So What Is Insider Trading?

Have you heard about the railroad workers charged with insider trading?

Late last month, the Securities and Exchange Commission brought an unusual and colorful insider-trading case: It accused two employees who worked in the rail yard of Florida East Coast Industries and their relatives of making more than $1 million by trading on inside information about the takeover of the company.

How did these employees — a mechanical engineer and a trainman — know their company was on the block?

Well, they were very observant.

They noticed “there were an unusual number of daytime tours” of the rail yard, the S.E.C. said in its complaint, with “people dressed in business attire.”

The case is raising eyebrows — and some important questions — about what constitutes insider trading at a time when the government is taking a tougher line against Wall Street and white-collar crime.

The U.S. Securities and Exchange Commission seal hangs on the facade of its building in Washington, DC.
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The U.S. Securities and Exchange Commission seal hangs on the facade of its building in Washington, DC.

And it comes amid a spate of prominent insider trading cases, like a controversial one against Mark Cuban, the billionaire owner of the Dallas Mavericks, which was dismissed and then recently reinstated.

That case may just be a preview of what is to come: “Illegal insider trading is rampant and may even be on the rise,” Preet Bharara, the United States attorney in Manhattan, said in a speech last week. And it is no longer just about prosecuting Gordon Gekkos. “The people cheating the system include bad actors not only at Wall Street firms, but also at Main Street companies,” Mr. Bharara said.

Many of the recent cases have one thing in common: an increasingly broad definition of what insider trading actually means.

Joel M. Cohen, a partner at the law firm Gibson, Dunn & Crutcher, recently wrote that there had been a “shift in insider-trading jurisprudence away from its roots in deterring and punishing those who abuse special relationships at the expense of shareholders and into a murkier area where the S.E.C. is policing general financial unfairness that has traditionally been considered beyond its authority to regulate.”

In other words, the S.E.C. is no longer just making sure that employees are not abusing their position and breaching their fiduciary duty; it is focused on making sure the markets “feel” fair.

So, given the ever expanding definition of insider trading, what exactly does inside information mean? It may come as a surprise to know that there is no actual language that defines the term in the legal books. The S.E.C. relies on Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, purposely vague provisions that make the purchase or sale of any security through “manipulative and deceptive devices” illegal. It is also a crime to engage “in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.”

If all of this sounds confusing, that’s because it is. And that’s why some argue that the S.E.C. should draw some bright lines around what insider trading is — and what it is not. In an age when information zips across the planet and sophisticated investors piece it all together, the public and investors deserve clear rules. A safe maxim might be: “If you have to ask if it’s right or wrong, it’s probably wrong.”

So back to the case of the railroad workers. Gary Griffiths and Cliff Steffes, who worked in the Bowden Rail Yard in Jacksonville, Fla., clearly had a hunch something was up even though they were never brought into the loop through official channels. The men, and members of their family, bet that a deal was in the works by buying tens of thousands of dollars of call options on the rail company’s shares. When Fortress Investment Groupacquired the company in May 2007, the men and their families made more than $1 million.

The S.E.C. claims that Mr. Griffiths and Mr. Steffes acted on more than a hunch. The commission says that “shortly after the tours began, a number of F.E.C.R.’s rail yard employees began expressing concerns that F.E.C.R. was being sold, and that their jobs could be affected by any such sale.”

The S.E.C. also claims that Mr. Griffiths was asked by the company’s chief financial officer for a “list of all of the locomotives, freight cars, trailers and containers owned by F.E.C.R., along with their corresponding valuations, which she had never requested before.” Florida East Coast Railway, or F.E.C.R., was a wholly owned subsidiary of Florida East Coast Industries.

Is all of that material information? Clearly, it is all nonpublic. But without being told directly that a deal was in the works, did the men actually have inside information? What would have happened if there had been no deal? Or if the company was later sold for a price below its prevailing stock market value?

In most instances, “if you overhear something and divine from the conversation that Party A is about to buy Party B, and you buy Party B, that’s fine. You can do that,” Mr. Cohen said in an interview.

In the case of Mr. Griffiths and Mr. Steffes, things get a bit more complicated. A lawyer for Mr. Griffiths said his client had done nothing wrong. Mr. Steffes’s lawyer could not be reached. But they both signed the company’s code of conduct, which explicitly said they could not trade on or disseminate material nonpublic information. So it is possible they breached their fiduciary duty. And they clearly were sophisticated enough to buy options contracts to carry out their plan. (One of the family members settled with the S.E.C., so it is always possible more damning evidence will emerge.)

Or, of course, maybe they were just observant?