Rule 10b5-1 Plans Drawing Scrutiny

Those who remember that the options backdating scandal first got started with an academic study may want to take a close look at a recent research paper examining Rule 10b5-1 plan trading. The paper, and subsequent press coverage and comments, suggest that questionable trading in Rule 10b5-1 plans could become the focus of the next big investigative event.

The SEC promulgated Rule 10b5-1 in 2000 to provide company insiders with a "safe harbor" within which to trade their shares in company stock without incurring litigation exposure. The Rule creates an affirmative defense against an accusation of improper insider trading if the insider has established a predetermined trading plan. The written plan should not permit the insider to "exercise subsequent influence over how, whem and whether to effect purchases or sales." A good summary of the purpose and structure of 10b5-1 plans can be found here.

A recent study by an assistant accounting professor at Stanford’s Graduate School of Business takes a hard look at actual trading inside 10b5-1 plans. The December 2006 paper by Alan Jagolinzer, entitled "Do Insiders Trade Strategically Within the SEC Rule 10b5-1 Safe Harbor?" (here), studied roughly 117,000 trades in 10b5-1 plans by 3,246 executives at 1,241 companies. He found that trades inside the plans beat the market by 6% over six months, by contrast to executives at the same companies who traded without plans and who beat the market by only 1.9%.

Specifically, Jagolinzer found that "a substantial portion of randomly selected 10b5-1 plan initiations are associated with pending adverse news disclosure" and "early sales plan termination is, on average, associated with pending positive firm performance." In other words, the study shows that insiders initiated plans to sell shares– and sold their shares – ahead of stock price declines, locking in sales at higher prices, and that insiders terminated plans – and refrained from selling shares—before the company’s release of positive news that drove the share price higher. Since most of the trading related to stock sales (as opposed to purchases), Jagolinzer’s findings regarding share sales are particularly significant. He found that "participants’ sales…tend to follow price increase and precede price declines, generating statistically significant forward-looking abnormal returns."

A December 16, 2006 BusinessWeek.com article reporting on Jagolinzer’s study, entitled "Insiders With a Curious Edge" (here), takes a closer look at trading in 10b5-1 plans at several specific companies, finding several instances of "impeccable" timing and "curious patterns." For example, the article found several instances of massive sales at stock price peaks, followed by plan terminations. The article notes that "despite the 'prearranged' nature of the trading plans, executives have enormous flexibility to start, stop, restart and amend them at will." As one analyst quoted in the article observes, if executives are "ending plans and starting new ones with each trade, how does that differ from simply trading outside a plan?"

None of this has been lost on the SEC. In a March 8, 2007 speech (here) at the Corporate Counsel Institute, SEC Enforcement Division Director Linda Chatman Thomsen specifically noted Jagolinzer’s study, and commented that his analysis

raises the possibility that plans are being abused in various ways to facilitate trading based on insider information. We’re looking at this – hard. We want 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 and using a plan for cover, they should expect the "safe harbor" to provide no defense.

A March 19, 2006 BusinessWeek.com article entitled "The SEC Is Eyeing Insider Stock Sales" (here) amplifies the theme that the SEC will be cracking down on improper trading in 10b5-1 plans and suggests that the SEC may be scrutinizing insider trading inside 10b5-1 plans at New Century Financial Corporation prior to its recent spate of bad news.

The SEC Actions Blog (here) also suggests that 10b5-1 plans are "a new enforcement target" and that the SEC may have already started to crack down on insider trading in connection with the New Century Finance Corporation investigation.

It is far too early to predict a trend, much less the arrival of the next scandal. Nevertheless, the combination of academic research, press attention, and most significantly, regulatory scrutiny, suggests that 10b5-1 plans will be an area of increasing attention in coming months.

All of this may be slightly disorienting for D & O insurance professionals, who are accustomed to thinking of 10b5-1 plans as the essence of good corporate practice. Indeed, trading plans structured and implemented according to the original intent of the Rule should still afford the protection for which the Rule was designed. However, insiders who are stopping or starting plans, or running multiple plans, for "strategic purposes," may find themselves unable to rely on the Rule’s safe harbor, or potentially even the focus of unwanted regulatory scrutiny.

This clearly is an area of emerging D & O risk, and while it is developing, it will also be the focus of increased scrutiny from D & O underwriters. Underwriters will want to know not only that a trade was pursuant to a plan, but also when the plan was started and whether the insider has multiple plans, or has had prior plans that started and stopped.

UPDATE: The April 4, 2007 Wall Street Journal has an article (here, subscription required) on the SEC's heightened scrutiny of Rule 10b5-1 plans. The article also discusses that the possible abuse of a 10b5-1 is at issue in the insider trading trial of Joseph Naccio.