and rationale for prohibiting it. The government says insider trading occurs when someone buys or sells stock based on material, nonpublic information received from an insider. While Aliza Waksal spoke directly with her father prior to her sale, Stewart knew the Waksals were selling (arguably not material information, since insider sales are not always reliable predictors of a stock's movements) only because her broker (not a true corporate insider) told her so. Although Martha tried to speak to Waksal, she was unable to get hold of him before selling her stock.

Likewise, the government says insider trading is illegal because it does "economic harm" to the market. Therefore the size of the trade must matter. Aliza Waksal avoided $630,295 in losses and her grandfather three times that, while Stewart saved only $45,000. By this measure, Aliza Waksal's sale and her grandfather's did more "economic harm."

Suppose we stretch the definition of insider trading beyond economic harm caused by the use of material, nonpublic information, and instead use the SEC's long discredited "fairness" or "level playing field" theory. According to this view, it was not fair that Martha knew the Waksals were selling before the rest of the market knew. That standard still wouldn't explain why Aliza Waksal's trade was legitimate. Stewart's excuse was that she had already told her broker she wanted to sell when the ImClone share price fell below $60, which is what happened on December 27. Aliza Waksal's excuse was that although she's an adult, she is still financially dependent on her father, so she had no choice but to do as he instructed, which included selling the stock and lying to government investigators. Which explanation sounds more plausible?

When Waksal worked out a settlement with the government, it reworded the language regarding Aliza Waksal's sale. The settlement now says Waksal "directed Aliza to sell all of her ImClone shares," and Waksal "benefited because he was her entire means of financial support." Thus Sam Waksal is guilty of his adult daughter's insider trading because if she hadn't sold, he would have ended up paying more of her bills. She didn't benefit from the trade, according to the government; he did.

Birth of a Crime

As the treatment of Aliza Waksal and other lucky ImClone investors suggests, the prosecution of insider trading has nothing to do with supposed economic harm or even "unfair" tips, let alone lying to the government. Instead it's about bringing down the biggest and best-known targets to make it look like the laws against insider trading are accomplishing something.

Such publicity stunts are necessary because the insider trading ban is bad economics and worse law. Although there's a broad consensus, among Wall Street executives as well as Washington policy makers, that trading on inside information is harmful to investors and the market, this consensus has never been supported by solid evidence. Yet during the last four decades the SEC has waged a campaign to maintain and expand the scope of the insider trading ban, perpetuating the myth that scores of insiders are secretly enriching themselves at the expense of the investing public.