Subject: Misc - Insider Trading
Last-Revised: 3 Jan 1996
From: mash@sgi.com

This article offers a primer on insider trading, with some focus on a
common insider's mechanism, namely stock options.  While I make no
claim to be an expert on this, I was an officer for a few years at a
company that was private and went public, but that was in  1992, so a
few rules may have changed since then.  The discussion below assumes
U.S.A. rules.

SUMMARY: the insider-trading sections of newspapers can be very
misleading if you don't know how to interpret them, but briefly:

a) If you see insiders buying a lot of stock on the open market, this
   might be worth investigating as a BUY signal ... although insiders
   are often wrong.

b) If you see insiders in fairly young companies *selling* stock,
   either by selling very cheap stock they've had a while, or by
   same-day exercise of a stock option and selling the resulting stock
   ... this rarely means very much.

The list of stock still owned strangely doesn't mean very much either,
for reasons explained below.  That is, sometimes readers get very
excited if they see that Joe Blow, CEO, has sold 10,000 shares and now
owns 0. What is not obvious from the paper is whether:

        (1) Joe Blow has no options left, is cashing out, and about to
            leave.
    OR
        (2) Joe Blow has vested options on a million shares, and has
            thus sold 1% of his stock to buy a new house.

Obviously, the imputed meanings are rather different ...

c) The *timing* of sales also means relatively little:

        (1) Silicon Valley financial advisors tell people to sell some
            stock *every* year for tax reasons.  More later.

        (2) Normally, there are at most 4 times during a year when an
            insider can sell stock anyway, and it is easy for other
            events to knock this down to 1-2, or even 0.  I've heard of
            cases where people got stuck for 2 years post-IPO not being
            able to sell *any* stock.

d) In general, interpreting the data from the paper alone is hard, you
   need the last couple years of annual reports and then read the fine
   print about executive compensation, special loans, extra covenants
   about non-sale of stock around IPO, merger, acquisitions, etc.

EXPLANATIONS:

(1) If you are a founder of a company, or even an early employee, you
    likely get some stock options, or own stock at minuscule prices
    (i.e., like $.10/share on stock you hope will be worth at least $10
    at IPO.) I don't know how the rules are now, but they used to
    strongly encourage actual purchase of some of that stock, at least
    2 years in advance of a potential IPO, in order to have stock that
    could get capital gains handling when sold 6 months after IPO.
    [When a company is founded, of course, no one has the foggiest clue
    of the likely increase in value ... although there are many hopes :-)]

(2) When you get closer to IPO, stock option pricing gets closer to an
    IPO price, which is usually adjusted via splits or reverse-splits
    to be in the $10-$30 range.

(3) Many companies continue to grant stock options after IPO, although
    the prices are of course much higher, which tends to force some
    different strategies.  From tax-treatment, it is advantageous to
    spread this out, as only a certain amount per year gets the
    favorable Incentive Stock Option (ISO) treatment, any above gets a
    Non-Qualified Option treatment.


    Silicon Valley companies use stock options extensively, and usually,
broadly across employees, not just for executives.  [Which is why the
Valley went berserk with the proposed law that required charging the
bottom line for the "expected future value of stock options" :-) if
anyone can predict such a thing, they are really smart ... but even
worse, it would have discouraged broad use of stock options, which
would have been truly sad.]

(4) If you have been in a high-tech startup, or even fairly early in,
    it is likely that most of your net worth exists in stock ownership
    and options of that company.  It is far more complicated, and takes
    longer than you'd expect, to get that money out without giving it
    to the IRS :-) [I do first-in-first-out on option exercises ... I'm
    still working on some I got in 1985...]

This is especially so if you are an insider, given:

        (1) SEC rules

        (2) Lawsuit issues [which fortunately have just improved!].
            I.e., if you are an officer, you're likely to learn some
            extra rules from the lawyers, that aren't laws, but are
            insurance against lawsuits.

        (3) Tax laws, like Alternate Minimum Taxes, which encourage you
            to *not* to sell in big lump sums.

(5) Briefly, when it comes to trading stocks, insiders:

        (1) Usually do no trades in month 1 and month 3 of a quarter:

                Month 1: no trades until quarterly report appears, plus
                         a few days for market to digest the results.

                Month 3: theoretically, by the beginning of month 3 you
                         know how the quarter will be.  This may be
                         actually true in some businesses, but not
                         others. In some parts of the computer
                         business, an awful lot of business is booked
                         during month 3, and shipped in the last 2
                         weeks, so people quite often have no idea at
                         this time whether they'll make the numbers or
                         not.  This is especially true for high-end
                         machines (like supercomputers, where
                         pure-supercomputer companies have occasionally
                         had crazed fluctuations because some $20M
                         machine got held up a week).  Right now, the
                         government shutdown and its effects on buying
                         and export licenses is a bit strange.  Similar
                         weirdnesses go on, for example, in some retail
                         businesses, where the Christmas season is
                         crucial.

                Anyway, that leaves <= 4 months a year for an insider.

        (2) Usually do no trades when in possession of material
            information that might affect the stock, and is not yet
            public, at least partly because it might or might not
            happen. For instance, somebody might be negotiating a
            merger or some really major sale, and the lawyers will tell
            you that you shouldn't trade then, to avoid lawsuits.  This
            may knock out some of the 4 months, and may be difficult to
            predict a year in advance; that is, it is personally
            dangerous to say: "I expect to sell stock 9 months from
            now."  Don't count on it.
        (3) Do no trades when forbidden by covenants that are part of
            IPOs or merger deals. There is usually a minimum of a
            6-month block after an IPO, and probably 3 after a merger.

        (4) (Don't know if this rule is still around, but): do not usually
            both buy and sell their stock in within the same 6 months.
            I think the rule has been mellowed to allow purchase of
            options and sell them off, but there used to be a terrible
            trap where you (a) sold some stock (b) then, slightly less
            than 6 months' later, were reminded that you had options
            expiring.  You exercised the options ... and *blam*
            computer at SEC nails you for illegal trading. [Years ago,
            advisors mentioned some horror stories, whose details I
            forget, but whose import stuck.]

            When combined with (1) and (2) and (3), plus some other
            rules about tax-treatment on pre-IPO stock options ... this
            might be paraphrased as: "You are in a maze of twisty
            little rules, all alike." But in general, the rules
            (explicit and implicit) strongly discourage insiders from
            *trading* (mixtures of buying and selling) their own stock
            very often; since insiders usually *have* stock options,
            that means they mostly sell.

        (5) Finally, some executive employment contracts have some
            really complicated agreements, often involving loans made
            the company to the executive to buy stock (so they can buy
            it when they aren't allowed to sell any to get the money to
            buy it with), but also saying placing restrictions on
            buying/selling stock.


(6) Financial advisors tell people that, no matter how well they think
    the stock will do over the long run, they should sell some % of
    what they have left every year, for diversification, so they have
    the cash available, and to spread it out to lessen the effects of
    the alternative minimum tax.  We once had a "class" in this, and
    the recommended percentage was 10%, but that was years ago, and
    was not a hard rule, just a general idea.

    Remember: unlike "regular" people, if an insider needs some money
    quickly, they *cannot* call their broker and sell some of their
    company's stock on the spur of the moment, and in fact, they cannot
    even be guaranteed that a window of opportunity to do so will
    necessarily be predictable.  It may be that with the changes to
    stockholder lawsuit rules, this will get a little more rational; as
    it has been, lawyers have recommended extreme paranoia regarding
    lawsuits, for good reason.  (So, what insiders do is use existing
    money, or quite often, borrow money with the options as security
    ... which has often caused people trouble later on.)

(7)  When you exercise an option (i.e., purchase the stock), you can:

        (a) Do a same-day exercise, that is, purchase the stock and
            immediately sell it, keeping the difference, and of course,
            incurring a normal tax liability on the difference between
            option price and exercise price, and non-qualified option
            treatment forces this. 

        (b) Purchase the stock and keep it for a year, then sell it,
            thus getting capital-gains treatment (at least sometimes)
            on any gain.  Of course, in doing so, are subject to later
            price fluctuations.  If you are an insider, note that you
            may not be allowed to sell when you'd like to, as described
            above.

    Needless to say, if the current stock price is $20, and you have
    10,000 options:

        (a) And your option price is $.10, you might do (b), i.e.,
            spend $1000.

        (b) But if your option price is $10, you need to come up with
            $100,000; the only way to get that might be to sell some
            shares you already own.  If what you have is vested
            options, then you might exercise some, and sell less, thus
            keeping some shares.  This gets tricky, as you have to sell
            enough to:

            (1) Cover the purchase.
            (2) Cover the tax liabilities.
            (3) Get some actual cash out.

        So, in the example above:

            (1) $200K: sell 10,000 shares @ $20.
               -$100K: exercise the options @ $10.
               ------
                $100K left: probably ~40% goes to IRS & (here) California
             ==> $60K in cash to actually do something with.

Bottom line: founders often actually own lots of stock, sometimes so do
early employees. But, for many insiders (and in fact, not just legal
insiders, but other officers and actually, *any* employees who have
significant stock positions and/or legal advice that restricts the
timing of sales), the natural state of affairs gets to be (as the
absolute cost of options goes up)

        (a) Have a bunch of vested options that account for a big chunk of
            one's net worth.

        (b) Do same-day exercise once or twice a year.

        (c) Actually *own* zero shares.

And these are basically driven by SEC rules, legal advice, and tax
laws, not by short-term price fluctuations.  [Note: anyone in high-tech
investing who doesn't expect short-term stock price fluctuations ... is
crazy :-)].

Thus, moderate sales by insiders ... simply don't mean much.   It takes
work to know whether or not a sale is substantial - for instance, an
executive may have an employment contract that includes an $X loan
(where I've heard of $X in the millions), where they moved to the area,
wanted to buy a nice house, and the deal is that within N months of
being allowed to exercise options, they are required (or encouraged by
interest on the loan) to do so ...  meaning they'd better sell off
enough stock to cover the loan, and the taxes incurred from selling the
stock.  The only way to figure this stuff out is to backtrack through
the annual reports and read the fine print.

OF COURSE, there have been cases where some insider sold a ton of stock
and should have known better...  but by-and-large, the pattern in young
high-tech companies is that insiders gradually sell over time to move
more of their net worth into more diversified holdings and be able to
enjoy it :-)

A slightly different pattern shows up in more-established companies
where stock options are not as widespread, insiders were not founders
or early employees. Here, there are often key executives who do *not*
have large stock positions (either owned or vested options) may decide
their stock is undervalued and buy a bunch on the open market.




-- 
-john mashey    DISCLAIMER: <generic disclaimer, I speak for me only, etc>
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