The Wall Street Journal (WSJ) published a herd of articles on November 27-28, 2012 relating to insiders trading via their 10b5-1 plans, variously titled: “Executives' Good Luck in Trading Own Stock”,“Investors Call for More Disclosure of Executive Trades”, “Timing Is Everything for Insider Sales”, and: “Reining in Executives’ ‘Luck’ in Trading Their Company’s Stock”. They are worthwhile reads, and cast a welcome bit of sunlight on a shortcoming in insider trading regulations.
As I’ve written in the past in my InsiderInsights Newsletter, and also discussed with several Dow Jones reporters when contacted as a source for insider trading articles, I’ve long believed it is just a matter of time before an insider plays too fast and loose with the extra legal protection afforded by 10b5-1 plans.
These so-called “automatic trading” plans allow insiders to set up a schedule for future trades in their own companies’ shares. These future trades may even occur if the insider happens to have material, non-public information at the time of the future trade. As long as the insider doesn’t know that will be the case when the plan is set up, the trade will be considered legal.
But 10b5-1 plans can be amended and halted at will, and given human nature, it is inevitable that some sort of back-dated change will be (or, more likely, has been) made to a plan as an insider realizes an upcoming event is about to make one of their upcoming pre-planned trades (or lack of a trade) financially unbeneficial.
I applaud the WSJ for bringing attention to the potential for mischief in 10b5-1 plans via the lengthy study they discuss in the lead article listed above. I also wholeheartedly agree with the crux of the regulatory solution offered in the last WSJ piece listed. The Securities Exchange Commission (SEC) should absolutely require the prompt disclosure of the adoption, cancellation, and change of a Rule 10b5-1 plan. I’d even go a step further by requiring disclosure of the actual details of each plan.
Still, the WSJ constantly using the results of their study to impugn present insider trading rules as being “so flawed” lacks appreciation for the original focus of insider trading laws, and how far these laws have (and continue to) evolve.
Even more surprising is the constant shock and dubious conclusions penned by the articles’ authors regarding the “good luck” they find insiders have when trading their own companies’ shares. This focus misses the conclusion that seems so obviously to follow from all their research: that investors can and should follow the insider trading activity filed at the SEC to make money themselves.
As I discovered over a decade ago when researching my first book on the topic of insider trading, even as the recession-era U.S. Congress was legislating new law to combat illegal insider trading as part of Section 16 of the Securities Exchange Act of 1934 (the 1934 Act), it realized that the disclosure it was mandating wouldn't completely stop the practice. The main focus was on disclosure.
Government records from that time state: "Because it is difficult to draw a clear line between truly inside information and information generally known by better-informed investors, the most potent weapon against abuse of inside information is full and prompt publicity".
That conclusion no-doubt was greatly influenced by the thinking of Lewis Brandeis, a Supreme Court Justice whose view on combating securities fraud was famously summed up by his saying: "sunshine is the best disinfectant."
Continuing the discussion in legislative records of the day: "The (Congressional) Committee is aware that these requirements are not air-tight and the unscrupulous insider may still, within the law, use inside information for his own advantage. It is hoped, however, that the publicity features of the bill will tend to bring these practices into disrepute and encourage voluntary maintenance of proper fiduciary standards by those in control of large corporate enterprises whose securities are registered on the public exchanges."
The emphasis on "within the law" is mine, but the wording shows that lawmakers were being realistic with their expectations of what the new regulations would accomplish. It doesn't imply that insiders are allowed to use material, non-public information. It does realize, however, that, since it is so hard to prove, insiders will get away with using it some times.
The most remarkably foresighted aspect of the1934 Act was that it did not actually include a specific definition of what illegal insider trading is. It still doesn’t. If it did, insiders would develop specific legal loopholes to neuter the intent of the law. (Today’s legislators may want to keep this in mind when fielding complaints about the lack of specificity in the yet-to-be-implemented Volcker Rule.)
Instead, the 1934 Act identified a grey area of illegality that insiders could tread within at their own risk. Push too far into the shadier corners, and a legal case may well result. Over the past 80 years, it is the results of case law that have represented the moveable boundaries of what will get an insider (or any other investor for that matter) into legal trouble.
The opportunity for misconduct specific to 10b5-1 transactions will undoubtedly add to the long history of case law surrounding insider trading. Considering the findings of the WSJ reports, perhaps those cases will occur sooner rather than later. I would certainly look forward to getting my eyes on the details of insiders’ 10b5-1 plans if the evolution of insider trading rules goes in that hoped-for direction. And I have no doubt that any rule change prompted by any current 10b5-1 shenanigans will hardly be the last. For while most insiders act scrupulously when trading their own companies’ shares, some don’t. And the investing public is right to agitate that any holes in insider trading law be plugged when insiders sneak through them.
So thank you WSJ for highlighting this issue. Yet the real conclusion of the WSJ’s numerous stories last week is frustratingly not highlighted by the reporters--even as they offer all the evidence for it. That conclusion: ride this gift horse instead of kicking it—just as the 1934 Act expected investors to do.
The four WSJ articles contain statements like: “executives do suspiciously well on their trades in the aggregate”; "We've found a lot of evidence that these insiders do statistically much better than we'd expect", and; “The Journal report contains some pretty striking examples of trades that were either remarkable coincidences or exquisitely timed by some executives”.
But the not-too-subtle dig at insiders’ ethics those statements take is self-blunted by this full-blown paragraph in one of the articles: “Executives will almost certainly, in the aggregate, be able to time their trades better than the average investor, even if they do not ever trade on inside information. The simple fact is that executives understand the business better than any member of the general public or analyst ever could and even if they do not have material nonpublic information, their trades will generally be more profitable”.
Now, if these bullish conclusions on insiders’ trading ability were simply those of journalists, they wouldn’t hold much water. But these conclusions are also absolutely backed by academic research, and—more importantly—by the experiences of the multitude of professionals who actively use the data in their investment process.
With all this powerful evidence on their pages, however, the articles are still more interested in seeing a conspiracy rather than an opportunity. That’s not only strange coming from the paper of record for investors. It’s also odd considering that the same Form 4 data the WSJ uses to impugn insiders’ ethics is easily accessible to any individual on the Internet these days, and could absolutely have been used to make money if one had put in the time to analyze it.
In fact, the speed and ease of access to the disclosures of insiders’ trades is vastly superior to that which the 1934 Act originally envisioned and mandated. The Internet has supplied the ease, and the speed stems from the shortened filing deadline for the Form 4s insiders use to report their trades. Thanks to Section 403 of the otherwise much malignedSarbanes-Oxley Act of 2002, the deadline was reduced to just two business days. The deadline for the first 68 years of the 1934 Act was up to 40 days.
So contrary to the WSJ’s implies, insider trading regulations based on disclosure are working better than ever at their original intent of leveling the playing field between insiders and individuals. The field will never be perfectly level, as that paragraph from the WSJ quoted above recognizes. But that was never the expectation of the 1934 Act. What was expected was that individuals who were so turned off by the outrageous practices of many insiders leading up to the 1929 stock market crash would regain gain confidence in the markets, and try their luck again in a game that seemed rigged against them.
Proof of just how much more the playing field has been leveled is supplied by the WSJ itself, most notably in their reviews of insider transactions at Micrel (MCRL), VeriFone Systems (PAY), and Hess (HES). But even their lead example of eyebrow-raising trades at Body Central (BODY) doesn’t get my blood boiling. And let me assure you: just because I don’t see the same impropriety as the WSJ does in its examples, I am in no way advocating that insiders should be able to trade on material, nonpublic information. (The great Henry Manne of the George Mason University School of Law does hold this view. I firmly disagree with him, although the WSJ itself has published many articles by Mr. Manne on the subject over the years. But that great debate is for another article.)
Let’s give the WSJ’s Body Central example its due, though. There does appear to be a notable acceleration in the selling by the company’s Chief Marketing Officer, Beth Angelo, just before this stock’s fall last May. Her 10b5-1 program was put in place in June 2011 after the company had been public for eight months. Fairly steady sales had her selling a net of 42,776 shares of BODY (that’s sales net of option exercises) in the first quarter of this year. Yet just 33 days in to the third quarter—just before bad news cratered the stock—she had already sold a net of 145,879 shares. The majority of these sales came a day or three before the stock plunged.
I agree that it is seems unlikely that there was a specific trigger in Ms. Angelo’s nine-month old 10b5-1 program to explain those larger-than-trend May sales, and that regulators appear to have a basis for inquiry. There seems to me to be less obviously deviant acceleration in the 10b5-1 sales of Body’ s founder, Jerrold Rosenbaum, but if an inquiry is started for Ms. Angelo, the truth would presumably out for Mr. Rosenbaum as well. And if this pair is found to have tinkered with their 10b5-1 plans to make their sales in early May, they should face the consequences.
To be clear, though: if not for those May trades, there would have been nothing remarkable or remotely iffy about the execution of these two insiders’ 10b5-1 plans. Insiders selling into strength—particularly selling via 10b5-1 plans and via options exercises—are the most common insider activity I see on a daily basis. Usually it is nothing but noise, and not worthy of any further research to see if a shorting possibility exists.
That said, anyone using insider data in their investment process should not have been caught in this stock’s collapse. The insider selling would have long ago disqualified BODY from being considered as a long. Adding to the weight of the “avoid” signal would be the notable percentage decline in subsequent holdings of these insiders after their sales.
So the example the WSJ led their main 10b5-1 article with does have both the whiff of impropriety (which they are so intent on implying), and actionable insider information that investors could have used to, at the very least, avoid the BODY blow—which I think is the real takeaway of their research.
But I’m more than a little concerned that a good many of the other 1,418 examples of “good luck” by insiders the WSJ refers too ominously would not prove very whiffy on closer inspection. Even the number itself doesn’t seem so statistically significant given the population of 20,237 trades their study analyzed.
The stated fact that “1,418 executives recorded average stock gains of 10% (or avoided 10% losses) within a week after their trades” was “close to double the 786 who saw the stock they traded move against them that much” also doesn’t represent a smoking gun of impropriety as far as I’m concerned. That stat just mirrors our experience at InsiderInsights and Insider Asset Management: that using insider data in the investment process leads to more winners than losers—and, to add to the out performance—winners that tend to go up more than the lesser number of losers cost us. That’s why we use the data, and that’s why we have a business.
Zinn’ed up charges
If the WSJ’s selection of Raymond Zinn, CEO of Micrel (MCRL), is any indication of the types of smoking guns represented in the remaining 1,400 or so cases of dubious trades they found, then I like what insiders are smoking.
I agree that the appearance of what ended up being a mere month-long 10b5-1 program in July 2007 looks unusually well timed before the subsequent fall of MCRL that month. Agreed. Point taken. SEC: please mandate that the existence and details of 10b5-1 programs be disclosed.
But where the WSJ is again prompted to get the pitchforks and torches to taunt this monster, I see a monster of a good indicator for the future price movements of MCRL.
Further back in the database at www.InsiderInsights.com one can see that Mr. Zinn’s “lucky” trades began with a couple 10b5-1 sales in January of 2004 and timely buys at the end of 2005. Both these two trades and the one demonized by the WSJ in July 2007, however, were very small in comparison to Mr. Zinn’s overall holdings. Even the (admittedly) too-well timed 2007 10b5-1 sales represented just 1.7% of his holdings.
Agreed, the monetary amount of what Mr. Zinn may have garnered unfairly in 2007 doesn’t argue against any principal if he in fact rushed that 2007 10b5-1 plan into existence knowing that soon-to-be-release earnings were going to be bad. But it seems to me that Mr. Zinn’s actions were much more valuable to any investors who acted on the very publicly available Form 4 information he furnished, then savings meaningful net worth for Mr. Zinn. Remember, his remaining holdings just shy of 11 million shares fell along with everyone else’s back then.
And to find wrongdoing in Mr. Zinn’s subsequent buys is just gratuitous. Yes, he bought MCRL well in early 2008. But the reporters neglect to point out that the stock fell back to his buy point by the end of 2008—where he bought yet again…which yet again provided extremely valuable information to any investor wondering if the stock had bottomed.
He also bought both high and low in 2010, and has been a slow-but-steady accumulator over the past year-and-a-half—even though MCRL has basically moved sideways. So he bought low, high, and during a plateau. There’s just nothing in his buys over the last five years that deserved to be impugned. But there is a solid argument that Mr. Zinn’s trades could have helped investors make money if they had paid attention to his Form 4s, just like the 1934 Act intended.
I’d argue similarly for the trades of Douglas Bergeron, CEO of VeriFone Systems (PAY), being profitably predictive instead of profligately prison worthy. Mr. Bergeron had a long-running 10b5-1 program leading up to the financial crisis. Like many smart insiders at that time, he seemed to think longer-term and cancelled his selling program. Presumably, he didn’t want to sell an asset at prices he thought were brought low by factors that he thought would pass.
After filing numerous sales per month during 2007, it became obvious by late December of that year that he had cancelled his 10b5-1 program after his November 25, 2007 sale. It would have been nice to know right away that it was cancelled, but InsiderInsights.com (like many other insider data providers) demarcates 10b5-1 trades, which makes it easy to see in a short period of time when a program ends. You just have to pay attention instead of expecting to be spoon fed the information.
Mr. Bergeron’s lack of 10b5-1 sales in December 2007 was a good and actionable bit of intelligence that could have helped anyone avoid the real pain in PAY (and most other stocks for that matter) in 2008. But Mr. Bergeron wasn’t done helping investors yet. His next open-market transaction came in early March 2009, when he increased his total holdings by a very significant 19.5% with a series of open-market purchases. He also bought PAY again later in 2009 at higher prices as both his stock—and the market—continued to recover.
After the year plus long periods of time between these two very useful sell then buy signals, Mr. Bergeron then obliged investors again over a year later by selling a very significant amount of his much appreciated holdings at the end of March 2011. These are the trades the WSJ finds issue with, and as the paper points out, just over a month later PAY headed south again.
But as dubious as Mr. Bergeron’s single set of March 2011 10b5-1 sales may have looked to investors in mid June 2011 after PAY had slid 44% from its late April highs, they were really a fairly unremarkable part of a larger pattern by this insider. The fact is that this obviously smart insider gave an obviously clear signal of his feelings on his stock, and investors had more than enough time to act on this signals themselves given his disclosures at the SEC.
Mr. Bergeron’s March 2011 sales don’t make me bristle with indignation, they make me want to pay attention to his future trades. (For what it’s worth, Mr. Bergeron’s latest trade of VeriFone stock was a 10b5-1 purchase of $5 million worth of PAY on July 6, 2012 for $32.50 a share). Again, viewing insiders’ disclosures is just what the 1934 Act envisioned even before the filing deadline for Form 4s was dramatically shortened from up to 40 days down to two business days, and before the authors of the Act could have ever imagined a distribution medium like the Internet, which made their disclosure mandates immensely more efficient.
As a final observation from me, the WSJ article’s attempt to demonize the 10b5-1 program of John Hess of Hess Corp. (HES), just seems backwards. They looked at the fact he stopped a 10b5-1 program in March of 2011, and made hay when their readers could have used the data to make—or, at least save—money.
As it turns out, Hess (HES) has actually been on InsiderInsights’ Recommend List since July 20, 2012, and first came to our attention via a troika of significant insider buys in April and May—including one by Chairman Hess. His reversal of opinion from having a 10b5-1 selling plan to making a large purchase added strength to the insider signal. Even so, we chose not to follow the Hess buyers into their stock immediately because we (correctly, as it turns out) believed they were early.
To repeat, using the data provided on Form 4s was part and parcel of why the U.S. Congress mandated hem in the first place. As I relayed up front, Congress of 80 years ago had no delusions that the 1934 Act would remove insiders’ unfair advantage. By mandating disclosure, they intended for regular investors to be able to see what insiders do, and act on the disclosure forms if they chose. And if (or, more when, when) an insider appears to do something unethical, the Form 4 itself is the perfect evidence in any case brought against them.
So while any regulatory system has shortcomings, my review of the WSJ’s examples made me conclude that the present regulatory paradigm is actually working pretty well after all these decades. Can it be improved? Absolutely. Will it? In time, no doubt. And if the WSJ articles fan the flames of 10b5-1 detail disclosure within the SEC, theirs will have been a very worthy bit of journalism.
I just can’t understand, however, how all the different WSJ authors involved in this large editorial initiative missed the obvious opportunity to educate their own investment-heavy readers about how to make money themselves from the Form 4 data stream they took so much effort to prove so profitable.
So allow me to fill that gap just a bit.
The WSJ has a law professor quoted as saying that 10b5-1 plans are “a huge gift to insiders”. But all the insider disclosure documents filed at the SEC are at least equally a gift to investors. Being a gift from government, however, they take real work to appreciate.
Any investor expecting to make easy money buying a stock just because an insider bought $1 million worth deserves the underperformance they will likely get. A growth investor would never expect to make easy money automatically investing in every stock that posted 100% year-over-year EPS growth. Was that growth $1 to $2, or 1 penny to 2 pennies. And what about the quality of those headline earnings? Analysis of the footnotes and income statement are needed. That headline growth number may grab your attention, but only as a trigger for further research--not as indicating a no-brainer buy.
It’s beyond me why so many investors (professionals to boot) expect using insider data as a first screen to take any less work, and why others think the numerous free articles literally littering the Internet under headlines such as “5 Stocks Insiders Love!” are all they need to reference to consider themselves as following insiders.
Investors have to look beyond the headline dollar value of an insider’s trade and view its relative size to that specific insider. What is that insider’s track record? When and how did they last trade their stock? What is the price pattern of the stock the insider is buying? Does the insider have a record of transactions at other firms? Are there other insiders trading the same stock? If so, repeat the process and aggregate the behavioral conclusions drawn by all the executives. And, by the way, Form 4s can have footnotes, just like financial statements.
It takes time, and/or some money to get the best organized and most timely insider data available. There is no free lunch in investment analysis. Never has been, and never will be. And also don’t forget that using insider data should only be one of many inputs when it comes to the final decision of if and when to pull the trigger on a security. Even for this “insider guy”, insider data is only my first screen to determine where I focus my subsequent fundamental and technical analysis.
As first screens go, however, it’s the best one I know of. And it generates stock ideas across the spectrum of investment styles and risk/reward tolerances. It’s just so unfortunate that investors are exposed alternately to free insider stories that dress up simple insider screens as real research, and articles such as those in last week’s WSJ that, though intriguing, don’t appreciate insider data for the actionable, stock-specific behavioral finance data stream it is.
Mr. Moreland began working with insider data in the early 1990s while an analyst for the old Individual Investor magazine. A fundamental analyst with an MBA in finance and studying for Level III of the CFA, Mr. Moreland long ago identified insider data as an excellent first screen to determine where to focus his research efforts.