by Ethan Roberts | November 20, 2013 7:57 am
Most investors don’t pay too much attention to the legal circuit, but in this case, they should. An important lawsuit with far-reaching implications for future insider trading rules is now slated for trial in early 2014.
The suit, brought about by shareholders of communications equipment maker Novatel Wireless (NVTL), alleges that in early 2007, Novatel executives withheld negative news from the general public and stockholders that likely would have damaged their company’s stock price. The suit further alleges that then, armed with this knowledge, insiders fraudulently continued to make positive statements about the company, leading the stock price higher, before selling their shares at a huge profit a few months later.
In January 2007, former Novatel COE George Weinert emailed company managers to warn them that Sprint (S) — one of its largest customers — planned to cancel scheduled orders, and that it would “have a major impact” upon Novatel’s business.
However, the suit alleges that this news was not made public for many months, while various company executives continued to speak positively about the company, propelling the stock higher. Novatel reported in May 2007 that its quarterly earnings would beat expectations and show “strong sales,” yet across the early months of summer, CEO Weinert sold $3.3 million worth of NVTL shares.
If that doesn’t make any sense to you, you’re not alone.
It was shortly after this sale that an analyst discovered the story while interviewing a Sprint executive, and released it publicly. Only after this — months later, in fact — did Novatel admit that there would be some lost sales. The negative impact on the stock price was huge.
As you can see from the accompanying chart, NVTL — which had traded between $10 and $13 early in 2007, then blasted its way up over $28 by mid-July — began to sink. By the end of 2007, the stock was down to $16.20. Six years later, NVTL has fallen on hard times and now trades at a paltry $2 per share.
Novatel’s defense to the lawsuit thus far has been to say that the lost business to Sprint was immaterial — that insider stock sales were made for other reasons. They maintain that company executives had preset trading plans that met all legal requirements.
If these corporate insider sales were truly “preset” ( i.e. automatic presales) as stated, then there might be no “smoking gun” here, because the sale dates would have been set up long before the company learned they were going to lose sales from a key customer. In such case, the fact that NVTL was higher at the time of the sales, although beneficial to the insiders, would be simply coincidental.
Another perfectly legal reason for the sale could have been that it was simply prudent to take profits after the stock had run up so much during the preceding five to six months. Company insiders — and for that matter, astute traders — do that routinely all the time.
However, it’s also possible that, knowing they had automatic sales upcoming in a few months, the executives purposely chose to keep the loss of Sprint’s business hidden so as not to depress the stock price. If there is any merit to that, Novatel could lose this lawsuit because, automatic sales or not, their actions could be perceived by the court to be fraudulent.
Depending on how the court rules, this trial could set the tone for future insider trading regulations going forward. But is any change really necessary?
Whenever there is insider buying or selling around the time that important company news is released, there will always be suspicions of insider knowledge. But the insinuation begs the question — when exactly are company insiders supposed to buy or sell their own stock?
People cry foul about the timing of insider transactions, but seldom offer any guidance as to when it would be reasonable for insiders to buy or sell.
In fact, there is always some news, good or bad coming out about a publicly traded company. There are dividend announcements, earnings reports, product launches, analyst upgrades/downgrades, M&A rumors, changing of CEOs/CFOs … you get the point.
Given that it seems like any time an insider buys or sells company stock, there’s something going on, it could be seen as illegal insider trading.
More importantly, if the Security Exchange Commission were to limit all insider transactions to automatic buys and sells with well-established preset dates, insiders still could withhold information at any time so as to artificially boost or reduce the stock price, whichever would benefit them more.
Some people maintain that all insider buys and sells should be illegal, but if that were to become law, publicly traded companies would be at a distinct disadvantage. The ability to buy and sell stock and stock options is one of the main benefits these companies have to offer prospective executives. Without these benefits, they might not be able to get the best people to work for them, or would have to pay them much higher salaries and other benefits.
For that reason, insider transactions need to remain legal, and I believe the regulations now in place are more than adequate.
But in the case of Novatel, if the court finds that they purposely misled the public to boost the stock price, then that activity should be punished by whatever means the court possesses.
As of this writing, Ethan Roberts did not hold a position in any of the aforementioned securities.
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