By James Hamilton, J.D., LL.M.
As a result of academic studies suggesting that Rule 10b5-1 plans may be being abused, the SEC staff is looking into the situation to make sure that people are not doing here what they were doing with stock options. If executives are in fact trading on inside information, noted Enforcement Director Linda Chatman Thomsen, the plan will provide no defense.
Rule 10b5-1 plans allow corporate executives to make a plan, at a time when they are not in possession of inside information, to make prearranged trades at specified prices or dates in the future. According to the director, the idea behind the Rule 10b5-1 plans was to give executives the opportunity to diversify or become more liquid through the use of plans with prearranged trades without facing the prospect of an insider trading investigation. Rule 10b5-1 provides appropriate flexibility to those who would like to plan securities transactions in advance at a time when they are not aware of inside information, and then carry out those pre-planned transactions at a later time, even if they later become aware of inside information.
Since the plans were first authorized in 2000, more than 35 percent of all S&P companies have had at least one executive sell shares under a 10b5-1 plan. In 2006 alone, executives sold more than $8.5 billion in stock through 10b5-1 plans.
The academic studies cited by the staff show that executives who trade within a 10b5-1 plan outperform their peers who trade outside of such a plan by nearly 6 percent. Presumptively, reasoned the SEC official, plan participants should be no more successful on average than those who trade outside a plan. While there may be perfectly legitimate reasons for the discrepancy, she continued, the data suggests that executives with plans sell more frequently and more strategically ahead of announcements of bad news. This raises the possibility that plans are being abused essentially to facilitate trading on inside information.
If executives are in fact trading on inside information and using a plan for cover, the plan will provide no defense. The SEC is looking at the disclosures surrounding 10b5-1 plans. The agency is also looking at multiple and seemingly overlapping 10b5-1 plans; as well as at asymmetrical disclosure around plans, that is, disclosure of entry into a 10b5-1 plan, without timely disclosure of related plan modifications or terminations.
One of the studies that drew the SEC’s attention was a Stanford Graduate Business School study stating that, despite its requirement that insiders plan trades when not privately informed, Rule 10b5-1 appears to enable strategic trading. The study suggests that, on average, trading within Rule 10b5-1 does not solely reflect uninformed diversification. Participating insiders' sales systematically follow positive and precede negative firm performance, the study found, generating abnormal forward-looking returns larger than those earned by non-participating colleagues. Further, the observed association did not appear to be explained by market transaction disclosure response or general periodic price declines.