Insider Trading and Strategic Disclosure

With COVID-19 cases rising rapidly around the world, Pfizer’s announcement on November 9, 2020, that its coronavirus vaccine was highly effective in early trials offered a rare bright spot for the coming winter.[1] But the news was soon dampened by word that the company’s CEO, Albert Bourla, sold some 60 percent of his Pfizer shares on the day of the announcement.[2]  According to Pfizer, Bourla’s sales occurred under a preset arrangement known as a 10b5-1 plan – so named for an obscure SEC rule designed to shield executives from spurious insider-trading accusations. The rule gives an affirmative defense against such accusations to public-company executives who commit to sell specified amounts of shares in advance.[3]

In the two decades since the rule’s adoption, research has shown that executives trading under it perform better than insiders engaging in ordinary trading,[4] in part because the rule permits executives to cancel prearranged trades later discovered to be disadvantageous.[5] The SEC has done nothing to address this obvious problems with the rule, leading the agency’s current chairman to call for immediate reforms.[6]  Yet little work has examined the link between insiders’ plans to sell under these SEC rules and the information public companies choose to disclose to investors.

In a new working paper, I present a preliminary analysis documenting the relationship between insider trading under predetermined plans and corporate disclosures. I show that, even when executives’ hands are tied as to when they trade, there appears to be a powerful relationship between insiders’ plans to sell and the news their companies disclose. I find that the likelihood, share volume, and dollar volume of insider sales under 10b5-1 plans are higher when good news is disclosed and  higher still when the disclosed news is better.[7] That is: The more insiders sell, the better news their companies choose to disclose.

In light of the recent events at Pfizer, I also consider whether these effects are concentrated in particular kinds of corporate announcements and within a particular industry. I show that the effect documented here is concentrated in earnings announcements and is especially common in the health care sector.  I also show that stock prices reverse after high levels of Rule 10b5-1 selling on positive news days, and that the price reversal increases with the share volume of Rule 10b5-1 selling – exposing ordinary investors trading during this period to losses.

One possible mechanism driving these results could be 10b5-1 plans in which sales are triggered mechanically by a transitory rise in the share price.  Such a trading rule could amplify the rewards to a “pump-and-dump” scheme whereby public companies disclose good news that induces investors to purchase stock, while failing to disclose that corporate executives have preplanned sales triggered by the share-price increase following these purchases.  While the exact contours of liability will likely turn on the disclosures (or lack thereof) in any given case, corporate insiders owe a fiduciary duty to their shareholders.  Failing to fully disclose the circumstances around a material corporate disclosure – including the gains that executives stand to realize from preplanned sales made pursuant to a trigger-price 10b5-1 plan – may constitute a materially deceptive scheme.

With this in mind, I consider legal reforms that might address concerns that the SEC’s rules in this area are subject to abuse. As noted above, SEC Chairman Jay Clayton has called for limited reforms, including a “cooling off” period restricting insiders from trading in the days immediately following the adoption of a 10b5-1 plan.  The evidence in this paper, however, suggests that such reforms would be inadequate, because insiders’ influence over the flow of information to the markets will continue long after such a period has expired.  Instead, I propose a disgorgement mechanism limiting insider profits from trading at ephemerally high stock prices that subsequently decline.

When corporate insiders engage in prearranged selling coinciding with a material disclosure that is followed by a long-run increase in the value of the company, they should be rewarded for creating value and share in the gains with other shareholders of the firm.  On the other hand, when insiders engage in prearranged selling coinciding with a material disclosure that is followed by a long-run decline in the company’s share price, there are strong reasons to require the insider to disgorge the gains that arose from trading at an ephemerally high stock price that subsequently declines.

ENDNOTES

[1] Jared S. Hopkins, Pfizer’s Covid-19 Vaccine Proves 90% Effective in Latest Trials, Wall St. J., Nov. 9, 2020, https://www.wsj.com/articles/covid-19-vaccine-from-pfizer-and-biontech-works-better-than-expected-11604922300.

[2] Jared S. Hopkins & Gregory Zuckerman, Pfizer CEO Joins Host of Executives at Covid-19 Vaccine Makers in Big Stock Sale, Wall St. J., Nov. 11, 2020, https://www.wsj.com/articles/pfizer-ceo-joins-host-of-executives-at-covid-19-vaccine-makers-in-big-stock-sale-11605139164.

[3] 17 C.F.R. 240.10b5-1(c).

[4] Taylan Mavruk & H. Nejat Seyhun, Do SEC’s 10b5-1 Safe Harbor Rules Need to Be Rewritten?, 2016 Colum. Bus. L. Rev. 133 (2016).

[5] Alan D. Jagolinzer, SEC Rule 10b5-1 and Insiders’ Strategic Trade, 55 Mgmt. Sci. 224, 224-25, 235-36 (2009); see also M. Todd Henderson et al., Hiding in Plain Sight: Can Disclosure Enhance Insiders’ Trade Returns? (Coase-Sandor Working Paper Series in Law & Econ., Working Paper No. 411, 2012), http://chicagounbound.uchicago.edu/cgi/viewcontent.cgi?article=1646&context=law_and_economics.

[6] Paul Kiernan, SEC Chairman Urges Corporate Insiders to Avoid Quick Stock Sales, Wall St. J., Nov. 17, 2020, https://www.wsj.com/articles/sec-chairman-urges-corporate-insiders-to-avoid-quick-stock-sales-11605637892.

[7] In the paper, I specifically consider the possibility that these findings are driven by 10b5-1 plans that automatically trigger insider selling when the share price crosses a certain threshold.  As discussed in the paper, the use of share-price triggers raises questions under the securities laws because public companies rarely disclose the details of these plans (like the trigger price).  Moreover, executives tend not to disclose sales contemporaneously with the release of good news.  The subsequent disclosure of insider selling on Form 4 can take up to 48 hours – too late to ensure that investors are making informed decisions when purchasing shares of a public company.

This post comes to us from Joshua Mitts, associate professor of law and Milton Handler Fellow at Columbia Law School.

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