Equities: Heavy Insider Selling Could Spell Trouble

What did they know and when did they know it? That's the question being asked by government regulators about corporate insiders who sold massive amounts of stock. The answer can help distinguish between simple profit-taking and outright fraud. To be sure, CEOs and their ilk have every right to sell company stock from time to time. It's a big part of their compensation package, and they'd be foolish

What did they know and when did they know it? That's the question being asked by government regulators about corporate insiders who sold massive amounts of stock. The answer can help distinguish between simple profit-taking and outright fraud. To be sure, CEOs and their ilk have every right to sell company stock from time to time. It's a big part of their compensation package, and they'd be foolish to keep all their wealth tied up in one investment. But recently, many have come to suspect that insiders have been dumping stock before telling investors that their business was in trouble — and that's illegal.

You don't even have to be an insider to illegally profit. Consider Martha Stewart's woes. Although she wasn't an “insider” at ImClone Systems, the domestic diva was close to company insiders, namely CEO Sam Waksal and her Merrill Lynch broker, Peter Bacanovic, who once worked there. Did they share material information regarding an imminent dose of bad news from the FDA? Waksal could end up in jail.

Possible wrongdoing at Apple Computer has also caught the eye — and ire — of regulators. Twice within the last two years, Apple insiders sold millions of dollars in company stock, just weeks before warnings of disappointing financial results. “The timing of those sales is certainly curious,” says Jonathan Moreland, director of research of InsiderInsights.com, an insider tracking firm.

In Olden Times

Today's questionable insider trades differ from those in the 1980s. Back then, Ivan Boesky and others profited from trading stocks that would soon be the subjects of M&A transactions. But in the last few years, “There appears to be a systemic connection between artificially inflating financial statements and massive stock sales,” says Rick Roberts, an attorney who was with the SEC Miami office in the 1970s and 1980s.

Small stock sales are acceptable. It's more troubling to see an insider sell most of his holdings, even as he is speaking optimistically about his company's prospects. “Obviously they feel their investments are better placed elsewhere, rather than in their own companies' stock,” notes David Coleman, who follows insider transactions for Vickers Stock Research.

Coleman advises investors to monitor insider transactions closely before buying a stock. And if a stock you own is the subject of heavy selling by insiders, “You should reconsider why you bought it,” he adds.

Insider transactions are listed on a variety of Web sites, including Yahoo!, Multex Investor, as well as Vickers and InsiderInsights. Many provide detailed histories so you can see if heavy selling (or buying) has foreshadowed a fall (or rise) in the stock price.

Horse-and-Buggy Rule

Surprisingly, insiders don't have to tell anyone they've sold (or bought) stock until the 10th day of the following month. That gives them weeks to sell stock and then dole out bad news. “That deadline may have been appropriate back in the 1930s, but in the age of instant financial news, this important stream of information has fallen behind,” says Moreland.

Congress is looking to close the loop by compelling executives to inform investors of a transaction within two days. Fines are expected to be much higher, and some insiders may start looking at jail time.

Is legitimate selling by insiders automatically a bad indicator for a stock? Not necessarily. These folks get annual stock option grants, so it's only logical that selling typically outweighs buying by a 2.5-to-1 ratio.

Not a Good Sign

That ratio recently surged to 4.1 — a 16-year high — which analysts think signals more bad news for the stock market. “The direction of that ratio has an amazing track record for predicting market turns,” notes Moreland.

Of course, when that ratio turns around, it should portend a positive turn in the market. In October 1999, insiders bought four shares for every three they sold. Within the next three months, the Dow surged to an all-time high of 11,722.

The No. 1 reason for bailing by an insider? Estate planning. In one of his last moves as SEC chairman, Arthur Levitt set up a program enabling execs to sell a fixed amount at fixed intervals. That way, an insider's moves would clearly be noncorrelated with any information he may possess. You can often find details of these selling programs within a company's annual 10-K or its proxy statement.

Before making your next investment move, you should research and understand the company's stock sales policies. And think twice before jumping in while insiders are bailing. It could keep you from holding the bag when the stock craters.

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