Scenario: the CEO sells a bundle of shares to pay for his safari vacation. By the time the paperwork reaches the public eye he is hunting angry beasts on the dark continent – and good thing, too, considering all the angry beasts back home who would like to have his head as a trophy. Conclusion: insider buying or selling is heavily scrutinized.
Financial media and investors love to point the finger at insider trades, particularly those that precede rises in stock prices and reap tremendous profits. Why do we love these stories? Because they’re packed with real-life drama: deceit, intrigue, greed and – if the SEC gets involved – justice!
Now, thanks to a few specialized web sites, there is a growing group of investors who religiously monitor insider trading. They believe the inside trader (any corporate executive or investor who owns at least 10 percent of a company’s registered shares) is like a blackjack dealer whose deck is rigged; and they can beat him at his own game by watching his movements closely. Of course any time he makes a move, they dial up the IR office to find out why. Some IROs note a direct correlation between the volume of inside shares traded and the volume of calls they receive.
The media love to use insider trading as an indicator of dodgy, if not criminal, behavior. Although the handcuffed Charlie Sheen in the movie Wall Street is a great Hollywood snapshot, it belies the fact that most insider trades are completely legal.
Ethics
While many outsiders remain skeptical, First Call’s director of insider research Bob Gabele believes legal issues are best left to securities regulators. ‘I have been doing this for a long time and there has always been a common effort that I see mounted against the insiders. I often get the question, Is insider trading legal or not? Well, you know what, I don’t even think it’s important. What is important is that investors can see the information and assess it.’ Gabele believes analysts should only use insider data as a barometer for stock performance. ‘I don’t think it’s for us to pass judgment on whether an individual’s actions are legal or not.’
It is becoming more difficult to get away with illegal insider trading. For one, there is more public scrutiny; trading is more closely watched, followed and critiqued than ever before. In addition, regulators are cracking down. The SEC hopes Regulation FD, which includes the first set of rules to specifically address insider trading, will help keep illegal trades in check.
According to Karl Groskaufmanis, a partner of Fried Frank Harris Shriver & Jacobson, FD hurdles certain legal obstacles. ‘Historically, there had been an effort by the SEC to regulate selective disclosure as illegal tipping under the law of insider trading, and it just didn’t work that well. So instead of trying to regulate selective disclosure under the insider trading law, they’ve crafted a separate rule apart from that rubric.’ Now that the burden of proof is lighter and illegal traders have fewer hiding places, there are stronger deterrents against illegal trading.
New opportunities
Companies strictly regulate how and when their executives may trade, and with good reason. They want to do all they can to avoid insider trading charges. For instance, many companies only allow their executives to trade during windows after the release of quarterly financial results. Even then, trading is often forbidden if any major news is on the horizon.
The SEC hopes FD will expedite legal insider transactions by allowing insiders to pre-arrange times for buying and selling stock. This lets them trade any time – even if they have market-moving news – so long as they schedule the transaction before they learn of the news. Furthermore, they can predict specific times in the year when they’ll need cash – for taxes, diversification opportunities or other personal expenses – and schedule those transactions without worrying about legal charges.
It also makes explaining their behavior easier. A word to the wise, though: corporate executives need to be aware that their behavior sends out strong messages. This should go without saying but sometimes it behooves the IR department to give them a reminder. Not only are their transactions being closely monitored, they are sometimes misinterpreted. Every move they make is a political move.
Analysis
Lon Gerber, insiderscores.com’s director of research, says there is a problem with following insider information too closely: ‘If you followed every trade out there, you would probably lose money.’ Gerber admits he often sees instances of stocks rising after insiders sell or falling after they buy.
For one thing, insider trading has a negative bias. ‘In the US we generally find that selling is a lot more common than buying,’ Gerber reckons, to a ratio of up to ten-to-one. This is due in part to executive compensation in the form of stock options. ‘Executives already have a lot of shares,’ he says, ‘especially in the technology
sectors.’ That means they rarely have to go into the open market to acquire shares. ‘Insider buying is somewhat straightforward in that if insiders are increasing their holdings there are probably good prospects for the company. If you want to be cynical, you could say they’re doing it as a PR play. But I would say they would do that on a token buy,’ says Gerber. ‘You wouldn’t see a large dollar commitment there.’
Gerber says things can get a bit more confusing on the sell side where there may be a number of different motives. ‘It could be liquidity – they may need money to buy a house. It could be diversification – many insiders have a lot of wealth tied to their own company and if the company has done well, they just want to take some profits.’
Of course there are many predictable instances when insiders cash out. Expiration of an IPO lock-up period is one. Another is when stock prices reach cyclical high points. But these transactions are easy to explain.
Difficulty arises when insiders dump their shares after stock prices slump. Many analysts see this as a demonstration of doubt that the stock will go back up. And in any slump there are usually other problems which help corroborate this view. Investors can interpret insider trading as a red flag, especially if the company shows other problems, and begin a general sell-off.
Bob Gabele says insider trading alone shouldn’t move the market, but it does. ‘Insiders’ actions are only a piece of a puzzle. Yes, it’s an important piece, but I think those who react to that piece are overreacting. It’s very important to combine it with the big picture. That’s what the insider game is all about.’
One of the things Gabele monitors is whether the sell-off is an isolated incident or part of a larger trend. For instance, is this seller alone or are others following suit? Also, what is the insider’s track record? Information like this is important in building a character profile and, more importantly, in determining how relevant any individual trade really is.
Fielding calls
VA Linux went public a little over a year ago and its IRO, Patrick Fossenier, has had to field a lot of calls about insider trading. Those calls began when the IPO lock-up period ended and several founding investors cashed out. He says the most effective approach is to simply put the situation in context. ‘I tend to distinguish between people who have an ongoing interest in the company, such as our executives, and people who have more of a pure investment background. Most of the trading happened as a result of our venture capital firm distributing to their shareholders. The people who received those shares didn’t have an emotional attachment to our company.’ When Fossenier points this out, he says, the trades seem much less significant.
When asked why executives are selling their shares, he replies with a ‘drop-in-the-bucket’ explanation. In summary, the shares being sold represent only a tiny portion of what the executives own. The motivation is personal liquidity. ‘If investors can understand that the executives aren’t selling any significant shares and that most of the sales are not by executives, it gives them greater comfort. I think the biggest thing people worry about when they see insider sales is that management is losing confidence in the company. I don’t know if that would be a correct assumption even if they were selling large amounts. But the fact that they aren’t selling large amounts gives investors comfort.’
Fossenier recently began receiving calls about an insider sale that was more difficult to explain. The insider in question was not a company executive nor a venture firm, but rather another company, Intel, which unloaded 160,000 shares (a significant amount but, again, just a small portion of its ownership) and the transaction jumped onto many people’s radar screens. ‘Because they’re not one of our executives and because I have no control over what Intel does or what it’ll do in the future, it’s a little more difficult to give comfort to somebody who is asking about it,’ Fossenier admits.
Thankfully, Intel had warned him of its intentions in advance and gave him permission to use its official explanation: ‘These sales represent profit-taking and in no way represent any change in the strategic relationship between our two companies.’ If callers needed more information, Fossenier says, they could call Intel themselves.
In the end, an IRO’s best defense is to educate insiders and outsiders alike. Executives need to be aware of how their actions are interpreted and shareholders need to know the full context of insider trades. Some come without warning, but if the IR department is left with the smoking gun it pays to have an alibi.
Error Warning
While InsiderTrader.com keeps high standards, Jonathan Moreland can only vouch for 95 percent of the data’s accuracy. Of course, this other 5 percent can cause IROs a lot of grief.
Inaccuracies come from a number of sources, he says. The most common errors occur when insiders file forms inaccurately. Also, third-party sources that gather official filings sometimes make mistakes in their transcriptions. ‘Form 4s and 144s are the most important pieces of insider data but they are not
mandated to be filed on Edgar. We certainly expect that they will be mandatory at some point but as of now only 5-10 percent are filed on Edgar.’ He predicts electronic filing will eliminate the need for third-party transcribers and reduce the number of errors.
However, there are other ways for misinformation to spread. ‘We get at least one call every week from people who say, I don’t plan on selling these shares, why do you have this 144? I ask them if they have recently opened a new account, and that’s often the explanation. IR people should warn their insiders that if they open up a new account with their restricted shares, some brokers automatically file a 144.’ (Form 144 allows for the sale of a restricted stock, but it isn’t a commitment to sell.)
Moreland says IROs should also keep corporate executives informed about the filing process and ‘really take them to task when they file incorrectly.’
Global Timeline
The country that aggregates the largest amount of insider trading data is the US. Insiderscores.com’s director of research, Lon Gerber, who tracks data from the US, UK, Hong Kong and Singapore, says this is due to the number of public companies in the US.
Ironically, volume does not necessarily make the most telling information. As Gerber points out, the US has a comparatively lenient filing requirement. ‘In the US, insiders are required to file form 4s by the 10th of the month following their trade, which means there can be up to a 40-day lag. In comparison, insiders in the UK file their transactions with their company and are required to do so within a week. Then the company has to file with the exchange within a day.’
Gerber says other countries are even stricter. In Hong Kong, for instance, insiders must file directly with the exchange within five days of their trade.
Form 144
‘This form must be filed as notice of the proposed sale of restricted securities or securities held by an affiliate of the issuer in reliance on Rule 144 when the amount to be sold during any three month period exceeds 500 shares or units or has an aggregate sales price in excess of $10,000.’ Source: US Securities & Exchange Commission
