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How insiders can unload stocks in secret
A lot of investors get nervous when company insiders start dumping stocks. But insiders increasingly are using hedged transactions to pocket cash in a way investors won't detect.
By Michael Brush
If you regularly check out the activities of corporate insiders to determine what stocks to hold or sell, be careful. You may be missing some important cues.
Insiders are increasingly using complex derivatives to protect against downside risk -- as opposed to outright selling stocks. And because of the way the transactions get reported, they might not make it onto your radar screen.
This past Valentines Day, for example, Merrill Lynch began coverage of the biotech company Neurocrine Biosciences (NBIX, news, msgs) with a decidedly unaffectionate neutral rating. But you could have gotten a similarly negative read before that. While Merrill was putting the finishing touches on the report in the two days prior to its release, Neurocrine Biosciences CEO Gary Lyons was hedging away downside risk on $4.5 million worth of his companys stock -- essentially selling 110,000 shares.
Unfortunately for investors who monitor insiders, it was pretty easy to miss this potentially bearish move by a key company figure. Thats because the commonly used insider databases -- like those at MSN Money or Yahoo! (YHOO, news, msgs) -- offered no clue what Lyons was up to. In fact, you still wouldnt know, as the hedges remain unreported at these sources even to this day.
Cynics may respond that with free, Web-based market data sources such as MSN Money or Yahoo!, you get what you pay for. But the fact is, those services werent to blame. Even if you paid for professional insider-tracking services like the venerable Vickers Insider Weekly Report, Insider Consulting Services based in Reno, Nev., or Edgar Online, youd have missed the transactions just the same.
Lyons hedging wasnt reported by any of them (though the transactions finally showed up at Edgar Online late last week). The only place this information appears reliably is in the Securities and Exchange Commission database itself -- and even there, there are often delays if the original filings were made on paper. Unfortunately for investors, it can take several hours to wade through all the raw insider filings for a company on the SEC database. Thats why most investors -- both professional and amateur -- rely on insider-tracking services like the ones mentioned above.
Are filings like these material for investors? They certainly can be. Insider selling is a proven red flag, and investors who mimic insiders making large purchases can beat the S&P 500 ($INX) by 11.7%, suggests research by Donn Vickrey of Camelback Research Alliance. Shorting stocks with heavy insider selling produces excess returns of 8.5%, according to Vickreys studies. Shares of Neurocrine Biosciences havent lost much value since the CEOs hedging maneuver, but insider sales rarely precede stock declines so quickly.
How the hedges work
In transactions that are typically engineered by investment banks, insiders are paid a discounted price for some number of the company shares they hold. That price tends to be 10% to 20% below market value at the time. In exchange, the investment bank agrees to accept delivery of the shares two to five years later -- even if the shares tank.
Typically, the arrangements are called prepaid forward contracts because executives are in effect selling the shares forward at some point in the future.
These deals, of course, protect an insider from downside risk, ensuring some level of wealth accumulation no matter what happens on the stock market. In most arrangements, the insider also can participate, at least in a limited way, in any upward move their stock may experience. If the companys stock rises by the time the deal is consummated two to five years down the road, the insider typically delivers fewer shares to the investment bank, with the insider then keeping or cashing in the rest.
Whos doing it
Other companies where stealthy insider hedges were put in place in the past few months -- meaning the trades werent reported by MSN Money, Yahoo, Vickers Weekly Insider or Insider Consulting Services -- include the following two standouts. (Details on the hedges were supplied by Thompson Financials Lancer Analytics and Camelback Research Alliance, perhaps the only insider tracking services aggressively hunting down these transactions right now.)- Insiders at Krispy Kreme Doughnuts (KKD, news, msgs) used derivatives to hedge away risk on an impressive 1.6 million shares for proceeds worth $48.8 million on Oct. 2 last year. None of the hedging was picked up by MSN Money, Yahoo!, Vickers Insider Weekly or other paid services. Like all companies mentioned here (unless otherwise noted), Krispy Kreme declined to respond to questions about the transactions.
Much of the hedging, or 1 million shares' worth, was done by a trust linked to John McAleer, Krispy Kreme's vice chairman. Meantime, many of the other Krispy Kreme hedges were put on by beneficial owners, or people who hold enough stock technically to be considered insiders even though they dont actively participate in management. (This suggests they know less about whats going on at the company.) Krispy Kreme stock is now at about $33, down from its all-time high of $45.75 in December 2001.
- FelCor Lodging Trust (FCH, news, msgs) CEO Thomas Corcoran used derivatives to hedge against risk in 219,125 shares of his companys stock on Feb. 13 and 14, for proceeds of $1.8 million. The deals were not picked up by MSN Money, Yahoo!, Vickers Insider Weekly or other paid services.
Two weeks after these hedges were in place, Moodys downgraded the hotel real estate investment trusts preferred stock rating to B3, from B2. Trading at $6.20 recently, the stock has fallen 7% from the closing prices on the days Corcoran put on the hedges. Investors cant say they didnt have fair warning. Prudential Securities cut the stock to a hold rating on Feb. 7.
Whats wrong with the system
Its important to keep in mind that insiders who hedge away risk with derivatives that slip under the radar arent doing anything illegal. Instead, investors are missing out on following the moves for a fairly mundane reason. They get lost in the paperwork.
In part because the use of hedging is relatively rare -- though it is picking up rapidly -- insider tracking services ignore the parts of the forms (Form 4s) where these hedges are reported. In a way, this makes sense, given the deluge of insider forms that are filed every day -- around 1,100 per day on average last year. Details of the hedges can also get buried in footnotes. And theres not standardized coding that makes them obvious.
Believe it or not, another problem is that the SEC doesnt make insiders report transactions electronically, the way all other important filings get delivered. That may change by the end of the summer because of federal legislation. In the meantime, the shortcoming makes it harder for insider-tracking firms to electronically search the mountain of insider filings for key words that would tip them off about hedges.
Motives for hedging instead of selling
All this raises an interesting question. Do insiders turn to hedges in part because they know many investors will miss them?
Certainly, some analysts suspect the ability to keep negative insider sentiment off the radar screen is at least part of the reason these hedges are used. These wont be publicized because most of the wire services are not going to catch them, says Lon Gerber of the Lancer Analytics division of Thompson Financial. It took us a while to develop the process to find these.
But the specialists who help design the hedges, like Robert McLaughlin of Kirkpatrick & Lockhart, a New York law firm, insist that secrecy has nothing to do with the practice. Indeed, even if theyre hard to find, these transactions are filed publicly. And in any event, there are other compelling attractions to hedging arrangements. Among them:- Executives get to keep voting rights in the shares they bargain away, notes Carr Bettis of Camelback Research Alliance.
- Executives get the money up front but dont have to pay taxes until later.
The money is treated as a loan, so the tax implications come when the deal is settled, says Kensey Nash (KNSY, news, msgs) CEO Joseph Kaufmann. He used prepaid forward hedges in January to raise money to pay off a company loan but still participate in upside for his stock.
Getting more popular
If youre not aware of these insider hedges, are you really missing out on crucial information? A short answer might be "no," since the transactions have been relatively rare. The relative scarcity of these transactions, however, is scant consolation if they happen at a company you own and you dont notice them.
Meanwhile, their popularity is growing, at least in percentage terms. In 2001, about 50 of these transactions took place, says Thompson Financials Gerber. Last year, that jumped 60% to 80 transactions. So far this year, there have been 13 of them at companies including Quest Software (QSFT, news, msgs), Kensey Nash and Meredith (MDP, news, msgs). Quest Software says the company's president, David Doyle, used hedging for the tax advantages, and that the hedges were part of an automatic "selling" program. The hedges at Quest Software and Kensey Nash were widely reported. The hedge at Meredith was not.
Anecdotally at least, insider hedges have been a useful signal of sharp declines around the corner.
Acxiom (ACXM, news, msgs) Chairman Charles Morgan used hedges to protect against downside in 150,000 shares of his company last Sept. 12. He took proceeds of $2 million in a transaction that was not picked up by the popular insider tracking services. Since then, his companys stock has fallen 20% to around $15, from about $19. The S&P 500 is down about 10% in the same time frame.
On the other hand, Apollo Group (APOL, news, msgs) Chairman John Sperling hedged against declines in 370,000 of his companys shares last April 26. Since then, his companys stock has appreciated around 30% while the S&P 500 has depreciated by about the same amount.
Bottom line: Only now is enough data emerging to run statistical tests to determine whether these kinds of hedges offer stronger sell signals than the outright sale of stock, notes Camelbacks Bettis.
However, studies by Bettis on other stealth insider tools popular in the past -- like zero cost collars that use a combination of puts and calls to hedge away downside risk -- concluded they werent any more valuable than outright sales in predicting stock price declines.
How to find the hedges
Still, you can be fairly sure that the hedges getting used today are pretty much like an outright sale in that they suggest an insider might think downside is on the way. So theyre useful to know about.
If you want to find them for stocks you own, the best way is to go to the SECs database and look for Form 4s. Then start digging. Typically you will see a table that has footnotes describing the hedging transaction. The language is a bit dense, but you can get the gist of it pretty easily.
It's worth trying to figure out. While insiders may be selling to raise money or to diversify their holdings, the sales also may signal stock declines ahead. And that's a signal you don't want to miss.
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