For the past decade, corporate executives looking to insulate themselves against allegations of insider trading have established special trading plans to govern their trading of company stock. These plans are designed to prevent executives from buying and selling company stock based on inside knowledge by determining, in advance, precisely when and how trades can happen.
But a recent Wall Street Journal investigation into these plans reached an unsettling conclusion: many executives are either extremely lucky or gaming the system.
Federal securities laws prohibit buying or selling stock based on material, nonpublic information. In 2000, the Securities and Exchange Commission enacted a “safe harbor” rule — SEC Rule 10b5-1 — that provides executives with an affirmative defense to charges of insider trading when the trades are made pursuant to a pre-arranged trading plan. The rule requires a written plan, drafted prior to the insider learning of the material non-public information at issue in the suit. The plan must list the amount and price of the securities to be sold or purchased; provide a transaction date; and prevent the insider from exercising “any subsequent influence over how, when, or whether to effect purchases or sales.” Subsequent trades must also be executed according to the trading plan’s terms. In addition, the trading plan must have been composed “in good faith and not as part of a plan or scheme to evade the prohibitions of this section.”
Over the years, these trading plans have become both popular and successful. Since 2004, the Journal reports, “insiders have filed an average of more than 18,000 forms a year about trades and ownership of company stock mentioning 10b5-1 plans.” Moreover, for the last decade, defendants have successfully pointed to the mere existence of such trading plans to refute charges that they traded on the basis of material, nonpublic information. This success has occurred despite a lack of transparency about the details of the trading plans. Executives are not required to file their plans or detail whether and how they have been modified. In fact, for the past decade, executives have operated in “trust us” mode.
That trust was sorely tested in November when the Journal published an article entitled “Executives’ Good Luck in Trading Own Stock.” An analysis of trading by 20,237 executives since 2004 found that 1,418 executives who traded their company stock in the weeks before news was announced posted average gains of 10% – or avoided losses of 10% – within a week of their trades. The number of executives who made similarly timed trades and lost the equivalent amount of money: 789. The Journal went on to highlighted several instances of suspicious Rule 10b5-1 trading and cited problems with the lack of transparency about the rule’s details.
On December 28, 2012, the Council of Institutional Investors wrote to the SEC to warn of the potential misuses of pre-arranged trading plans. The Council asked the SEC to establish clear protocols regarding when plans could be established, lag time between their setup and any trading, how frequently plans could be modified or canceled, and to what extent plan details should be disclosed. The Council also advocated for greater board oversight over Rule 10b5-1 plans.
Such increased scrutiny is long overdue. Regulators and private litigation must closely examine the uses of trading plans and demand greater disclosures from executives, boards and companies. Moreover, the SEC should accept The Council’s proposal for the establishment of clear, uniform “best practices.” Finally, corporate boards must exercise far greater oversight over the establishment and use of the trading plans. The “trust us” days are over.
-Patrick T. Egan, March 2013