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For a financial advisor, keeping up with the news is only part of the job. Helping clients separate a meaningful development from a misleading headline is another part. Time and time again, headlines come up about a company insider executing a large sale, and clients ask whether they should be concerned. Knowing how to read the underlying SEC Form 4 filing can help an advisor explain to a client what happened and put the headline in context.
These filings can also supplement company research, but not every transaction deserves the same weight. This article walks through the explanations and transaction codes that can help an advisor separate routine activity from trades worth investigating further.
Navigating the SEC’s Edgar
All disclosed insider trading activity is on the SEC’s EDGAR search page and categorized under Form 4. This page includes every type of filing a publicly traded company is required to make. Users can narrow it down to the insider trading reports by selecting “Insider equity awards, transactions, and ownership” in the “Filing category” drop-down menu; then selecting “Insider trading report” from under the “Form” option in the “Refine search results by” box on the left side of the page. These filters show filings for trades that changed the share holdings of executives, directors, and stakeholders with more than a 10% share in their company, with the maximum legal delay from trade to Form 4 filing being two business days.
It may sound like a gold mine to have a page full of official insider trading data, but the commonality between the SEC’s filing archives and physical gold mines is that they require a lot of blasting, sifting, and digging to find gold. In this article, I discuss how to separate what is certainly fool’s gold from what deserves a closer look in the mine of SEC filings.
Pay Attention to Explanations
The very first thing to look at in a Form 4 filing isn’t the company, the insider’s title, or even the number of shares involved in the transaction. It’s whether there is green text in the “Explanation of Responses” section near the bottom of every filing. The explanations are surprisingly helpful when deciding whether a filing supports a particular hypothesis, but there are still a few more spots to check on a Form 4 before determining how much it should impact that hypothesis.
Anything can be written in the Explanation of Responses section, but there are several common explanations that an advisor should know if they want to be able to review filings efficiently. A common explanation for transactions is a Rule 10b5-1 trade, which can apply to either buys or sells. These transactions, like this one from an Apple insider, are arranged at least 90 days ahead of the transaction date, but no longer than 120 days after the 10b5-1 filing date for employee insiders. The SEC offers these planned transactions to provide an affirmative defense to insider trading liability. Covering tax liabilities is another common reason why insiders sell shares, and there is an example of that in this American Airlines filing, where the green explanation text includes “the proceeds from the transaction are being used to help satisfy tax obligations.”
Other common explanations include dividend reinvestment programs (often tagged as DRIP) like this filing for Texas Instruments, and shares acquired through the Employee Stock Purchase Plan (frequently abbreviated to ESPP) like this one for Taiwan Semiconductor. Another thing to note about the Texas Instruments filing is that the amount of shares was fractional, and sometimes these filings might not even be for an entire share!
Clearly, the “Explanation of Responses” field can uncover some of the mystery behind insider trading forms, but another field can help an advisor determine how much weight an insider’s trade should lend to a bearish or bullish hypothesis.
Derivatives Have Their Own Rules & Requirements
Placed above the explanations is “Table I – Non-Derivative Securities,” which contains field 3, “Transaction Code.” First, check for whether the transaction was filed under Code M. If so, that would mean the trade was the result of derivative conversion, such as an option contract or a Restricted Stock Unit (RSU) acquired through the client’s compensation package. RSUs have a vesting date tied to continued employment, so the insider needs to remain with the company through that date for the RSUs to convert to common shares.
Stock options, however, have a vesting date for when an insider is allowed to exercise them. After the option is vested, the exercise date of the option is at the insider’s discretion. The “Explanation of Responses” field often mentions key words like “option,” “exercise,” and “RSU,” which provide clues about the details of the derivative-based transaction. Derivative transactions not related to a compensation package are filed under Code X.
Compensation-based derivative transactions from Code M transactions need to be kept in mind when looking for telling sell-side transactions. Often, the insider wants to cash out once their derivatives take effect, and this requires a new line to document the transaction on Form 4 with Code S in field 3.
An example of this transaction pattern can be seen in this filing about $260,000,000 of shares sold by World Wrestling Entertainment CEO Vince McMahon. It’s a rookie prospector’s mistake to focus solely on a single transaction listed in the form and use it to add outsized weight to their bearish thesis, especially when it was done by the CEO. Each reported transaction needs to be taken into consideration when interpreting Form 4 activity.
Private Transactions Are Very Informative
This article outlines key things to look for in a Form 4 filing to weigh whether the trade reflects well-informed timing. But what truly qualifies a trade as involving personal financial risk and reward to an insider? Transaction Code P indicates an open market/private purchase and is what an advisor should look for to discover occasions when an insider has risked their own cash to increase their shareholdings of the company they work for.
For example, in this filing, a director of Cognizant selected Code P to indicate a 100% increase in shareholding size, as calculated by comparing Table I, field 5, “Amount of Securities Beneficially Owned Following Reported Transaction(s)” with the number of shares listed in field 4 to its left.
There are several spots to check on a Form 4 before giving it more weight than it warrants relative to a bullish or bearish hypothesis. The glimmer of insider trading transactions fades when they’re pre-planned under Rule 10b5-1. When the trade is done through Code M–vested derivatives, the acquisition of shares is a lot less noteworthy than a Code P open market purchase that involves personal financial risk/reward for the insider.
In the case of a Code P transaction, any disposal of shares alongside a derivative-based transaction may very well be routine profit taking instead of a telling insider liquidation event. Share acquisitions through the Employee Stock Purchase Plan or Dividend Reinvestments are also routine, timed transactions that are not very significant from an insider trading perspective. These categories are all color-coded to simplify insider trading research at the site InsiderTradeAlerts.
Understanding the underlying mechanics of the SEC Form 4 transaction allows an advisor to explain to their clients with confidence whether a reported insider trade adds meaningful weight to a market hypothesis. Understanding the transaction codes and explanations section can help the advisor avoid reading too much into routine activity, while identifying transactions that deserve a closer look. Used alongside company fundamentals, technicals, and broader market information, insider trading filings support a more informed conversation and provide a more holistic view of a company.
Chris Babayans has been passionate about computers since troubleshooting his first technical problems on the family computer. This passion carried into higher education and resulted in a bachelor’s degree in information technology. A curiosity about how to turn technology into an edge in the financial market drives his work today.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
