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Rules still shield insiders who bail out
Sales by higher-ups are a reliable indicator of trouble ahead. But many execs are pocketing profits without tipping off investors -- and the SEC doesn't care.
By Michael Brush
With stocks rising last year after a brutal bear market, many top executives and directors found a way to sell big equity stakes in their companies without anyone noticing. They did so through complicated hedging transactions that flew below the radar of most investor research -- thus depriving many investors of information that may have soured them on those stocks.
I wrote about this hedging practice last year (see "How insiders can unload stocks in secret"). At the time, it seemed like a passing fad. Now it's clear that it wasn't.
Already in 2004, according to required government filings, insiders have rid themselves of exposure to $230 million worth of stock in their own companies by using obscure derivatives. Thats about 2% of insider sales. What's more, the Securities and Exchange Commission is investigating some individuals for failing to report such transactions at all, according to a March report in the Wall Street Journal.
Hedging maneuvers like these are not illegal as long as they are disclosed. As with any other sales of their own company stock, insiders must report such transactions with the SEC. Conveniently for the participants, hedging transactions aren't recorded on the SEC forms in the same user-friendly manner as straightforward stock sales. The transactions are also harder to decipher once they are found.
Insider selling is a sell signal
If the $230 million worth of insider hedging transactions this year had been booked as outright sales, they might have sparked sell-offs in the stocks involved; insider selling is a proven red flag for many sophisticated investors. As it was, the maneuvers passed mostly unnoticed.
The biggest hedges this year have come at Tyson Foods (TSN, news, msgs), Knight Trading Group (NITE, news, msgs) and eResearch Technology (ERES, news, msgs). Insiders at these companies have used derivatives to sell anywhere from $25 million to $30 million worth of stock.
Related news and commentary on MSN Money
Because these hedges were buried in the footnotes of SEC forms, none of them appeared as sales in insider reporting services commonly used by the public. They werent reported by the venerable Vickers Insider Weekly, for example. And you cant find them in the insider sales sections of popular investor Web sites such as Yahoo! (YHOO, news, msgs) and MSN Money. Only Thomson Financial uncovers and reports these hedging transactions. But the hedges arent distributed to the public by Thomson in any of the services it circulates widely for use by individual investors.
Popular among insiders
Here's how the hedges work, reported or not.
Typically, an investment bank will pay an insider up front for a block of shares when the hedge is put on -- but typically 10% to 20% less than the market value at the time. In exchange, the investment bank agrees to accept the shares two to five years later, even if the shares tank. This protects the insider from downside.
Lets say, then, the shares rise. The more they rise, the fewer shares the insider must deliver. In this way, participants enjoy profits on some of the upside for their stock.
Instruments such as these tend to be called prepaid forward contracts because executives are, in effect, being paid in advance for selling the shares forward -- meaning theyre delivered at some point in the future.
Insider experts such as Thomson Financials Lon Gerber suspect many insiders use these hedges at least in part because they dont hit the radar screens of most investors.
But there are plenty of other advantages, including two big ones:- Voting rights. Executives keep voting rights in the shares, even though theyve essentially sold them.
- Tax benefits. Insiders dont have to pay taxes until they deliver the shares years later, because the money they get up front is treated as a loan.
Missed signals
Here's a look at some of the negative stock signals that investors may have missed this year:
Tyson Foods. Investors scanning the reported insider transactions at Vickers Insider Weekly or popular sites like Yahoo! and MSN Money saw about $33.4 million worth of sales by top managers at the meat processor Tyson Foods for the first quarter.
But relying on those results was like buying meat from a butcher with his thumb on the scale.
What investors missed was about 60% of the "sales" by insiders that quarter, once you factor in two moves by top Tyson insiders to hedge away the risk of owning another $49 million worth of stock.
On Feb. 25, or two days after stories began to circulate of bird flu infecting poultry in the United States, Donald Tyson, the retired chairman of the meat and poultry processor, used derivatives to furtively sell off 2 million shares in the company worth some $31 million.
On March 19, board member (and former chairman and CEO) Leland Tollett disposed of 1 million shares through derivatives, a stake worth $18 million at the time. Within weeks, news broke that Standard & Poors may cut Tysons credit rating. Another story surfaced that the SEC was investigating perks offered board members. Tyson Foods had no comment on the insider hedging.
Knight Trading Group. Scan the public databases for insider activity at Knight Trading Group, a market maker in securities, and you see a pretty bright picture. Youll find that insiders bought $5.8 million worth of stock in the first quarter while selling just $1.5 million.
That looks pretty encouraging, but heres what you just missed. On Jan. 26 Director Robert Lazarowitz used a hedge to reduce his exposure to the company by $29 million; the deal involved the sale of 2,024,000 shares or about 40% of his holdings. The stock closed at $14.59 that day and fell to under $12 within weeks. It recently traded for around $13.
eResearch Technology. Steady offloading of shares by insiders at this Philadelphia company added up to around $27 million worth of sales for the first quarter -- at least according to the common insider databases. But unfortunately for investors, that was only half the story at eResearch Technology, which aids pharmaceutical companies in their drug research.
On Feb. 9, CEO Joel Morganroth hedged away exposure to another $25 million worth, or 750,000 shares, in a transaction that you wont see at the popular sources of data for insider activity. The stock closed at $33.14 the day of the hedge. Then it slid 18% over the next seven weeks to $27. It recently moved up to around $30.40. eResearch Technology declined comment on the hedge.
Within the law
Again, none of these insiders did anything illegal by putting these hedges in the footnotes of the disclosure forms used to report sales to the SEC. Its just that transactions reported in this manner escape the attention of most insider reporting services. They often have trouble identifying and understanding the details of the hedges in the footnotes because they are reported in a haphazard manner.
Sometimes they clearly say put or call or option, says Thomson Financials Gerber. Thomson is the only service that picks up and reports on these transactions. But a lot of times you have to read the footnotes because it is not clear. You have to do more digging.
Digging through the SEC database on their own, investors would have trouble finding them, as well. They would have to wade through the footnotes of thousands of forms each week, which is why investors rely on the popular insider databases to begin with.
Fact is, there is a simple fix to the issue. The SEC could simply require insiders to categorize their hedges and report them with a uniform code that would be easy to spot, just like with other insider transactions.
But dont expect any help from the SEC on this one soon. Last week, the commission said it has no plans to streamline this reporting. There is a cost associated with collecting that data, says Gerber. It would be easier if there were a simple code. That would make it a lot easier.
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