August 5, 2005
Insider Trading Plans: Rule 10b5-1
Senior executive managers who want to buy and sell stock in their own companies call their lawyers. They know that if they hold non-public material information, any transaction completed by them is illegal insider trading. But what are the boundaries of the rule? Pushing up to and not over the boundaries can mean significant profits. Lawyers, put on the spot, chaffed at the risk of giving incorrect advice. Practices developed to miminize risk. "Do not buy or sell in the weeks before the filing of a quarterly report but buy or sell within two weeks of its disclosure."
In 2000 the SEC, responding to pressure from lawyers to provide "safe-harbors" promulgated Rule 10b5-1. Under the rule executives could be in place a "plan" for buying or selling shares that created a schedule of automatic transactions, enabling the executive to trade even though, at the time of any one trade, the executive had non-public material inside information in her possession. The rule makes sense -- in theory.
In practice, the rule has three loop-holes that enable abuse. First, the SEC has developed a custom of allowing an insider to stop sales under the plan if an executive is sitting on good news. This is an overly rigid application of the "abstain or disclose" mantra. A sensible reading of Rule 10b-5 would prohibit the conduct, as a decision not to close a planned sale is still "in connection with the purchase or sale" under the language of the Rule. The requirement should not be confused with the actual purchase or sale requirement for plaintiff standing under Rule 10b-5, articulated in the Blue Chip Stamps case. Second, executives can time the release of postive and negative news to pre-date purchases or sales scheduled in the plan. This ought to be illegal market manipulation. And third, an executive can create such plans with superior information on a companies long-run prospects. The information may not be definitive enough or private enough to be "non-public" or "material." This is legal but the SEC should require that the plans themselves be made public. Currently only the actuals purchases or sales under the plan, disclosed within two days after completition, need be disclosed. The plans themselves are material information to investors and should be made known to the market. This would also help with the second problem, reducing the impact on market prices of timed disclosures.
New studies show that executives make extra-market returns on their plans of over five percent and it is information based. See Professor Alan Jagolinzer's study. This should not happen and the rule needs to be tightened up.
August 5, 2005 | Permalink
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