Catching an Inside Trade Can Be Hard
It’s painful enough when a company surprises Wall Street with bad news, and the firm’s stock plunges 20% or 30% in a day.
But when stockholders learn that some of the company’s top executives sold their shares a few weeks before the bomb was dropped, the anguish of financial loss quickly is replaced by a feeling of rage against management.
“You cheated!” scream shareholders. “We didn’t know what was coming,” argue the executives.
In recent months, the list of companies suffering swift stock declines has lengthened, and so too has the list of “Lucky Pierres,” corporate officers who managed to bail out of some or all of their shares before the price plunged. Their actions become public knowledge when they file required trading reports with the Securities and Exchange Commission in Washington.
A few recent eye-openers:
* The chief financial officer and the general counsel of waste-management giant Browning-Ferris Industries sold large amounts of their stock several weeks before the company issued a dismal earnings projection Sept. 3. The stock fell $4 that day, to $21.75. The executives had sold their shares at $27 or higher.
The two resigned under pressure on Sept. 26, after the SEC began an investigation. The stock now trades at $17.625.
* Pennzoil Co. Chairman Hugh Liedtke sold 40,000 of his shares, or 21% of his stake, early in August at about $73 each. Two weeks later the stock plunged $6 on rumors, later confirmed, that the company would delay an expected restructuring. Pennzoil stock now trades at $66.25.
* Executives of National Medical Enterprises, the Santa Monica-based hospital firm, have been heavy sellers of the stock all year. Between June 14 and Aug. 26, nine officers sold 122,960 shares at prices ranging from $22 to $23.50, according to Fort Lauderdale, Fla.-based Invest/Net, which tracks executives’ trades.
Last week, NME’s shares tumbled on word that the company is being probed for alleged fraudulent billing practices at some of its psychiatric hospitals. The stock dropped $4.125 to $16.125 last Monday. It closed Friday at $17.125.
Isn’t there a law against so-called insider trading? You bet there is--albeit a fuzzy one. Basically, SEC statutes forbid any person from trading a stock based on “material, non-public” information if that person has a responsibility of trust regarding that information.
In other words, if you’re privy to company secrets, you can’t trade on those secrets until the public at large knows about them. If you do, the SEC can sue to take away whatever ill-gotten gains you reaped and then hit you for triple damages. Jail also becomes a possibility.
To many shareholders, the issue would seem to be cut and dried: Who’s in a better position to know about bad news coming down the pike from a company than its own executives? If insiders sold, they must have known something.
But in fact, the mechanics of insider stock sales are far more complicated than the proverbial “what did they know and when did they know it” question implies.
For one thing, if a mid-level executive maintains that he had no idea that his company’s prospects were changing for the worse, the SEC might be hard-pressed to show otherwise. “It’s very difficult to prove intent,” said David Coleman, editor of Vickers Weekly Insider Report, a Washington, D.C.-based newsletter that tracks insider transactions.
What’s more, insiders rightly note that the public often takes the misguided view that it’s always suspect when an executive sells stock. Surely an executive can’t be expected to hold his or her shares forever. Like any other investors, they have a right to take profits.
It’s also true that insider stock transactions are skewed by the fact that many executives receive shares in their company via stock grants or options, as part of their compensation packages. When insider-tracking services look at executive buying versus selling in a particular stock on the open market, they may see nothing but sales because so many insiders get their stock through options rather than open-market purchases.
Thus, a successful company may grant more and more stock options to its executives as they steer the company to greater heights. And as those option grants increase, some selling naturally follows, as the insiders take home some of their paper profits.
As the accompanying chart shows, many companies whose executives have been heavy stock sellers this year have seen their shares soar in value--so the insiders’ sales could hardly be viewed as an omen in every case.
Finally, insiders say the focus on their sales often doesn’t take into account the number of shares they keep. David Olson, corporate communications chief for National Medical Enterprises, says that although company executives have taken some profits in the stock this year, “They still own approximately 8% of the company,” a percentage that he says is far higher than insider ownership at many other medical firms.
All that said, can the investing public really be expected to believe that insiders never try to front-run bad news and save themselves a few dollars? The SEC has rarely pursued such cases, especially when the stock sales are relatively small.
Yet the number of suspicious-looking cases this year has raised red flags, many experts admit. “There appear to be more conspicuous instances of it recently,” says Ralph Whitworth, president of the Washington-based United Shareholders Assn., a shareholder-rights group.
That rise in questionable trading could just be a function of Wall Street’s extreme case of nerves as the economy stagnates, says Robert Gabele, head of Invest/Net. Because bad news is more devastating for individual stocks in a market so focused on short-term corporate results, otherwise-innocuous insider decisions become more noticeable.
Whitworth believes that the best course of action for executives today is to avoid a stock sale if it could at all be viewed as improper, given a company’s near-term prospects. “People say it’s hard to define insider trading, but I think every executive at every company knows when they’re in a gray area,” he said.
“And the more senior the executives, the more caution that should be exercised,” he said.
Coleman, of Vickers Weekly, argues that the real problem is that most companies choose not to keep shareholders well-informed of what’s happening with the business. He favors allowing executives to sell stock at will--as long as they simultaneously tell the public what they already know about their company’s prospects.
“If there is information that ought to be told, then it ought to be told,” he said. “I think there ought to be more disclosure and fewer restrictions.”
Where Insiders Have Sold Heavily
Is it a bad sign for a company when its corporate officers are heavy sellers of the company’s stock? The answer is: sometimes but not always. Here is a list of companies whose officers have sold their shares at a brisk pace the past 12 months. The figures show the number of officers who bought or sold shares on the open market. For some companies, sellers always outnumber buyers because insiders are cashing in stock they received through options, which don’t count as open-market purchases.
Past 12 months: Fri. stock 1991 Stock change Company Buyers Sellers price high/low from ’91 high General Motors 4 48 37 3/4 44 3/8-30 3/8 -15% U.S. Surgical 0 26 76 3/4 79 1/4-31 1/4 -3% Baxter Intl. 0 25 33 1/2 37 1/8-25 5/8 -10% Rexon 0 24 7 1/8 11 1/2-4 7/8 -38% Microsoft 0 22 89 5/8 91 1/4-48 5/8 -2% Pall Corp. 0 20 36 1/4 40 7/8-22 1/2 -11% Dow Jones 1 20 24 1/4 30 5/8-23 5/8 -21% Nat. Medical Ent. 2 19 17 1/8 25 3/4-16 -33% Martin Marietta 1 16 49 3/4 60 3/8-42 3/8 -18% S&P; 500 index -- -- 381.45 398-309 -4%
Source: The Insiders newsletter
