Insider Selling Isn't Always A Bad Sign

By Glenn Curtis AAA

Insiders at public companies essentially have two options for buying and/or selling their companies' stock. The first is to conduct the transactions in the open market. That is, they can buy or sell securities through a broker just like any other retail investor. The second option is to conduct the transaction on a systematic basis through what is called a 10b5-1 plan. This Securities and Exchange Commission (SEC) rule permits a systematic form of insider trading that is not only legal, but can also be beneficial for both the insiders (and their companies) and individual investors. Read on to learn more.

What is a 10b5-1 plan?
Rule 10b5 is one of the most important acts put forth by the SEC. This rule makes it unlawful to defraud, mislead or operate in any fraudulent manner in transactions of securities on national exchanges.

This rule was also enacted to prohibit the purchase or sale of a security on the basis of non-public information. Any trade made with material non-public information, or insider information, is deemed as insider trading and is illegal under Rule 10b5.

In 2000, the SEC made an administrative ruling, known as 10b5-1, or 10b5-1 (c), which allows for a defense against the insider trading rule as long as the individual can determine that no non-material insider information was used as the basis for the trade.

This ruling created a situation where insiders could create a trading plan in advance of a trade if they set a specific date or price at which to effect a transaction (either a purchase or a sale). When that event transpired, it triggered the trade. These trading plans are known as 10b5-1 plans.

For example, executives may want to purchase shares throughout the calendar year. To do so, they (under the plan) purchase a fixed number of shares at specified dates, such as the first trading day of the month. The transaction is automatic. The insider will be safe even if he or she has insider information at the time of the sale, as long as the plan was set up when no material non-public information was known.

Conversely, if an insider wants to diversify his or her holdings but doesn't want to sell a large portion of stock at any one time for fear that it might send the wrong message to the investment community, the individual may set up a plan that liquidates 1,000 shares per month over the next year. Again, the trades are automatic and take place at a set point in time.

Benefits for Insiders
There are several benefits of 10b5-1s for both insiders and individual investors:

A Better Appearance
Because a 10b5-1 is a pre-set systematic method of accumulating and/or disposing of shares, the possession of insider information becomes essentially irrelevant. By definition, this will help stem accusations of insider trading and/or front running after a trade is consummated. In short, for executives at high profile companies that are frequently the target of shareholder suits and almost always subject to scrutiny from the investment community, this system can be invaluable.

Windows and Blackout Periods Don't Matter
Many - if not most - companies have established trading windows, or time periods when an individual executive may conduct a transaction in the stock. Many companies have also established blackout periods where, during a certain time period, absolutely no transactions in the company stock may be effectuated.

However, a 10b5-1 renders both of these strategies moot. That's because the trades are systematic and take place regardless of whether the individual has inside information or the company is about to report good or bad news.

Eliminates the Need to Read Into Insider Data
When an insider buys or sells stock on the open market, the law states that the company/insider must make the trade details public. When this data is reported to the SEC, major news wires and/or market data providers will then disseminate it widely to their readership or client base (particularly if the transaction was effectuated by an individual at a well-known company). Furthermore, in many instances the data may also be interpreted and used by journalists in their articles.

Unfortunately, when data is released in this manner it is sometimes wrongly interpreted. In other words, when an insider sells his or her stock, some may interpret the transaction as though he or she no longer stands behind the company, when in fact the transaction may represent only a small portion of the individual's assets.

Conversely, small insider purchases are sometimes construed as an indicator that the current price offers a terrific buying opportunity, when in fact the insider intends to make purchases in the future at numerous prices.

The Benefits for Investors
Limits Incorrect Interpretations and Makes Intentions Known
Insider data is sometimes wrongly interpreted by individual investors and/or large institutional shareholders, which can lead to mass selling or mass buying. However, when an executive consistently buys or sells shares each month (or quarter, or at some other pre-established period), the investment community becomes aware of the plan and will not typically react with such blind emotion.

Also, when an insider sells stock on the open market, investors typically look just at the transaction. They tend to ignore other characteristics of the trade and/or evidence of why the insider may have initiated the purchase or sale.

For example, if an insider sells 5,000 shares of XYZ stock, the only thing that most investors will hear or see is the date the stock was sold, who sold it and at what price. But they won't know, for example, whether the sale of 5,000 shares makes up only a tiny portion of what the executive continues to hold and believe in.

When a systematic plan is in place, investors will be able to see the insider's intentions more clearly. For example, when certain insiders liquidate shares at consistent points throughout the year, investors are more apt to be aware of and understand that an insider is simply diversifying his or her holdings, and that the remaining sizable position in the stock implies confidence in the company.

Investors Know What to Expect and When to Expect It
Part of the problem with insider data reporting is the time it takes for such information to reach the average investor. While the SEC mandates that Form 4 (filings that must be made when changes in ownership occur) must be filed within two business days of a trade, it sometimes takes a week or more for that data to circulate to the average shareholder through news services or some other data provider.

Data/trade information may also come to investors at an inopportune time - like on a Friday afternoon when many traders like to go home "flat" (or without any long positions). When this happens, it could exacerbate the normal selling. That said, when a systematic plan is used investors know, or should expect to see, sales (or purchases) at given points in time. This is comforting to many shareholders.

Bottom Line
Systematic investment plans are much more beneficial for both insiders and individual investors than transactions effectuated on the open market. A 10b5-1 plan allows executives to diversify their holdings without creating a stir in the investment community, and allows investors to keep an eye on executives' sales of shares.

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