Rules of Game Are Changing for Inside Traders

There’s a contingent of investors that maintains that following the moves of corporate insiders--officers, directors and big stockholders--is the road to riches.

When insiders are buying their own companies’ shares, it’s a sign that the company’s stock price is about to rise, some maintain. When they start selling, it might be time to get out. Investors can easily find out what insiders are doing, because the Securities and Exchange Commission requires company executives to notify the federal agency any time they buy or sell shares in the firm they work for. And a number of research firms compile that information and send it out to newspapers and newsletters.

Insiders are right more than half the time, according to Al Hadhazy, senior analyst at the Miami-based Institute for Econometric Research. And, as stock market indicators go, that’s pretty good.

As it is, industry experts maintain that hundreds of thousands of individuals base at least part of their investing decisions on whether corporate insiders are buying or selling.


However, the Securities and Exchange Commission recently enacted a handful of rule changes on insider trading that could alter the game plan for these investors.

At this stage, no one is sure whether the changes will make the art of investing with insiders more or less lucrative. Some of the new rules seem to help those who watch insiders; some seem to hinder them.

In any case, if you are one of the many investors who like to know whether company executives have enough faith in their firms to invest their own cash, these are important changes to know about.

In brief, the old rules relating to insider trading were relatively simple. If an insider bought and sold shares within a six-month span, any profits had to be given back to the company. (That’s because the SEC once speculated that such short-swing trades were naturally based on non-public information. And trading on non-public information is illegal.)


However, anyone with the title of vice president or above was considered an insider. And in a number of industries, that meant that many people who were not privy to confidential information were subject to these rules.

Additionally, the rules could make the exercise of stock options difficult in some cases. Stock options, which are rights to buy company shares at a set price in the future, are commonly given to top-ranking company officers. When officers exercise, or buy, these shares, they often have large gains that trigger huge income tax bills. But their profits are purely on paper until they resell the shares.

For example, an executive is granted 100 rights to buy company shares at $10 in the future. A year later, the company’s shares are trading for $20 and the executive exercises these rights. He now owns shares worth $2,000, but he paid $1,000. The Internal Revenue Service says the executive must pay tax on the $1,000 paper profit.

Some executives didn’t have enough money to pay the tax on their gain without selling the shares, and they couldn’t sell the shares because that would cause them to run afoul of the SEC’s insider trading rules. A Catch-22.


On the other hand, those who watched insiders considered the exercise of stock options a positive sign. Since these insiders had to hang on to their shares for at least six months, investors figured that executives who had reason to best understand the company’s prospects were optimistic about its future. (The six-month rule was also why insider trading experts maintain that the indicator is best used during a six-month to two-year span.)

But as of May 1, the SEC said insiders need only wait for six months after stock options “vest"--or become available to purchase by insiders--before they can sell. Options often vest long before insiders exercise them, which means many could buy and sell their company-optioned shares almost simultaneously.

And company officers will not have to tell anyone when they exercise these rights. They will have to reveal it only when the options are granted, said William Morley, an associate director in the corporation finance division at the SEC in Washington. That makes it much harder to determine whether insiders are optimistic or pessimistic about the company’s future.

But on a positive note, the changes also narrow the definition of insider, so those who will be reporting insider transactions will be in a better position to know the company’s prospects.


Moreover, insiders will have more impetus to report their purchases and sales because of other provisions in the law. In the past, about 40% of these transactions went unreported, Morely said. But in about a year, companies will have to start advising shareholders about company officers who fail to report purchases and sales of company stock. That is expected to significantly increase “voluntary” compliance with the law.