This article explains the recent media, SEC and public attention to trading by company executives through so-called Rule 10b5-1 plans, which continues to be a problem for public companies, despite a downtick in insider trading cases filed by the SEC last year. The interest has been largely generated by an academic paper, which spurred the SEC and Congress to reconsider the rules around trading plans.
Academic Paper Shows Significant “Red Flags”
In January 2021, an academic paper revealed that “red flags” abound in the use of so-called “Rule 10b5-1 plans” utilized by company insiders to trade (ironically) without the appearance of insider trading. Under such plans, company insiders instruct a third-party in advance, usually a broker, to buy or sell the company’s securities at a pre-determined date or based on pre-determined criteria. By setting the trades in advance, and leaving them to a third-party to execute, the insider can avoid (in theory) allegations that he or she was aware of non-public information about the company at the time of the trades. The purpose of trading plans is to provide a safe venue for executives—who almost always have material non-public information about the companies they are running—to make routine trades without risking the appearance of insider trading.
Law and commonsense dictate, however, that a trading plan cannot be used as a scheme to insider trade without consequence, which would defeat the entire purpose of the rule. Yet, the recent academic paper suggests that many executives may be doing exactly that. The “red flags” appear in three primary areas.
1. Insufficient Cooling-off Periods
A “cooling off period” is the period between a plan’s adoption and the scheduled trades. The shorter the period of time between the adoption of the plan and the first scheduled trade, the more it appears that an insider is utilizing the plan to trade on currently known information, including information that may not yet be known by the public. Because of this, one might expect that insiders would not trade within, say, 30 days of implementation. Yet, the study found that nearly 15% of plans called for trades within the first 30 days. Some plans even scheduled trades on the very same day as implementation—a farcical use of a trading plan under any circumstance. Perhaps even more concerning, the study also found a significant correlation between stock performance and plans with cooling off periods of less than 30 days, suggesting that insiders who traded immediately following implementation avoided significant losses in their company’s stock. These trades were also, on average, significantly larger than trades with larger periods of time between plan implementation and execution.
2. Single-trade plans
Some plans examined by the paper scheduled only a single trade, rather than a series of planned trades that one might expect of an executive planning for his or her cash flow or portfolio needs in the future. Single-trade plans are suspicious, especially with limited cooling off periods, because they suggest that the insider is motivated by a single event—potentially non-public information—rather than the type of advanced planning encouraged by Rule 105b-1 (i.e., a “regular, pre-established [trading] program”).
Despite these concerns, the paper revealed that single-trade plans are strikingly prevalent: the paper examined over 10,000 single-trade plans with a median size of over $600,000 and an aggregate transaction volume of over $26 billion.
3. Plans Adopted Prior To Earnings
Because executives are routinely aware of quarterly performance before it is publicly announced, virtually all public companies adopt blackout periods prohibiting trades after the close of a quarter (or even days and weeks before) and the public announcement of earnings. Yet, the paper revealed over 6000 plans implemented less than 90 days before an earnings announcement with trades scheduled to be executed prior to the earnings announcement—i.e., scheduled in a way that could permit the insider to take advantage of non-public information about the company’s financial performance before it is announced to the market. Trades in these plans could have easily been scheduled to occur after the company’s next earnings announcement, but weren’t, raising questions as to why.
In June, the SEC revealed that, partly in response to the academic paper, it was taking a fresh look at the use of trading plans by company executives. SEC Chair Gary Gensler expressed concerns around some of the issues identified in the paper, including:
- Cooling-off Period. Chair Gensler recommended a mandatory cooling off period when insiders or companies adopt trading plans before they can make an initial trade, noting that periods of four to six months have previously received SEC support.
- Limitations on Cancellation. Chair Gensler asked SEC staff to consider limitations on when and how plans can be cancelled because currently there is no regulatory prohibition on canceling a trading plan when in possession of material nonpublic information.
- Mandatory Disclosure Requirements. There are currently no disclosure requirements for trading plans, and Chair Gensler recommended disclosure for adoption and modification.
- Number of Trading Plans. Chair Gensler asked SEC staff to consider the implications of permitting insiders to enter into multiple plans, potentially permitting insiders to cancel, amend, or choose the most favorable plan to rely on for sales.
Congress Weighs Action
Later in June, two senators introduced a bipartisan bill to address the use of “loopholes” in the laws governing trading plans—such as those discussed above—which permit insiders to trade based on non-public information. Specifically, the bill would require the SEC to study whether Rule 10b5-1 should be amended to: (i) limit the time frame during which an issuer or insider can adopt a trading plan to issuer-approved trading windows; (ii) limit the ability of issuers and insiders to adopt multiple trading plans; (iii) establish a mandatory delay between the adoption of the trading plan and the first trade under the plan; (iv) limit the frequency that issuers and insiders may modify or cancel trading plans; (v) require issuers and insiders to file with the SEC trading plan adoptions, amendments, terminations, and transactions; and (vi) require corporate boards to adopt policies for trading plans and monitor trading plan transactions.
In our view, the renewed attention to insider trading, including the potential use of trading plans to execute trades based on non-public information, is a positive development for public company shareholders. At a minimum, it serves as a reminder to public company boards that all companies must have clear and effective insider trading controls in place at all times. These controls must prevent trading by employees in advance of significant public announcements such as quarterly earnings, merger transactions, resignation of key personnel, or significant product updates. Companies that continue to permit trading—or the implementation of trading plans—are more likely than ever to draw the attention of regulators and shareholders. While company insiders are certainly entitled to transact in the company’s stock (which often plays a significant part in executive compensation), the best policy is to avoid even the appearance of misconduct. In virtually all cases, thoughtful consideration of the timing of trades, coupled with the use of a trading plan implemented well in advance, will be sufficient to protect against even the perception that executives are taking improper advantage of the information available through their positions.