Uncovering Insider Trading

It isn't a coincidence that corporate executives seem to always buy and sell at the right times. After all, the CEOs and CFOs of the world have access to every bit of company information you could ever want. This doesn't mean individual investors are left in the dark. Insider trading data is out there for all who want to use it. This article will discuss what insider trading is, how we can understand insider trading and where to find insider data on the web.

What Is Insider Trading?
There are two types of insider trading: legal and illegal. First, let's talk about the illegal variety. Illegal insider trading is the buying or selling of a security by insiders who possess material that is still not public. The act puts insiders in breach of their fiduciary duty. As you can imagine, this is a definite faux pas for anyone closely involved with a company.

A common misconception is that only directors and upper management can be convicted of insider trading. Anybody who has material and non-public information can commit such an act. This means that nearly anybody - including brokers, family, friends and employees - can be considered an insider.

The Securities and Exchange Commission (SEC) is extremely strict with those who trade unfairly and thereby undermine investor confidence and the integrity of the financial markets. Don't think that those who place the trades are the only guilty ones. If someone is caught 'tipping' an outsider with material nonpublic information, that tipster can also be found liable. The SEC uses the 'Dirks Test' to determine if an insider gave a tip illegally. The test states that if a tipster breaches his or her trust with the company and understands that this was a breach, he or she is liable for insider trading.

Insider Trading Isn't Always Illegal
There is an important thing to emphasize here: insiders don't always have their hands tied. Insiders legally buy and sell stock in their own company all of the time; their trading is restricted and illegal only at certain times and under certain conditions.

The SEC considers insiders to be company directors, officials or any individual with a stake of 10% or more in the company. Insiders are required to report their insider transactions within two business days of the date the transaction occurred (before the 2002 Sarbanes-Oxley Act it used to be the tenth day of the following month). For example, if an insider sold 10,000 shares on Monday June 12th, he or she would have to report this change by Wednesday June 14th. Changes in insider holdings are sent to the SEC electronically (although not required to be sent electronically) as a Form 4, which details a company's insider trades or loans. A Form 14a, also filed by the company, lists all the directors and officers along with the share interest they have.

This kind of information is extremely valuable to individual investors. For example, if insiders are buying shares in their own companies, they usually know something that normal investors do not. They might buy because they see great potential, a merger, acquisition or simply because they think their stock is undervalued. One of the greatest investors of all time, Peter Lynch, was noted as saying that "insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise". Insiders are prevented from buying and selling their company stock within a six-month period: therefore, insiders buy stock when they feel the company will perform well over the long-term.

What the Research Says
Nejat Seyhun, a renowned professor and researcher in the field of insider trading at the University of Michigan found that when executives bought shares in their own companies, the stock tended to outperform the total market by 8.9% over the next 12 months. Conversely when they sold shares, the stock underperformed the market by 5.4%. If you're interested in learning more on insider trading, we strongly recommend reading Seyhun book Investment Intelligence from Insider Trading.

Where To Find Insider-Trading Data
This is definitely one area of investing that has revolutionized investing. With the click of a mouse, anyone can find the latest insider trade data for just about any public company. Here are a couple of sites that provide insider-trading data for free:

• Yahoo! Finance - Look up any quote on Yahoo! Finance and click on "Insiders" for a list of the latest trades. Some insider trading filings don't appear in databases until a month after the fact, but Yahoo seems to have one of the most current data feeds.
• SEC EDGAR Database - While not visually appealing, this is where trading data is first sent. To find these filings on the SEC website, you must search for the 'central index key' (CIK) for the company. The CIK is used on the SEC's computer systems to identify corporations and individual people who have filed disclosure with the SEC. Once you have the CIK, you can search for individual filings at: http://www.sec.gov/cgi-bin/srch-edgar. Generally speaking, we would recommend using Yahoo! Finance or another site for insider trade data; EDGAR can be confusing - even for us!

Insider trading data is nothing new. For years, people have been basing their investment decisions on the actions of insiders. While this data is important, just remember that large companies might have hundreds of insiders, which means trying to determine a pattern can be difficult. Continue, as you normally would, to complete your due diligence on a company, but also be aware of what insiders are doing. They probably know more than most of us do!