Insider Trading and Rule 10b5-1 Plans: Lack of Clarity and Potential for Abuse. June 2009

Transcription

1 Insider Trading and Rule 10b5-1 Plans: Lack of Clarity and Potential for Abuse June 2009 Stanley Veliotis, PhD, LLM, CPA, CEP Assistant Professor Fordham University 441 E. Fordham Rd, Bronx NY Agenda -Insider Trading Incentives -Insider Trading Law -Rule 10b5-1 Plans -Potential Abuses of 10b5-1 Plans -Recommendations 1

2 Insider Trading Incentives - Long recognized right for founders and subsequent other insiders (senior or otherwise) to cash in on success of firm, as evidenced through stock price increase (e.g., sell compensatory stock) - Incentive to maintain or increase stock price before a sale -or to maintain or lower stock price before a stock buy (or option grant) - Popular reported cases involve learning about something not known by the public and trading before public learns. -This can occur with any employee (even outsiders) -E.g., discover oil, learn a drug trial fails - Less broad group of employees have ability to trade on information they have a hand in releasing -Several US empirical studies suggest key insiders manage earnings that are reported right before a stock sale - However, some studies show that insiders are also fearful to trade stock close to earnings announcements -A desire to pump and dump tempered by desire to avoid litigation Insider Trading Law - US Exchange Act Section 10(b), Rule 10b-5 anti-fraud provisions - Civil (government or private party) or Criminal actions - Require culpable state of mind ( scienter ), not mere negligence - Rule 10b-5 was initially intended for fraudulent statements -Often scienter is demonstrated by motive, such as insider stock sales - But Rule 10b-5 also covers certain trades by insiders made on the basis of nonpublic information -Thus, insider trading can be a primary violation of Rule 10b-5 (or the trading can be used to evidence of scienter in broader 10b-5 case) - In primary violation cases, courts often required evidence of insider s use of the information, not mere possession. 2

3 Insider Trading Law Rule 10b5-1 - US Securities & Exchange Comm. (SEC) released Rule 10b5-1 in Possession alone is now sufficient to be liable (i.e., no longer need to show use) -This is a chilling prospect. So SEC put in affirmative defense: - If insider commits in advance to stock sales, those sales are not subject to claim they were made on basis of nonpublic info. - Insider must: -act with good faith, and -not have had material nonpublic info at time of adoption of Plan - Insider is allowed to terminate plan and there is no obligation to inform the SEC or the public of the plan s existence or its details. -Lack of clarity as to - does 10b5-1 actually protect against primary violation even if self-created info? - whether SEC intended to remove scienter value in broader 10b-5 cases? Rule 10b5-1 Plans -Plans have become increasingly more popular -Most plans have preset trades (or algorithm) - but some grant sole discretion to a broker -Many Plans indicate that the sales are occurring in order to: -Diversify -Provide liquidity -Pay tax and/or exercise price on option -Repay loans -Pay personal items such as -Children tuition -Divorce settlement 3

4 Potential Abuses Under 10b5-1 Plans -SEC: Plans may be abused in various ways to facilitate trades based on inside information. We re looking at this hard - Concerns started with various iterations of study by Prof. Alan Jagolinzer and many business press articles citing Planrelated trading at troubled firms Potential Abuses Selective Termination - Jagolinzer (2009) paper finds that Plan sellers have higher abnormal stock returns than their non-plan selling colleagues at the same firm. - He argues that this may be occurring because of the right of insiders to terminate Plans, which implies a strategic selective termination option. - In other words, if insider knows stock price will likely drop after Planned sale, he will allow the sale to continue. If he knows it will likely increase, he terminates the Plan. - This could lead to the abnormal returns found in Jagolinzer s studied data set. 4

5 Potential Abuses Strategic Timing of Information Release -Others (e.g., Horwich) argue that Plan-selling insiders may benefit by strategically timing the issuance of true news while hiding under cover of Plan s protection -For example, if a Planned sale is happening on June 12, maybe the insider accelerates good news disclosure to June 11. -If the news is bad, maybe he delays the release until June 13. Potential Abuses Distorting Information Content -Veliotis (2009) argues that insiders also have incentive to distort what is reported -For example, if a Planned sale is happening on June 12, maybe the insider positively distorts info released on June 11 -Fact that sale is being made under Plan does not logically reduce incentive to maximize proceeds -Even if good faith existed at Plan adoption 5

6 Potential Abuses (continued) - Approx. 30 court cases have taken inoculating view of Plans as reducing or eliminating ability for a sale to evidence scienter in 10b-5 cases. - While some of these cases had procedural issues related to how to raise the Plan as an affirmative defense, they rarely suggested abuses may be happening - Only two cases raised (as asides) the possibility that Plans could be abused but no facts were presented in the cases - Veliotis (2009) recommends that litigants/government plead these aspects before their cases are dismissed at early procedural phase. - Veliotis (2009) argues that older cases should be considered as precedent; they looked suspiciously on pre-planned sales because they are even more likely to lead to price maximizing behavior - Compare to sales that occur under a spontaneous decision. In other words, Planned sales on their face involve a plan and are more likely to include strategic abuses noted above, while other sales may or not be the product of a plan. - Courts also appear to view all Plan trade as being free of primary 10b-5 liability - Loophole?: Should 10b5-1 Plan protection apply even to self-created info? Recommendations for Firms & Insiders - Stay sensitive to insider trading exposure for insider and for firm - Insider trading cases are still hot button issues, even after Enron - Outside US, see if similar insider trading regulation and opportunities exist. - Qualters (2009): White collar crime enforcement is going global - Involve counsel and seek to use Plans as much as possible - No reason not to use Plan if one has a sale on the horizon - Ideally enter into Plan as far in advance as possible - Do not casually modify Plans - Try to use broker discretion Plans - Coordinate with blackout periods and other insider trading limits/information policies set by firm - Lawyers typically have recommended that insider disclose Plan s existence at the outset: - calm market participants - preempt litigation - but weigh benefits against a downside of disclosing a Plan that later is terminated - Disclosure typically occurs in footnote to Form 4 (notice of trade filing). But many disclose earlier in, e.g., press release, 8K, analyst calls, other SEC filings. 6

7 Recommendations (continued) -In light of possibility litigants or courts may begin to take note of the potential abuses, insiders and the firm may wish to have insiders consider following, even if just for public relations purposes: - if terminating, do so far in advance of news events - do not allow Plan sales to occur within certain pre- or post-earnings release dates - do not allow Plan trader to arbitrarily determine info release dates - do not use Plans for large isolated trades; instead space out the sales, ideally over several quarters, to limit perception issues - Some of the above are more targeted to key (influential) insiders, but consider applicability to all insiders. 7