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Insider Trading: Understanding the Basics

This is part 1 of 3 in a series where I breakdown:

• What insider trading is

• How to find trades & which ones to follow

In the world of finance, few topics generate as much intrigue and discussion as insider trading. As part of this mini-course series, we're diving into this subject to figure out if it's truly worth our time.

What is Insider Trading?

Insider trading refers to the buying or selling of a company's stock by individuals with privileged access to non-public information. These individuals typically include:

• Company officers

• Directors

• Influential shareholders (usually those owning more than 10% of the company's stock)

Why Does Insider Trading Matter?

Insider trading is significant for two primary reasons:

1. Information Advantage: Insiders have access to a broader information set than outside investors. This includes detailed knowledge about product approvals, regulatory decisions, factory performance, product sales, customer feedback, supply chain risks, and funding opportunities. When insiders trade, they potentially reveal insights based on this privileged information.

2. Alignment of Interests: When executives purchase company stock, it aligns their interests more closely with those of shareholders. This can serve as an incentive for them to work harder and make decisions that benefit the company's long-term value.

The Legality and Gray Areas of Insider Trading

While insider trading might seem unfair at first glance, it is legal under certain conditions. Insiders are permitted to trade as long as they don't possess "material private information." This refers to non-public information that could significantly affect the stock price if made public.

Examples of material information include:

• Pending acquisitions

• Loss of major customers

• Impending labor strikes

• Regulatory decisions

However, the line between general insider knowledge and material information can often be blurry, leading to ongoing debates about what constitutes fair trading practices. Let's examine two cases that illustrate this complexity:

Case 1: Martha Stewart (2001)

In December 2001, Martha Stewart, a well-known businesswoman and television personality, sold nearly 4,000 shares of ImClone Systems, a biopharmaceutical company. This sale occurred just one day before the FDA announced its decision not to review the company's cancer drug, Erbitux. The FDA's decision caused ImClone's stock to drop by 16% in a single day.

Key details of the case:

1. Timing of the Trade: Stewart's sale took place on December 27, 2001. The FDA's announcement came on December 28, 2001.

2. Financial Impact: By selling her shares before the announcement, Stewart avoided a loss of approximately $45,673.

3. Connection to Inside Information: Stewart's broker, Peter Bacanovic, also represented Sam Waksal, the CEO of ImClone. Waksal had attempted to sell his own shares after learning about the FDA's impending decision.

4. Legal Consequences: In 2004, Stewart was convicted of conspiracy, obstruction of justice, and lying to federal investigators about the reasons for her stock sale. She served five months in federal prison.

5. Defense and Gray Areas: Stewart maintained that she had a pre-existing agreement with her broker to sell the stock if it fell below $60 per share. However, prosecutors argued that she received inside information about Waksal's attempted sale.

Case 2: Satya Nadella (2013)

In August 2013, Microsoft CEO Satya Nadella bought 118,000 shares of Microsoft stock worth approximately $4 million. This transaction was properly reported to the SEC via a Form 4 filing. At first glance, this appears to be a straightforward case of legal insider trading. However, several factors complicate the assessment:

1. Potential Access to Non-Public Information: As CEO, Nadella likely has access to a wide range of non-public information about Microsoft's operations and strategies.

2. Materiality is Subjective: What constitutes "material" information can be subjective and may only become clear in hindsight.

3. Timing Considerations: While the trade wasn't immediately followed by any major announcements, Nadella might have been aware of longer-term strategies that could impact the company's future performance.

4. Burden of Proof: In cases of suspected illegal insider trading, regulatory bodies like the SEC must prove that an insider used material, non-public information to inform their trading decisions.

5. Regular Trading Plans: Many executives establish pre-planned trading schedules (known as 10b5-1 plans) to avoid suspicion of insider trading.

The key takeaway is that the legality of insider trades often exists in a gray area. Without access to all the information available to regulators and the company's board, it's challenging to definitively state whether a trade is legal or illegal.

Finding Insider Trading Information

Every insider must file a Form 4 with the SEC within three business days of making a trade. This information is publicly available through:

• The SEC EDGAR database

• Third-party websites like OpenInsider.com or SECForm4.com

These resources provide valuable data on insider trades, including the date, number of shares, price per share, and the insider's position within the company.

Conclusion

There will always be someone who knows something that someone else doesn’t, this is more prevalent the higher up you go on the food chain. Which is why I think everything is a gray area till it’s illegal.

Part 2 will go over how to find high-probability set-ups and filter good vs. bad trades.