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.
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:
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."
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.
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
"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
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
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