Is Transaction Code J Hiding Insider Trading?

A recent study (“Insider Trading by Other Means”) published in the Harvard Business Review finds fault with the use of code J when reporting transactions on Form 4.

Background – What Are Transaction Codes?

A transaction code must be associated with any transactions reported on Forms 4 and 5. This code is critical; it communicates the nature of the transaction to readers of the forms.

All the transaction codes that can be used are pre-defined by the SEC; you can’t make up your own codes. Here are a few examples:

• Code A is used to report grants of equity awards that are exempt under Rule 16b-3.
• Code M is used to report exercises of stock options or other conversions of derivative securities (e.g., vesting of RSU awards) that are exempt under Rule 16b-3.
• Code F is used to report shares withheld or surrendered in payment of tax withholding or option exercises.
• Code G is used to report gifts of stock either to or from the insider.
• Code P is for purchases of stock (on the open market or in private transactions).
• Code S is for sales of stock (on the open market or in private transactions).

The SEC has defined 20 transaction codes in total. As you can see from the examples above, each code provides important context about the transaction being reported, including the type of transaction, whether the transaction occurs under the umbrella of a compensation program, whether the transaction is exempt from the short-swing profits recovery provisions, and even the rule that the transaction is exempt under.

You can find the full list of codes in the instructions to Form 4 and Form 5.

What If a Transaction Doesn’t Have a Code?

Sometimes insiders engage in transactions that the SEC didn’t think of when it defined the transaction codes. This is where code J comes in. Code J is sort of a catch-all code that can be used if there isn’t an appropriate code for a transaction.

One thing about using code J is that it doesn’t provide the context that the other codes do. It doesn’t indicate the nature of the transaction or even whether it is exempt from the short-swing profits recovery provision. For this reason, when transaction code J is used, the SEC requires a footnote explanation that describes the transaction.

Is Code J Being Used Inappropriately?

Maybe. The authors of a study published in the Harvard Business Review certainly think so. In the introduction to their paper, they write the following:

For more than thirty years, perhaps the most prevalent strategy for insider trading has gone undetected and unaddressed. This Article uncovers the techniques by which executives and directors sell overvalued stock worth more than $100 billion per year, shifting losses to ordinary investors. The basic idea is that insiders conceal their suspicious trades by publicly reporting them (as they are required to do) in ways that confuse or discourage investigators.

The authors compiled a database of substantially all insider dispositions of common stock since 1991 that were reported using transaction code J (180,970 transactions involving $3.4 trillion in value) and concluded that, on average, these transactions yielded significant “abnormal profits” (or avoided losses), suggesting that J-coded transactions are often timed to precede announcements of negative news and declines in the issuer’s stock price.

The article questions the appropriateness of code J in a variety of contexts, whether permitted by the Section 16 rules or not, saying that code J is used as a subterfuge for suspicious trading:

We find that insiders who trade using the subterfuges we describe outperform the market by up to 20% on average.

Even where code J is appropriate, the authors note that prosecutors, regulators, and others overlook J-coded transactions and fail to investigate them for possible insider trading:

Prosecutors, plaintiffs, journalists, and scholars all overlook J-coded transactions. Almost no transaction marked “other” has ever led to adverse consequences, nor has anyone ever been punished for wrongly using the J code.

The authors find several categories of “opportunistic coding” that create opportunities for subterfuge:

• Miscoding: Fraudulently using code J without any legal basis, such as by reporting sales under a 10b5-1 plan or in private transactions using code J rather than code S.
• Trade Laundering: Using code J when legally permitted but only after structuring the transaction to allow someone else to sell the shares without having to report them, such as when an investment fund distributes portfolio securities to its investors.
• Transactions with the Corporation and Forced Sales: These are transactions in which code J may be legal and appropriate, but the use of code J may enable opportunely timed or otherwise suspicious transactions to avoid investor and regulator scrutiny that might normally be applied to S-coded transactions.

A Call for SEC Enforcement

The article is focused on ferreting out true insider trading, not Section 16 reporting compliance, but the authors call on the SEC to bring Section 16(a) enforcement actions against insiders who miscode or fail to include an explanatory footnote when reporting transactions with code J, and also recommend that the SEC treat miscoding as a 10b-5 violation where it conceals that the insider is dumping stock.

The authors also urge the SEC to adopt new transaction codes for certain transactions they found to raise insider trading concerns, most notably fund distributions of portfolio securities, and transactions involving loans, options, and forward sales.

The authors have a track record of success in getting the SEC to consider reforms. As Liz Dunshee explains in a blog for TheCorporateCounsel.net, a  Bloomberg article reports that this paper isn’t the group’s first foray into insider trading analytics: their earlier research on “insider giving” was cited in the  SEC’s 2022 rule changes on insider trading and Rule 10b5-1 plans and supported the Commission’s decision to require insiders to report gifts on Form 4 within two business days.

Should You Stop Using Code J?

I don’t think that’s the take-away for the study. The fact is that sometimes there is no appropriate code and transactions must be reported using code J. Here are my recommendations:

• If there is a more appropriate code than code J, use the more appropriate code. Only use code J when there isn’t another code that is applicable to the transaction.
• When using code J, include the required footnote to describe the transaction.
• Know what the transaction codes are and how they are used.

When in doubt, Romeo & Dye’s Forms and Filing Handbook (available only at Section16.net) is a lifesaver. With over 240 model forms illustrating the appropriate way to report well over that number of transactions (many model forms include two or more transactions), this resource can tell you what transaction code to use for whatever transactions your insiders can think up. The Handbook even gets a shout-out by the study’s authors:

Romeo and Dye’s two-volume handbook offers more than 1000 pages of practical guidance, focused just on the details of how to fill out the one-page Form-4 and its peers. Romeo and Dye also publish a treatise on Section 16 law, more generally.