Two Modest Proposals for Fixing Insider Trading Rules
Jonathan Moreland is publisher of InsiderInsights.com, a Web site that analyzes insider trading, and a weekly newsletter. He writes a column that appears on this page as part of his business relationship with TheStreet.com.
The Securities Exchange Act of 1934 was a tremendously forward-thinking piece of legislature that was intended to level the playing field for individual investors in the wake of the 1929 market crash. Blatantly unfair trading practices by some corporate insiders at the time exacerbated the feeling that the stock market was stacked against individual investors. The 1934 Act established the SEC and differentiated between illegal and legal insider trading. It also laid the framework by which insiders would report their legal trades. It is a paradigm that is still unparalleled in any financial market outside of North America, and is part of what makes U.S. financial markets the most transparent in the world. Even the U.S. Constitution needed amendments, however, and it's clear from recent activity involving insiders at companies like Enron and Global Crossing, who bailed out of their company's stock before prices started plummeting, that changes are needed. Here are two of the most obvious ones. 1. Shorten the filing deadline for Form 4s to one week. That the SEC actually takes into account how much its rules will cost those affected to comply is one reason for my respect for that bureaucracy. It is also why my first suggestion is a no-brainer. The present deadline for insiders to get their Form 4s, which apply when shares are sold on the open market, to the SEC is "within 10 days after the close of each calendar month," according to the 1934 Act. This means that any insider who trades his own company's shares any time during February, for example, has until March 10 to get a Form 4 reporting the trade to the SEC. (For Form 5s, which apply when insiders undertake certain other transactions such as selling stock back to their company, insiders have even more time -- they simply have to file within 45 days of the end of the company's fiscal year.) On the 10th of each month there is a predictable bulge of Form 4 filings at the SEC. Insiders (or, just as likely, their secretaries or in-house counsels) don't necessarily wait until the last minute to file to be sneaky. It's only human to put off annoying paperwork. But it's time to annoy insiders more by shortening the filing deadline. Reducing the time insiders can procrastinate is not adding a tremendous burden to these execs. At most, it will cost them more in stamps if they trade during numerous weeks within the same month. But that insignificant burden is worth it to generate more timely flow for this very important data. Every week I see just-filed Form 4s that prove insiders have an unfair advantage when trading their companies' shares. Uncannily, insiders have purchased just weeks before their stocks pop, or sold just before some bad news makes their stocks tank. Purchases last November by executives at Covad Communications ( COVD) are a good recent example of insiders buying stock before a big rise, as are the purchases late last year by executives at microcap USA Video ( USAV). A recent award for unusually prescient sales goes to executives at Microsemi ( MSCC), who conveniently filed their Form 4s late with the SEC, after their stock had already weakened substantially from where they sold. I don't care that insiders may have crossed the line from legally trading as better-informed investors to illegally trading on material nonpublic information in these cases. I just want to see the information as soon as possible so I have a better opportunity to profit from it. A broader opportunity investors missed because of the present deadline was during markets' collapse in the wake of Sept. 11. Plenty of insiders bought their stocks as others ran for the exits. Their actions were a solid indication that, though the world had changed, it hadn't ended. Thankfully, executives at numerous firms saw fit to mail their Form 4s into the SEC immediately, including: BE Aerospace ( BEAV), Hartford Financial ( HIG) , Take-Two Interactive Software ( TTWO), Genta ( GNTA), United Auto Group ( UAG) and Bio-Reference Labs ( BRLI). Insiders aren't always right, of course, but anyone following the execs in late September and early October profited handsomely. Alas, most insiders procrastinated, only getting their Form 4s to the SEC when they had to. But by mid-October, most of the stocks insiders had bought were already well into recovery mode. As far as I can tell, the present deadline was mandated with the postal delivery times of 1934 in mind. Isn't it time to change it? 2. Mandate that Forms 3, 4, 5 and 144 be filed via EDGAR. Mandating that insider forms be filed on the SEC's EDGAR (electronic data gathering, analysis and retrieval) system is going to happen someday, so why not make it sooner rather than later? The SEC didn't initially make EDGAR filings of these documents mandatory, because filing Form 4s is the responsibility of the individuals themselves, not large organizations, as is the case with 10-Ks and other company filings. Once again, it was determined at that time that it was too great a burden on individuals to expect them to have the hardware, software and technical knowledge to properly file these forms electronically, and unfair to make insiders pay others to do it for them. Also, as relayed to me by an SEC employee: "We had our hands full handling questions on how to use EDGAR from the 15,000 or so companies that were made to use it in the mid-1990s. There are at least 10 times as many individual insiders, and we don't have the personnel to handle their service needs if they were made to use the system." With personal computers and the Internet, though, the technical burden for most insiders has surely become a nonissue. These same tools would allow third parties to charge much less to insiders to do it for them too. A more obvious solution that would also take into account SEC manpower issues, however, is to make the companies responsible for filing their insiders' Form 4s and related filings through the EDGAR process they use now for their company filings. There is a precedent for this imposition to companies. In 1991 the SEC distinguished between Form 5s and Form 4s, and also made firms disclose in their 10-Ks and proxy statements if any insiders filed very late or inaccurately. The SEC even gained the ability to ban insiders from serving as officers or directors of a public company altogether if transgressions were serious enough. In response, many a general counsel's office began helping their executives comply with filing commitments, and as a result, roughly 5% to 10% of insider filings are already filed via EDGAR. So it can be done, but that incompleteness makes EDGAR a third-rate source for insider-trading data at this time. But the most important reason for mandating EDGAR filings is that until they are, the original reason the forms were legislated into existence will continue to be turned on its head. The forms were meant to level the playing field for individual investors, but today they still serve mainly to give institutions -- who can afford to pay for the most timely feeds of the data -- yet another leg up. When individual investors can see the data simultaneously with institutions, the original intentions of the 1934 Act will be restored.