Friday, September 16, 2005

The Same Refrain: Insider Trading By Company Employees

This is one we've heard before, yet somehow it just keeps happening.  The SEC sued four employees of Cryolife, Inc., and two of their spouses, for selling shares in the company immediately before a product recall.  Cryolife sells implantable human tissue, and the FDA ordered a nationwide recall of the company's product.  Before the news became public, the defendants sold their shares, avoiding a loss of approximately $136,000 when the stock dropped from $9.46 to $2.03.  The SEC Litigation Release (here) discusses the case, which the defendant's settled by paying disgorgement and a one-time penalty.

Bruce Carton on the Securities Litigation Watch blog has an interesting post (here) imploring employees of company's whose shares are publicly traded to avoid the insider trading temptation -- one that the Cryolife employees could not resist -- if they think they will get away with it.  Bruce writes:

I saw it when I was at the SEC and I've seen it regularly ever since:  SEC enforcement actions against employees of publicly-traded companies who get advance notice of earnings news or other big news concerning their companies and buy/sell the company's stock prior to the announcement of that news.   Of course, that practice is called "insider trading" and it is against the law.  As I hope to persuade you below, it is also called "incredibly stupid."  Seriously, people, we're talking about Darwin Award-level stupidity here. 

I would add one more item to Bruce's list of reasons why it's difficult to get away with insider trading, at least on any significant scale.  One of the best ways to make a "big score" on inside information is to trade in options, particularly the out-of-the-money kind that are especially cheap.  Once the news hits, either positive or negative, the upside can be enormous.  The recent SEC case involving highly suspicious trading in Reebok stock options the day before the announcement of the Adidas takeover is a good example of how the leverage from options trading can produce large profits.  If you trade options, however, you will be noticed by the options market-makers.  Unlike stock trading, in which firms usually sell shares out of their inventory, stock options are written by firms that make a market in the securities by writing calls and puts.  Like a Las Vegas sports book (and no criticism is meant by the comparison), the market makers seek equilibrium, a match between those buying and selling the options, and they will hedge their position to limit the potential exposure.  When a sudden burst of buying (or selling) catches them in an exposed position, that money comes straight out of the firm's capital, and they will raise the roof if the transactions look suspicious.  Both the exchanges and the SEC pay attention to the complaints of options market makers because they have a very expensive ring-side seat for insider trading.  The big money may be in options, but that money comes from someone whose livelihood may be seriously affected by the transactions.  And, they know who you are. (ph)

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