February 14, 2023 | InsiderSentiment.com Team
In this post, we'll answer some commonly held questions about insider trading, such as what it means when insiders are selling stock. As an investor, is important to understand these basic concepts about insider trading so that you can best use this information to support your own investing activities. You can also read our first blog post, "The Relationship Between Insider Trading And Stock Prices," where we cover in detail how insider trading affects the stock price of a company.
Let us first define insiders. When we say insiders, we are referring to top officers (CEO, CFO, CIO, general counsel, division chiefs, presidents, Senior VP, etc.), directors (Chairperson of the board, outside directors as well as officer-directors) and owners of more than 10% of any equity class of securities in publicly listed corporations. These insiders are sometimes also referred to as legal insiders.
Insiders can sell stock in their own companies to meet their liquidity needs, for diversification purposes or to avoid taking losses on their holdings based on their material non-public information. By selling, insiders may be able to avoid the losses associated with subsequent stock price declines. It is illegal and fraudulent to sell on the basis of material, non-public information. However, the bar to proving fraud in a court of law is high, as are the penalties for fraud, which amount to up to 20 years in prison and/or one million dollars in fines and penalties, and three times their illegal profits in disgorgement.
Selling could be due to liquidity or consumption needs, such as selling stock to meet some unexpected expenses, or simply to consume. Selling could also be for diversification purposes, which refers to insiders selling stock in order to reduce their concentration of wealth in a single stock.
Insiders can also purchase shares of their own corporations. In this case, there is only one motivation: To benefit from inside information. There is no such thing as buying shares for diversification or consumption purposes. When insiders buy shares in their own companies, the diversification problem is exacerbated. Similarly, if insiders have extra cash to invest, they can choose one of thousands of stocks, instead of the shares of their companies.
It is not illegal for insiders to make profits from selling shares. All that is required is that they do not possess material, non-public information at the time of selling. There is no limit to how many shares or how often insiders can sell, or even how much profit they can make. The fact that insider trading laws do not per se prohibit profitable trading means that insiders can avoid risky situations (which we will explain shortly), trade profitably and at the same time avoid potential litigation.
By law, insiders must file Forms 3, 4, and 5 with the Securities and Exchange Commission (SEC) to report their trades in their own companies within two business days of the trade. This means that all insider trading data exist for all publicly listed corporations in the US. There is universal coverage for all firms at all times.
Based on examining these reports, insiders have engaged in more than one million open market purchase and sale transactions in their own firms over the last ten years alone, averaging over 100,000 trades per year. Of these totals, more than 300,000 are purchases while more than 830,000 are sales. The total number of shares purchased by insiders is over 58 billion, while the total number of shares sold by insiders is over 70 billion. The total dollar volume of trading over the past ten years is over $3.4 trillion. Very few of these transactions are challenged as possibly illegal by government authorities such as the Justice Department or the SEC.
These open market sales and purchases do not include many other insider transactions such as stock and option awards, option exercises, gifts, and other transactions. For instance, over the past ten years, insiders have reported over 555,000 instances of stock awards, averaging more than 100,000 shares each. In addition, insiders have reported more than 2 million instances of option awards, averaging more than 50,000 shares each. Since insiders receive so many shares and stock options as part of their compensation, they tend to sell these shares once the awards are vested, earned and exercised in the open market. This is the main reason why insider selling exceeds insider buying. You might comfortably say that insider trading is commonplace, useful and informative.
Section 16 of the Securities and Exchange Act imposes three general restrictions on insiders: 1- Insiders must report all trades to the SEC within two business days, 2- Insiders cannot make profits from buying and selling within 6 months. If they do, these profits must be returned to the corporation, and 3- Insiders cannot short-sell their own companies stock (or buy more put options than the shares they own) in order to benefit from stock price declines.
Insiders are not allowed to sell at all times. There are black-out periods (typically starting one month prior to earnings announcements and lasting for a few days after the earnings announcement), when insiders are not allowed to sell or buy at all. Insiders also need to obtain clearance from compliance officers of their corporation to be able to trade during other sensitive periods, such as dividend announcements, corporate restructuring and M&A. Case law indicates that if insiders trade too close to the announcement date (say within one month of the announcement) to these kinds of corporate events, they are more likely to face challenges by the legal authorities. Consequently, insiders typically trade more than one month before the required corporate announcement to avoid many of these potential problems, and still end up with profitable trades.
Section 10 of the Securities and Exchange Act makes it illegal to buy or sell securities in the possession of material, non-public information.
To demonstrate that any selling is not associated with material, non-public information, insiders can pre-plan their selling in so-called 10(b)5-1 trading plans associated with diversification or liquidity needs. These plans must be set-up while insiders do not possess any information, list all planned buying or selling and the plan typically becomes effective 90 days after filing. Interestingly, past academic research shows that much of the plan-related buying and selling is also based on material, non-public information.
We also investigated insider trading over the past two years. Based on examining these reports, insiders have engaged in more than 250,000 purchase and sale transactions in their own firms over the last two years alone. So there is no evidence that insider trading is getting less common over time. If anything, it seems to be growing over time. Of these totals, more than 50,000 are purchases while approximately 200,000 are sales. Total number of shares purchased by insiders over the last two years is over 6.8 billion, while the total number of shares sold by insiders is over 14.2 billion. You might say that insider selling has accelerated relative to insider buying during the past two years.
As shared with subscribers to InsiderSentiment.com, at this time insiders are selling moderately and are also refraining from buying stocks relative to past trends, even though stock prices have fallen significantly from their recent highs. This is not an ominous signal yet, but nevertheless it is a negative signal and it is concerning for those investors who are considering taking on risk at this time.
While we do not recommend basing your entire investment strategy on imitating insider trading, 40 years of academic research has shown that insider trading information is one of the most important forward-looking signals in the stock market. Consequently, insider trading information should be part of your overall strategy, complementing your consultations with your investment advisor given your own unique investment needs, personal attributes and risk characteristics. To emphasize this point, you should always receive customized investment advice from your investment advisor before engaging in specific trades.
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InsiderSentiment.com is built in consultation with Professor H. Nejat Seyhun of the University of Michigan Ross Business School. Professor Seyhun is the world’s leading expert on insider trading, having authored the classic book, “Investment Intelligence from Insider Trading”. With the help of Professor Seyhun’s decades of insights, we process and filter the daily insider trading data so as to extract the purest signal that we then present to you. This way, you can know exactly how to interpret the current actions of publicly traded companies’ top insiders, so you can make the best determination for your own portfolio and risk tolerance.
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