While it is illegal for insiders to trade on material, non-public information, the SEC has created a safe harbor Rule 10b5-1 since October 2000, by allowing insiders to set up trading plans in advance of actual trading.^[1]  Since these planned trades are set up in advance of subsequent trading, they allow insiders to buy and sell shares despite possessing material non-public information at the time of the trade, and consequently, they can serve as an affirmative defense in case of litigation.   However, these plans are not foolproof.  There is growing suspicion among both finance and legal experts that significant loopholes exist in the design and execution of these plans and that the plans are being abused to hide more informed insider trading.  We decided to investigate by examining profitability of all planned transactions under the 10b5-1 rule.

In order for a plan to qualify as safe harbor, the SEC has mandated three specific conditions: 1) Insiders must have entered into a binding contract to purchase or sell a security and provided written instructions to do so prior to becoming aware of material, non-public information; 2) Insiders must either specify the amount, price, and date of trade, or provide a formula, algorithm, or a computer program to determine those parameters. Such formula, algorithm, or computer program cannot permit the insider to exercise subsequent influence on the execution of these trades; and 3) Insiders must demonstrate that all such purchases and sales must have occurred pursuant to the plan.^[2]

One potential concern with Rule 10b5-1 is that executives can possess material, non-public information at the time they set up these plans.^[3]  If true, this would undermine the entire foundation for the SEC Rule, which rests on a requirement that the plans be set up before the insider becomes aware of such information.  A second concern is that insiders can incorporate their material non-public information into the plans’ trading formulas at the initial stage.  These plans allow the insiders to condition their planned trades on future market conditions (such as future stock price), which can create problems.   A third concern is that the insiders can subsequently cancel or modify their existing 10b5-1 plans, or set-up additional new plans as they come into new material non-public information.^[4]  If insiders initially expected a price decline and subsequently the prospects of the firm improve, insiders can simply cancel their previously planned sales.  If so, these plans would not provide substantive constraints on insider trading activity.  A fourth concern is that since insiders do not need to disclose either the existence or the details of the plan under the current rules, there is no way to verify that insiders are actually complying with their own specific plan rules instead of improvising over time based on subsequent material non-public information.^[5]

To investigate these issues, we create a database of all insider transactions that are executed under a trading plan from 2003 to 2013. We then compare the profitability of planned transactions to non-plan transactions.  Our database contains 7,776 10b5-1 plan insider purchases and 328,724 non-plan insider purchases, for a total insider purchase sample size of 336,500 transactions.  Similarly, our database contains 267,713 10b5-1 plan insider sales and 926,579 non-plan insider sales, for a total insider sale sample of 1,194, 292.  Overall, our total sample contains 1,530,792 insider trades.

Our results indicate that planned transactions are profitable.  Furthermore, they are as profitable as non-planned transactions.  In fact, the very first transactions from the plans show significant abnormal profitability, indicating that many plans are set up at a time when insiders possess material non-public information.  Second, our results suggest that irregularities in trading patterns—both irregular trading intervals as well as irregular trading volumes—are associated with greater abnormal profitability.  This finding is consistent with the concern that insiders could be modifying, canceling or setting-up new plans which deviate from their original planned trades when they subsequently acquire material non-public information.  Third, profitability increase with volume of trading under the plan.  This finding again suggests that insiders have material non-public information when they set up the plans since trading volumes are determined when the plans are set up.

Our evidence clearly shows that these safe harbor plans are being abused to hide profitable trades made while in possession of material non-public information.  To prevent further abuse of the SEC’s safe-harbor rule, and stop insiders from using planned transactions to hide to trades based on material, non-public information, we propose that SEC change its 10b5-1 rules and require that these plans satisfy four additional constraints.  First, we propose that the very first trade from a proper plan must be scheduled no less than six months after the plan is filed.  This rule will increase the likelihood that even if the plan is set-up when insiders possess material non-public information, the scheduled trades will not be able to exploit most of insiders’ informational advantages.   Second, we propose that if the plan is modified or a new plan is set-up, the six-month rule must apply anew to any subsequent planned trades.  Third, we propose that the SEC repeal its permission regarding prices, formulas and computer programs and insist that safe-harbor plans’ trading decisions cannot be conditioned on future stock price or future market conditions.  Instead, insiders must simply submit the number of shares to be purchased or sold, and dates of these proposed transactions.  Fourth, we propose that the details of safe-harbor plans must be disclosed publicly so that both the SEC and investors can verify that the executives are actually complying with their own proposed rules.  Without these much needed reforms, SEC’s current safe harbor rules appear to have the opposite of their intended effect.

ENDNOTES

[1] 17 C,F,R, § 240.10b5-1 (2014). We will also refer to Rule 10b5-1 as the safe-harbor rule.

[2] 17 C,F,R, § 240.10b5-1(c)(1)(i) (2014).  Planned trades do not affect insiders’ transactions outside the plan.  , Trades outside the plan do not have the safe harbor presumption.

[3] Jean Eaglesham and Rob Barry, “Trading Plans under Fire:  Despite 2007 Warning, Experts Say Loopholes Remain for Corporate Insiders”, The Wall Street Journal, December 13, 2012.

[4] See Jean Eaglesham and Rob Barry, “Trading Plans under Fire:  Despite 2007 Warning, Experts Say Loopholes Remain for Corporate Insiders”, The Wall Street Journal, December 13, 2012.

[5]   See, Jean Eaglesham and Rob Barry, “Trading Plans under Fire:  Despite 2007 Warning, Experts Say Loopholes Remain for Corporate Insiders,” The Wall Street Journal, December 13, 2012.  Also see “The SEC is Eyeing Insider Stock Sales, Bloomberg Businessweek, March 18, 2007.

The preceding post comes to us from H. Nejat Seyhun, Professor of Finance and Jerome B. and Eilene M. York Professor of Business Administration, Stephen M. Ross School of Business at the University of Michigan, and Taylan Mavruk, Assistant Professor of Finance, University of Gothenburg.  The post is based on their recent paper, which is entitled “Do SEC’s Safe Harbor Rules Need to be Rewritten” and available here.