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Steering Clear of Illegal Trading Practices
A woman participating on BetterInvesting’s Investing Discussion List recently said that during a club meeting, she mentioned that her brother worked for a company the club held in its portfolio. She wondered whether this constituted insider information even if nothing else was shared.
Martha Stewart’s time in jail brought to the forefront the topic of illegal insider trading. Fortunately, in almost every circumstance, investment clubs won’t have to worry about violating the Securities Exchange Act of 1934.
Sections 16(b) and 10(b) of this act directly address insider trading. Section 16(b) applies only to directors or officers of the corporation and those holding greater than 10 percent of the stock. Most investment club partners won’t meet this criteria. Section 10(b) is the more far-reaching section and is more likely to apply to investment club members in limited circumstances.
Section 10(b) states, “To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act), any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” The federal Securities and Exchange Commission also adopted Rule 10b-5, which adds anti-fraud provisions that leave a lot of room for interpretation. A few examples of cases the SEC has successfully filed concern:
• Employees who traded their corporation’s securities after learning of confidential corporate information.
• Friends, business associates, family members and others who traded securities after receiving such information.
So when the club member asked about insider trading, there’s some validation for being cautious. When trading the stock of corporations to which you or your partners (and friends or relatives) are privy to insider information, it’s best to investigate whether the information shared is something readily available to the general public. If the information shared was from a newspaper, on the corporation’s website or other public media outlet, it isn’t considered insider information.
On the other hand, if you buy or sell the stock based on information shared that isn’t available to the public at large, it would likely be considered illegal insider trading. Maintain records of every Stock Selection Guide, Portfolio Evaluation Review Technique report and any other consideration your club used to determine trade actions of the stock in question. That way, if your club is ever accused of trading on insider information, you have documentation to prove otherwise.
A Good Problem to Have
from BetterInvesting’s Investing Discussion List in February
Annette Mohs: Our club (Outwest Investment Club of Las Vegas) has survived 10 years with between six and eight members, and though we had a rough first four years, we have improved greatly and surprised ourselves with our strict rules of trading and prospered during this recession.
We have never had more than one person interested in joining and have been desperately looking to increase membership the last few years. All of a sudden we have six great candidates interested but are scared that adding this many will be detrimental and wonder how we should manage this many new members.
Henri Russell: I can see your concern. I think six to eight members is a good number at a meeting. More than that seems to cause more visiting, more talking at once. However, having more has its advantages, too — more money to invest, more brains to contribute, more people to do research, etc.
But I would be leery of adding six new members at one time. You might talk among yourselves and decide on a particular limit to membership. (If they are all excellent candidates, however, there may be no problem.)
Our club has seven members at the moment and we have a limit of 12 total members, but we would really like to limit it to 10. We are very selective on new members. We want to make sure that they are really interested and will contribute and will have the same mind-set — i.e., the way we research stocks before buying, not buying on the news of some TV station or next-door neighbor, etc.
You might give them a three-meeting trial before you vote them into the club. Make sure they are committed. Don’t remind them of the meetings; make sure they are committed to attending the meetings without prodding. Expect them to contribute a stock study and contribute at the meeting.
Lynn Ostrem: Oh, man. I saw this message come through and I shook my head. This is a terrific and terrible predicament to be in, all at the same time.
In my mentoring class, I talk about a past club where we doubled our membership over a two-month period. We didn’t have a good plan in place to deal with the training, ongoing mentoring and personality snafus that would eventually overwhelm the club and, ultimately, cause its demise.
So in 2007, when the Crow River club found itself in the same situation, I felt that the maturity of the club and the experience we had developed, plus the time and effort we had put into our training and mentoring program, would give us a different outcome. It didn’t. It was a disaster! And I teach this stuff!
The problem is two-fold. First, people tend to gravitate to the members in the club that do the least amount of work. If you don’t train them in properly, keep their enthusiasm up and make the learning fun early on, they tend to fade into the crowd. Then, instead of having one or two slackers in the club, you have half a club full. And it’s not necessarily because people don’t want to pull their weight; they simply didn’t get enough mentoring in the beginning, so bad habits were set.
The other problem for me, in both of my situations, was a matter of personalities. When you have a group of six to eight people with a certain mind-set, and you bring on one more person, that person will meld into the group. When you have six to eight people and bring on six more, there can be a drastic change in the whole club dynamic. And it can be a real struggle to pull all these new personalities into the fold. That takes the attention off of business as usual, which in turn can cause political issues.
Trying to effectively manage a half-dozen newbies is harder than you think. Even with help from other members, you will burn out trying to stay on top of your duties in the club and making sure they are getting what they need, too.
So for these reasons, I would seriously recommend that you consider assessing the qualities of the prospects, choosing the top two and putting the rest on a waiting list. I wouldn’t waste their time by making them come to three meetings only to put them on hold. When you feel the first two are well-established in the club, bring the rest in one at a time. You will be a much better club for it.
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Colleen Mulder-Seward is a BetterInvesting member and freelance writer.