Insider Selling Isn't Always A Bad Sign

Insiders at public companies essentially have two options for buying and selling their companies' stock. The first is to conduct the transactions in the open market whereby they 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 legal. However, the trading activity allowed via 10b5-1 can be beneficial for both insiders and individual investors.

Understanding Rule 10b5-1

Rule 10b5 was originally created by the SEC in 1934, making it unlawful to defraud, mislead, or operate in any fraudulent manner when conducting securities and stock transactions on national exchanges.

Rule 10b5 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–called insider information–is deemed as insider trading and is illegal under Rule 10b5.

However, 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. The trading activity is allowed as long as the individual can determine that no non-material insider information was used as the basis for the trade.

A 10b5-1 Plan

The 10b5-1 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). Once the event has transpired, the trade is triggered. These trading plans are known as 10b5-1 plans.

For example, executives may want to purchase shares throughout the calendar year. The 10b5-1 plan allows them to purchase a fixed number of shares at specified dates, such as the first trading day of the month. The transaction is automatic and executed by a broker. The insider or executive would be safe from an SEC violation even if they have insider information at the time of the sale–as long as the plan was set up when no material non-public information was known.

Sometimes an executive may want to diversify their 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. Investors monitor insider buying and selling since buying activity is often seen as a positive sign that executives believe the stock will rise in the future. Conversely, insider selling can be seen that executives believe the company and its stock price may underperform in the future.

As a result, the executive may establish 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 of 10b5-1 Plans for Insiders and Investors

There are several benefits of 10b5-1 plans for both insiders and individual investors.

Improves Transparency

Because a 10b5-1 is a preset systematic method of accumulating and selling of shares, the possession of insider information becomes less relevant. The systematic approach helps stem accusations of insider trading and front running after a trade is consummated. Front running is when someone enters into a trade with knowledge of private information that can influence the price of the security, resulting in a financial gain. A 10b5-1 plan helps executives improve transparency surrounding insider transactions preventing the appearance of inappropriate behavior.

Windows and Blackout Periods Become Less Relevant

Many companies establish trading windows or time periods when an individual executive may conduct a stock transaction. Companies also establish blackout periods, which stipulate that, during certain time periods, no stock trades can be transacted.

However, a 10b5-1 essentially renders both of these strategies moot since the trades are systematic. In other words, the trades take place regardless of whether the individual has inside information (at the time of the transaction) or if the company is about to report good or bad news.

Reduces the Misinterpretation of Insider Activity

When an insider buys or sells stock on the open market, the law states that the trade details must be made public. When the trade data is reported to the SEC, major news outlets and investment firms disseminate the information to the public.

Unfortunately, when the data is released, it can be misinterpreted. For example, when an insider sells their stock, some investors may infer from the transaction that they no longer stand behind the company. The result could be an increase in selling activity by investors. In reality, the insider's sale might be immaterial, meaning it represents 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. Investors might also infer that the insider knows some positive news about the company that's about to be released and rush to buy shares to take advantage of the expected favorable price moves. In reality, the insider's intention was to merely purchase several tranches of shares in the future at various prices.

However, when a systematic plan is in place—as in the case of a 10b5-1 plan—investors are able to see the insider's intentions more clearly. For example, when insiders liquidate shares at consistent points throughout the year, investors are aware of the plan and are more apt to understand that the insider is merely diversifying their holdings.

Also, the remaining sizable position owned by the insider demonstrates that the executive still has confidence in the company. As a result, the insider activity doesn't lead to a frenzy of trading activity by investors.

Investors Know What to Expect and When to Expect It

Insider data reporting can experience a time lag before it reaches the average investor. The SEC mandates that Form 4—filings made when changes in ownership occur—must be filed within two business days of a trade. However, the activity can sometimes take several days before it's reported to investors via news outlets, brokers, and investment research services.

Trading activity may also come to investors at inopportune times, such as on a Friday afternoon when many traders have gone home or are not actively trading. The systematic nature of a 10b5-1 plan helps investors know when to expect sales and purchases.