Insider Selling Means Something, Just Not What You Think

Includes: GLUU
by: Keith Burtscher

There are many, many articles and comments on articles on Seeking Alpha trying to divine what high ranking company officials may be thinking and doing in regards to their company's stock price and their own holdings in the company stock. One commonly held opinion is that executives are sometimes like rats on a sinking ship and we should watch what they are doing and emulate them.

In his article on GLu Mobile (NASDAQ:GLUU) "Glu Mobile: 4 Insiders Have Sold Shares This Year", Markus Aarnio stated that 10b5-1 trading plans can be used by insiders to dump stock using inside information:

"For example, a CEO of a company could call a broker on January 1 and enter into a plan to sell a particular quantity of shares of his company's stock on March 1, find out terrible news about his company on February 1 that will not become public until April 1, and then go forward with the March 1 sale anyway, saving himself from losing money when the bad news becomes public. Under the terms of Rule 10b5-1(b) this is insider trading because the CEO "was aware" of the inside information when he made the trade. But he can assert an affirmative defense under Rule 10b5-1(c), because he planned the trade before he learned the inside information."

So the implication here is that anytime an insider goes ahead with a 10b5-1 sale he may have terrible news about the company and so let a preplanned trade proceed. This is pretty clearly accusing GLU insiders of insider trading, exploiting a loophole in the regulations. What I think the investing public doesn't understand is that senior level management is a very risk averse bunch when it comes to their own money. An acquaintance of mine who works in private equity once told me that his personal investments are in very low risk areas because "I'm leveraged enough to high risk through my job". That encapsulates succinctly the attitude of those that have taken the high, established road to the top. One result of going to MBA school is that graduates are trained to look for the sure thing, especially when it comes to their own money. As a result stock option plans, which are intended to align the interests of management and shareholders, are actually viewed by executives as just another form of compensation, with risks that they try to mitigate.

A very wise woman once told me this on the subject of stock options - "You sell as much stock as they'll let you, as fast as they'll let you". She was a securities attorney and her husband had been a CFO of several ever larger publicly traded companies. One crashed and burned after a big run up in the stock during the Dot Com era and another was acquired at a big premium. It didn't matter what the eventual outcome was, their program was to sell the same amount each and every month, and they got very rich that way. She also said that when they exercised an option grant they always immediately sold at least enough to pay the taxes.

Most people not living in that marvelous world don't realize that once options "vest" the recipient gets to decide when to exercise the options. Mostly what happens is that they exercise and sell at least a portion instantaneously so as to cover the taxes and the money needed to buy the remaining options. Then they sell those over a period of time, in a preplanned 10b5-1 program. This is an established modus operandi for executives and is a kind of reverse dollar cost averaging. As I said before these people are actually pretty risk averse, they want a kind of automatic system for harvesting an optimal amount from their stock options, and they can't trade on inside information, so this kind of a plan works best for them.

Another aspect to stock options is that the higher the stock price goes the more equity the holder of the options has. So you can imagine what happens in the MBA-trained brain of the insider: they are calculated the residual value of all their options and as the stock price increases, then comparing this as a percentage of their total net worth. The higher the figure, louder and louder alarm bells go off with the warning "Diversify, Diversify!". So they exercise and sell, and give the proceeds to some lucky financial advisor to invest for them in very safe securities.

A completely different kind of beast is the founder/owner. They don't follow those rules for the following reasons:

1) They own a substantial stake in the company. There is a massive difference in owning shares versus having vested or unvested stock options. Whereas the high ranking employees with options would have to come up with money to exercise, the founder(s) owns their shares as a result of establishing the company and their cost basis is basically zero. So there is no burning need to dispose of shares unless money is needed for lifestyle enhancements.

2) Founders are risk takers, definitely not looking for the sure thing. An example of this would be Mark Zuckerberg turning down $1 billion for Facebook (NASDAQ:FB) early on. He would have walked away with $300-400 million for a year's work.

3) Founders will occasionally speculate in their own stock, and have difficulty being dispassionate about the company they brought into the world. Aubrey McClendon, the founder and CEO of Chesapeake Energy (NYSE:CHK) believed so intensely in Chesapeake's prospects that during the financial crisis he bought CHK stock on margin. He got hit with one of the biggest margin calls ever and lost most of his fortune.

Ultimately, founders are owners and sometimes speculators/investors - but high ranking employees, officers and directors are just very well paid hired hands, in spite of the efforts of compensation committees. As much as compensation is structured to make high ranking employees have skin in the game, the very same employees use established tactics to minimize the risks to their financial position from the change in fortunes of the company and its stock price. For the most part reading anything into insider sales is about as accurate as reading tea leaves, though I guess it is lucrative for the many websites that monitor them.

Disclosure: I am long GLUU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.