Bob Robertson

Article Summary:

Defining and examining insider trading.

Understanding Insider Trading

"Insider trading" is a term most of us associate with something illegal. However, the term actually includes both legal and illegal conduct. The legal version is when corporate insiders buy and sell stock in their own companies. So, what is the illegal version? The question is trickier than it seems. In order to prosecute someone for insider trading, it must be proven that the defendant had a fiduciary duty to the company and/or intended to gain personally from buying or selling shares based upon their inside information.

What is an Insider?

1. To protect individual investors, the U.S. Congress in 1934 established the Securities Exchange Commission (SEC). It realized that corporate executives (insiders) had an unfair advantage when trading their own companies' shares. However, since shares were used as employee incentives and executive perks, they could not ban such transactions. Rather, they chose disclosure. When insiders do trade, they must tell the world about it. The "insider" was defined as an officer or director of a public company, or an individual or entity owning 10% or more of any class of a company's shares. The intent was to cover people who have the most knowledge of the inner workings and future prospects of a publicly traded company, those who routinely possess information that is unavailable to the general public.

2. The concept of "disclosure," as mandated by the 1934 legislation, requires insiders to report their stock holdings and trading activity on a series of forms, which become public record. A Form 144 (a planned sale) must be filed with the SEC prior to, or on the approximate date, of sale. The seller then actually has ninety days to complete the transaction. These filings only include estimates of dollar amounts. An insider may file a Form 144 and not actually complete the sale. When a sale is completed, the insider should have filed a Form 4, indicating the transaction was completed. The number of insiders in a publicly traded company can vary with specific-position definitions as well as the size of the company. Intel (INTC) with a market cap of $108B show 322 names on a recent roster. That means the SEC considers 322 employees with the company as insiders, who must provide full disclosure. A smaller company, VMSI with a market cap of $388M, shows 19 insider names.

3. The messages Insider selling provides is unclear. Is it bearish on the part of corporate insiders? Not necessarily. There many reasons a company insider would sell shares in the company. It may be prudent personal financial planning or simply personal reasons why insiders may wish to raise some cash. Insider buying is a different story. Here, employees "in the know" are putting new money into the stock of their corporations. There is only one rational reason for an insider to do this; they think the price will go up. This is not a foolproof indicator of where the company is going because insiders can be wrong. However, since insiders are closer to the business than are outside investors, we should at least give the information careful consideration.

4. If we see insiders buying a lot of stock on the open market, this might be worth investigating as a BUY signal... although insiders are often wrong. How about insider sales? We may get excited if we see that James Exec, CEO, has sold 10,000 shares and now owns 0. What the data does not tell us is the detail; whether James has no options left, is cashing out and is about to leave, or that he may have vested options on a million shares, and has just sold 1% of his stock to buy a new house. Quite a different reading on the report.

5. Contributing to the difficulty with stock sales by officers are the exercise of stock options. For example, one company stock option program works like this:

  • An officer receives as a benefit an option to buy, say, 100 shares of their company stock at $40 per share (the market value on the date of grant). The option has a ten-year life and vests in one year (vesting is the time required for an employee to exercise an option benefit). That means he can exercise the option after one year, or anytime during the following nine years.
  • Suppose that after one year, the stock price has increased to $50 and the officer exercises the option. He must pay the option exercise price of $4000 ($40 times 100 shares). At the current market price of $50, he gives the company 80 shares to cover the original option value. That means (excluding taxes), the officer will have a profit of $1000, or 20 shares at $50 per share.
  • Ten of these shares are restricted, meaning he must hold the shares for five years, and the remaining 10 are unrestricted. He is then given a reload option grant, at the current market price (an option to purchase 80 shares at $50 per share). When this transaction takes place, the company reports to the SEC that the officer has acquired 100 shares by exercising the original option, sold 80 shares to cover the exercise price of the original option, and received a reload option grant to purchase 80 shares.
  • The result of all this is the officer has increased his company stock ownership by 20 shares, but will have 20 fewer options.
6. We needn't follow the details of the preceding example, however it helps to understand why it can be so tough to track insider trading activity. Gathering data on insider trades is a difficult task. In general, to do a thorough job, it requires the last couple years of annual reports so we can read the fine print about executive compensation, special loans, extra covenants about non-sale of stock around IPO, merger, acquisitions, etc. However, there are many sources of insider information available. Even so, Insider data as published on the sites, its rarely 100% accurate. The primary source of error comes from those who fill out the Forms. Even attorneys who are paid well to do this paperwork for busy executives sometimes make mistakes. Common errors include a form being entered twice in the database, making the total transactions doubly large, or a transaction price entered incorrectly, or an options-related trade being presented as an open-market trade, etc., etc.

7. Now, what if we want to buy a stock based on insider information? We know that buying or selling stock with inside information is bad, following the tribulations of Martha Stewart. Trading on inside information is not legal since we are not supposed to know non-public information about public companies. However, it is legal to do the next best thing. Namely, see what the insiders who have inside information are doing with their own money. No skullduggery here since when corporate insiders buy or sell their stock they must disclose!

Bob is the co-founder of Pro-fundity, an Internet forum for beginning investor improvement, helping investors think and do for themselves. The difference between success and failure in the market is razor thin. That balance is tipped predominantly to those that learn as much about themselves as the market. Pro-fundity helps that happen! For more information, visit www.pro-fundity.com.

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