Despite insider trading being more commonly associated with illicit activities, legally, company insiders can buy and sell their stock. Legal insider trading activity is often tracked and analyzed by investors to gain insight into the internal sentiment of a company, and the lawful buying and selling decisions made by a company’s top executives can influence overall stock price and trading volume. As such, while insiders may find themselves in situations where they need to buy or sell their stock quickly, careful consideration should be made before buying or selling their company shares.
Basics on Insider Trading
Beginning with basics: an insider is defined as a director or officer of a corporation or a person directly or indirectly owning at least 10% of the stock. Unlawful insider trading refers to the buying or selling of a security on the basis of material, nonpublic information about that security or issuer for either profit or to prevent a loss. Information is considered material if there is a substantial likelihood of that information affecting a company’s stock price.
One of the more well-known instances of illegal insider trading is the case involving Martha Stewart. During her successful career as a homemaker mogul, Ms. Stewart was charged by the Securities and Exchange Commission (SEC) for selling all of her stock in a biotech company, ImClone, after receiving an unlawful tip from her broker. The tip was related to ImClone’s then CEO, Samuel Waskal, who unlawfully dumped his stock, through this broker, in advance of a public announcement that ImClone’s primary product had failed to receive FDA approval. This led to a drop in the company’s stock value. Mr. Waskal also tipped several of his friends and family members to sell their ImClone stock. He subsequently pled guilty to charges that included securities fraud and bank fraud. Ms. Stewart was charged, convicted, and imprisoned for obstruction of justice for lying during the investigation.
Legal Insider Trading
Insiders do, however, routinely and legally engage in buying and selling equity with proper disclosures to the SEC and to the public. SEC Form 4 is a form that is filed to legally disclose a trade by an insider of company stock within two days of a purchase or sale. SEC Form 5 is used for documenting earlier transactions that may not have been disclosed on Form 4 or qualified for deferred reporting. Postings of these form filings can be found on company websites, through the SEC, or through various other sites that track these transactions.
Beyond the information gleaned from these forms, and as part of their due diligence, investors may consider trends and patterns as important indicators when considering a trade. Variables such as timing, frequency of shares sold, stock price and volume, or whether the buying or selling is limited to one executive or others are all closely analyzed. As a general principle, executives buying stock can indicate positive prospects to investors; and conversely, executives selling their shares, particularly at a loss, can attach a negative outlook to a company.
Given the potential for incorrect interpretations, and to help make messaging around insider actions more transparent to investors and the Street, companies may consider establishing a 10b5-1 plan. With the adoption of SEC Rule 10b5-1, insiders can set up affirmative defenses to illegal insider trading. Under this rule, insider buying and selling are limited to predetermined shares at scheduled times, so that information possessed by insiders is less of an influence on their decision to trade. The structured nature of these plans not only mitigates insiders’ risk of exposure to violations of insider trading, but it also helps to limit misinterpretations by investors.
If you have questions on insider trading and the impact this activity may have on your investors and the broader financial community, contact us today.
Ji-Yon Yi, Associate