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The inside tip on insider trading

Ignorance of the law is not a legal defense. You've probably heard this expression before. It means that you can still get in trouble for breaking a law that you didn't realize existed. For example, you can still get a speeding ticket even though you didn't know the speed limit. Similarly, stock trades can get you into trouble, if you don't learn the difference between legal and illegal insider trading.

Get inside the CEO's head

The first step in recognizing a potential legal problem involves understanding the term "insider." A company insider refers to the chairman, president, chief financial officer, vice presidents and directors, or someone who owns 10 percent or more of a company's shares. Insiders are required to notify the Securities and Exchange Commission when they buy or sell large blocks of stock (500 shares or more) and this information is made publicly available in places such as the Wall Street Journal, Value Line Investment Survey or various insider-trading newsletters and Web sites.

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Investors often study this type of information because insiders are more likely to know when it's the best time to buy or sell their company's stock. H. Nejan Seyhun, finance professor at the University of Michigan's business school in Ann Arbor and author of "Investment Intelligence from Insider Trading," suggests that heavy insider buying is most relevant if it occurs when stock prices are rising. Likewise, insider selling is significant if it occurs when stock prices are going down. Here are a few more of Seyhun's tips for using insider information:

  1. Examine who's doing the trading. "Top executives [i.e., CEO, president, CFO] are more likely to have good information, followed by vice presidents, followed by directors, followed by large shareholders. ... Look for people who are involved in the company's decision making. ... Shareholders [not employed by the company] are actually quite a bit removed from the decision making process."

  2. Look for a sustained period of insider buying or selling. Insider buying is a more significant indicator than selling because executives generally don't buy their firm's stock unless they expect to make money. On the other hand, they might be selling their shares for legit reasons rather than because they expect the company's value to drop. For instance, they might want to buy a new house or pay for their kid's college.

    "If you see one or two insider transactions then you want to ignore those. Watch for sustained buying from a number of top executives with no selling," says Seyhun.

  3. Find out how many shares are being traded. "Ignore very small or very large transactions. If an insider trades 100 or 200 shares, then ignore that. If an insider trades 1 million shares, then ignore that as well. If that trade was really based on inside information then the insider would want to break [the transaction] up and hide it."

The thin gray legal line

Now it's time to discuss the naughty kind of stock deals that you need to avoid, or what the SEC refers to as fraudulent insider trading. The SEC defines this as "... buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security." This type of trading is frowned upon because it weakens investor confidence in the fairness and integrity of the securities market, according to the SEC. Unfortunately, the vagaries of just what constitutes fraud make this far from a black-and-white issue.

"It gets very complicated," admits John Heine, a spokesman for the SEC in Washington. "The facts and circumstances of each case are what determine whether a violation has been committed."

Heine feels that some trades based on inside information may look like insider trading violations but don't actually qualify as one. For instance, a restaurant waiter might overhear a businessman discussing a certain company and then use that nonpublic information to make a stock transaction. The waiter would still be protected from prosecution because there was never any fiduciary duty or relationship of trust established between the waiter and his customer, according to Heine.

However, Heine's waiter might not necessarily be free and clear from prosecution, according to William Wang, a law professor at the University of California's Hastings College of the Law in San Francisco. Wang claims that the person might be breaking the law if the information pertained to a tender offer, a.k.a. takeover bid, or if the waiter's employer had a policy prohibiting workers from taking such an action.

"You should try to err on the side of caution," states Wang, author of "Insider Trading," a legal guide for preventing exposure to insider trading liability. "If you have reason to believe that it is nonpublic information then you shouldn't use it. You would have to consult with a securities attorney to know where you stand."

I fought the law and the law won

Heine and Wang agree that there is a misconception that you're legally protected just because you don't work for the company whose stock is being traded. Heine adds that the SEC once prosecuted a psychiatrist whose patient was the wife of the CEO of a publicly traded company. The doctor had made some stock deals based on some insider information that the patient had passed on to him. The court ruled that a relationship of trust had been established between the physician and his patient so their conversations were considered confidential.

Wang believes that even hairdressers could also be held liable if they had the same relationship with their customer that the psychiatrist had with his patient. Investigators are usually tipped off to insider trading violations when there's been heavy trading of a security even though nothing new has happened with that firm. Possible penalties for insider trading violations include prison time and heavy fines.

The lesson to be learned here is that you shouldn't mess with questionable stock tips unless you're sure that the source, and your conscience, are both clean. Going to trial is like entering a drawing for an all-expenses-paid trip to the state penitentiary. It's a contest you'd rather avoid.

-- Posted: April 10, 1999


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