In this paper, Gaming the System: Three ‘Red Flags’ of Potential 10b5-1 Abuse, from the Rock Center for Corporate Governance at Stanford, the authors examined data from over 20,000 Rule 10b5-1 plans to investigate the extent of insider trading abuse. The study found that some executives did use 10b5-1 plans to conduct “opportunistic, large-scale selling that appears to undermine the purpose of Rule 10b5-1” and highlighted three “red flags” that could be used to detect potentially improper exploitation of Rule 10b5-1. Although the authors acknowledge that they could not determine for certain whether any insiders that avoided losses or otherwise achieved “market-beating returns” actually traded on the basis of material nonpublic information, they contended that average trading returns of the magnitude they found in the study “are highly suspect and, as such, these red flags are suggestive of potential abuse.”
Corporate executives are constantly exposed to MNPI, making it sometimes difficult for them to sell company shares without the risk of insider trading, or at least claims of insider trading. To address this issue, Congress developed the Rule 10b5-1 safe harbor. In general, Rule 10b5-1 allows an insider, when not in possession of MNPI, to establish a formal trading contract, instruction or plan that specifies pre-established dates or formulas or other mechanisms—that are not subject to the insider’s further influence—for determining when the insider can sell shares, without the risk of insider trading. To be effective, the contract, instruction or plan must also conform to the specific requirements set forth in the Rule. In effect, the Rule provides an affirmative defense designed to demonstrate that a purchase or sale was not made “on the basis of” MNPI. If a 10b5-1 contract, instruction or plan is properly established, the issue is not whether the insider had MNPI at the time of the purchase or sale of the security; rather, that analysis is performed at the time the instruction, contract or plan is established.
After the plan has been established, the insider can modify it, so long as he or she is not aware of MNPI at the time of the modification, and can terminate it at any time—even if the insider is in possession of MNPI at the time. Why is that? Because the termination (and related cancellation of any planned trades) is not “in connection with the purchase or sale of any security.” The authors also point out that, while the SEC may have contemplated at the time the Rule was adopted that plans would likely provide for multiple trades spread out over time, there is no requirement to that effect, and plans can be used for a single trade. In addition, there is no requirement that multiple trades be spaced apart. The authors also note that, although there are requirements that insider report transactions on Forms 4 and 144, there is no independent public reporting requirement for 10b5-1 plans (other than the requirement on Form 144 to provide the date of plan adoption if the sale was under a 10b5-1 plan). However, some insiders do provide that information voluntarily.
The wide berth the Rule gives executives to conduct transactions under these plans, together with the absence of public information requirements, has long fueled controversy about Rule 10b5-1 plans. (See the SideBar below) In particular, some view the ability to amend or cancel the plans as providing opportunities to exploit the Rule. For example, the study posits a hypothetical where “a pharmaceutical executive without possessing any MNPI could set up a plan to sell shares before drug trial results are scheduled to be publicly disclosed. If the executive eventually learns MNPI that the trial is likely to be successful, he or she can cancel the planned sale, and instead sell shares after the positive trial results are publicly disclosed when prices are higher. Alternatively, the executive eventually learns MNPI that the trial is not likely to be successful, he or she can let the planned sale execute at inflated prices prior to the disclosure of the negative trial result. In either case, the executive is able to sell at the most advantageous price.”
The study looked at data on all sales reported on Form 144 between January 2016 and May 2020 and the adoption date of any corresponding 10b5-1 plans. The study examined a total of 20,595 plans, trading activity by 10,123 executives at 2,140 unique firms, and 55,287 sales transactions totaling $105.3 billion during the period. The average (median) trade size was $1.9 ($0.4) million.
The authors identified three “red flags” that they associate with opportunistic use of 10b5-1 plans:
“1. Plans with a short cooling-off period
2. Plans that entail only a single trade
3. Plans adopted in a given quarter that begin trading before that quarter’s earnings announcement.”
Cooling-off periods
The study showed that there is substantial variety in the duration of cooling-off periods. Although the mean (median) cooling-off period was 117.9 (76) days, and 82% began trading within six months, 1% of plans had no cooling-off period at all and began trading on the same day as plan adoption. About 14% of plans began trading within the first 30 days and 39% within the first 60 days. Only 29% of cooling-off periods were four months or longer. Looking at a distribution of sales, the authors also identified “a regular pattern” of a two-week wait as well as a “spike in initial trading” 30 days after plan adoption. The study also showed a correlation between initial trade size and duration of the cooling-off period, with trades under plans with cooling-off periods of less than 30 days being about 50% larger (median $573,000) than trades under plans with a cooling-off period of six months or more (median $360,000). However, the largest median initial trades (at $619,000) occurred with cooling-off periods of 61 to 90 days and, at 91 to 120 days, the median was $615,000.
Perhaps most interesting, the authors also looked at “loss avoidance,” calculated against industry-adjusted stock returns over the six months after the first planned sale, i.e., the greater the negative return following the sale, the greater the loss avoidance. The study found “that trades of plans with short cooling-off periods avoid significant losses and foreshadow considerable stock price declines that are well in excess of industry peers. The first planned trade with a cooling-off period of less than 30 days is associated with a subsequent industry-adjusted return of -2.5 percent. Similarly, the first planned trade with a cooling-off period between 30 and 60 days is associated with a subsequent -1.5 percent return. When the cooling-off period is extended beyond 60 days, evidence of loss avoidance disappears.” Accordingly, the “shorter the interval between plan adoption and the first trade, the more likely it appears that the plan is being used opportunistically. With longer cooling-off periods, opportunistic trading disappears.”
Single-trade plans
In the study, 49% of plans covered only a single trade. The trade under these plans had a median size of $639,000, compared to a median size of $356,000 for trades under multiple-trade plans, although total sales under these plans were larger ($79 billion compared with $26 billion for single-trade plans). About 38% of single-trade plans provided for the trade within 60 days of plan adoption, while only 22% provide for the trade more than six months out. Notably, the data showed that trades under single-trade plans were “consistently loss-avoiding regardless of cooling-off period. Single-trade plans with short cooling-off periods exhibit the highest average loss avoidance, avoiding an industry-adjusted price decline of -4 percent. In contrast, the trades under multiple-trade plans are only loss-avoiding within 30 days of plan adoption (industry-adjusted price decline of -1 percent). Beyond this, trades of multiple-trade plans are not loss avoiding.”
Adoption and Trade Relative to Earnings Announcements
According to the study, with regard to trades soon after plan adoption, 38% of plans provided for trades one to 90 days before that quarter’s earnings announcement, with plans that executed a trade in the window between adoption and announcement foreshadowing large losses and stock price declines: during the 120 days after the sale, the study reported that “the stock underperforms industry peers by between -2 percent and -3 percent. In contrast, loss avoidance is not evident for trades occurring after the earnings announcement.” The authors suggested the possibility that some executives may use 10b5-1 plans to circumvent blackout windows.
Recommendations
- Require a cooling-off period. Taking a cue from former Chair Clayton as well as prior recommendations, the authors recommend adoption of a requirement for a four-to-six-month cooling-off period. The data showed that initial trades after that time period did “not systematically anticipate stock price declines.” They also recommend that, at a minimum, trades should not be permitted on the same day as plan adoption.
- Disqualify single-trade plans. The authors note that single-trade plans are not really different from traditional limit orders and, they contend, are inconsistent with the original expectations of the manner in which the Rule would be used. Here, the authors recommend that the rules disqualify from the safe harbor single-trade plans and require that, to qualify, plans must provide for multiple transactions that are spread over a certain time period.
- Disqualify plans with trades prior to earnings announcements. The authors recommend that plans that are both adopted and commence trades before the next earnings announcement be disqualified from the affirmative defense. (A cooling-off period of four to six months would also work in this context.)
- Require disclosure. The authors recommend that the SEC consider requiring disclosure of 10b5-1 plans or at least information about their adoption, modification, termination and maximum shares to be sold, most likely on Form 8-K; reporting on Form 4 if a transaction is under a 10b5-1 plan and, if so, the date of plan adoption or modification; and filing of Forms 144 on EDGAR (which the SEC has already proposed, as discussed below). Although not expressly a recommendation, the authors ask whether planned 10b5-1 plan sales, which they view as analogous to hedges and pledges, be required to be disclosed in proxy statements like hedges and pledges. In addition, the authors recommend that companies take the initiative to require general counsel approval of 10b5-1 plans, which, they note, has been shown to “significantly [reduce] insider trading advantages,” and to prohibit adoption of plans inside trading blackout windows.
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