TheCorporateCounsel.net

Here’s a bold statement:

For more than thirty years, one of the most prevalent strategies for insider trading has gone undetected and unaddressed. This Article uncovers the techniques by which executives and directors sell overvalued stock worth more than $100 billion per year, shifting losses to ordinary investors. The basic idea is that insiders conceal their suspicious trades by publicly reporting them (as they are required to do) in ways that confuse or discourage investigators.

We develop a taxonomy of concealment strategies, complete with suggestive examples. We then empirically test our taxonomy using a database of essentially all stock trades since 1992. We find that insiders who trade using the subterfuges we describe outperform the market by up to 20% on average.

Worse yet, we find evidence that this simple subterfuge works. Essentially no one has ever been prosecuted for undertaking one of these suspicious trades. Nor do journalists or scholars seem to appreciate them. Accordingly, we call for scholars and prosecutors to cast a wider net in their studies and market surveillance, then discuss implications for the design of insider-trading reporting requirements and related legal rules.

That’s the abstract from “Insider Trading by Other Means,” a new 66-page research paper by Sureyya Burcu Avci, Cindy A. Schipani, H. Nejat Seyhun and Andrew Verstein, which is published in the Harvard Business Law Review. This Bloomberg article points out that this paper isn’t the group’s first foray into insider trading analytics: their earlier research on “insider giving” was cited in the SEC’s 2022 rule changes on insider trading and Rule 10b5-1 plans and supported the Commission’s decision to require insiders to report gifts on Form 4 within 2 business days.

Now, the authors are taking aim at Form 4 transaction codes. Specifically, “J codes” that are used to report transactions that don’t fall into any other transaction code category. They are calling for action – and it’s fair to think the SEC Enforcement Division will listen, given its focus on insider trading and fondness for data analytics (and according to a 2004 blog from Alan on Section16.net, they’ve investigated transaction codes before). Here’s an excerpt:

[I]nvestigators have been unduly passive with respect to insider trading proxies. Code J is a strong signal that insider trading may be underway. Investigators should, at the very least, treat suspicious J transactions as worthy of inquiry. Indeed, they should probably go further and prioritize J-coded transactions more aggressively than ordinary S transactions.

This recommendation is even stronger where the filing bears other worrying marks. J transactions are required to include an explanatory footnote. Filings that lack an explanation, or which use the wrong transaction code, are out of compliance with the law. Transactions with the issuer, or distributions from investment funds, may appear to be benign, but our tests indicate that these are especially likely to be suspiciously timed. Accordingly, investigators should take these keywords to be informative proxies.

Most centrally of all, investigators should take late-filed J-coded transactions to be highly suspicious. Our findings indicated intense abnormal returns with J-coded transactions are reported long after the transaction took place. In most cases, these transactions are already improper, and worthy of investigation for that reason. But even if delayed filing is sometimes justified, the overall trend remains strong. Investigators should scrutinize even lawfully delayed J-coded transactions because such transactions are strongly associated with abnormal profits.

Likewise, investigators should examine more closely the transactions between insiders and their corporations. We found that J-coded transactions discussing SEC Rule 16b-3 were suspiciously well timed, despite the SEC’s view that these transactions are often benign. Plainly, the story is more complicated.

When scrutiny unearths false or deceptive Form 4 filings, prosecutors should take aggressive action.

Despite the findings, my own experience is that the vast majority of folks are truly attempting to correctly report transactions under a complex Section 16 regulatory regime. So, how do we stay out of the crosshairs? The authors note that this is an area where “the law abides partially in the craft wisdom about what is commonplace and acceptable” – but they mention a great resource:

Romeo and Dye’s two-volume handbook offers more than 1000 pages of practical guidance, focused just on the details of how to fill out the one-page Form-4 and its peers. Romeo and Dye also publish a treatise on Section 16 law, more generally.

Forgive me for including a shameless plug, but I have to admit I would struggle in my day job if I didn’t have access to Peter and Alan’s vast array of accumulated wisdom. If you aren’t already a member of Section16.net, you should sign up. And more urgently, make sure to catch the star himself, Alan Dye, at our “Proxy Disclosure & 21st Annual Executive Compensation Conferences,” October 14th and 15th! We have an awesome agenda filled with expert practitioners who will share their insights. Alan, Dave, John, Meredith and I love this community and we are very eager to see as many folks as possible in person in San Francisco! Register and book your hotel room today, if you haven’t already done so. Virtual attendance is also still an option if you’re not able to join the party in person!

– Liz Dunshee