When the WSJ performs a study and publishes the results on the front page, it often has consequences. It's worth remembering that it was a study reported in the WSJ about stock option backdating that kicked off the option backdating scandal of the mid-2000s (see, e.g., this news brief, this news brief and this news brief). Now, the WSJ has conducted a new front-page analysis of trading by insiders under Rule 10b5-1 plans that "shows that executives benefit when sales happen quickly after the plans' adoption." Academics and the SEC, the WSJ observes, suggest that "some corporate insiders might be using nonpublic information to game the system." Under SEC Chair Gary Gensler, the SEC has already proposed new rules to "freshen up," as Gensler likes to say, the rules on 10b5-1 plans, including mandatory cooling-off periods after adoption or modification of the plan—an aspect of the proposal designed to address precisely this issue. The WSJ analysis found that about 44% of the trades reviewed (about 33,000 stock sales), would not have been permitted under the cooling-off periods proposed in the SEC rule. The SEC has targeted April 2023 as the target date for adoption. (See this PubCo post.) In the light of some of the results shown, will the new study reinforce the SEC's inclination to adopt its new proposal?
The SEC's proposal on 10b5-1 plans includes a number of provisions aimed at addressing problems that have been identified with 10b5-1 plans, among them:
- two new cooling-off periods—a 120-day cooling-off period after adoption or modification for officers and directors and a 30-day cooling-off period for companies;
- written certifications for officers and directors at the time of adoption or modification that they are adopting the plan in good faith are not aware of MNPI about the company or its securities;
- prohibition on multiple overlapping trading arrangements;
- affirmative defense available only for one single-trade plan during any 12-month period;
- requirement that Rule 10b5-1 trading arrangements be entered into and operated in good faith;
- a new checkbox on Section 16 forms to show that the trade was made under a 10b5-1 plan;
- required gift disclosures within two business days (see this PubCo post for a discussion of a study about the potential for opportunistic timing of executive gifts of shares while aware of MNPI); and
- a number of enhanced disclosure requirements, including narrative disclosure about the company's equity grant policies and practices addressing the timing of grants and the release of MNPI; annual disclosure of insider trading policies and procedures; quarterly disclosure of whether the company or officers or directors adopted or terminated any contract, instruction or written plan to purchase or sell securities of the company, whether or not under Rule 10b5-1, describing the material terms of those trading arrangements; and a new table showing grants to NEOs made within 14 days before or after an issuer share repurchase or the filing of a periodic report or Form 8-K that contains MNPI. (See this PubCo post.)
In the study, the WSJ analyzed 75,000 10b5-1 plan stock sales by corporate insiders from 2016 through 2021, based on a review of Form 144 filings. (The analysis "adjusted returns to remove the effect of sector-wide moves in the market.") The data showed that about 20% of these trades "occurred within 60 trading days of a plan's adoption. The timing in aggregate made the trades more profitable: On average, those trades preceded a downturn in share price more often than when insiders waited longer to trade, the analysis found. Collectively, insiders who sold within 60 days reaped $500 million more in profits than they would have if they sold three months later, according to the analysis." But trades that occurred 120 days or more after adoption of the plan had more uniform results, as "roughly half sold before a downturn and half before a stock upturn, suggesting that the sellers reaped no unusual gains after more time had passed." In the analysis, about 5% of the total trades occurred less than 30 days after plan adoption, with slightly under 2% occurring in less than 14 days. And the study showed that some executives even traded the same day they adopted a plan.
The article observes that, currently, there's no requirement for public disclosure (other than on Forms 144, which are typically filed on paper, but see this PubCo post for a description of the new electronic filing mandate). In addition, plans can be modified or canceled at any time.
The article indicates that, based on a review of disclosures of insider stock sales in recent years, about 60% of insiders said those trades were conducted under 10b5-1 plans.
The WSJ analysis also "found scores of examples where company insiders adopted a plan when a quarter was nearly complete and sold stock under the plan before that quarter's results were announced." The article provides a number of specific examples, such as the company where, in 21 instances, insiders sold stock on the same day they adopted their plans, with stock price drops within 60 days following those trades for all but four of the trades.
This isn't the first study to address problems with 10b5-1 plans—it's not even the first study from the WSJ. And the results seem to be fairly consistent. In 2012, a study conducted by the WSJ indicated favorable results that appeared to be more than serendipitous from trading by insiders under 10b5-1 plans. The article identified a number of problems with 10b5-1 plans, including the absence of public disclosure about the plan or changes to it and the absence of rules about how long the plans must be in place before trading under the plans can begin. (See this Cooley News Brief.)
Other studies have also been conducted. In this paper, Gaming the System: Three 'Red Flags' of Potential 10b5-1 Abuse, cited by Gensler in 2021 remarks (see this PubCo post), the authors, from the Rock Center for Corporate Governance at Stanford, examined data from over 20,000 Rule 10b5-1 plans to investigate the extent of insider trading abuse. You may be able to trace aspects of the new SEC proposal to the findings of this study. 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." Although the authors acknowledged 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 MNPI, 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." The authors identified three "red flags" that could be used to detect potentially improper exploitation of Rule 10b5-1:
"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."
The study showed that there is substantial variety in the duration of cooling-off periods, including 1% of plans that 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. 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." In addition, 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."
In the study, 49% of plans covered only a single trade. 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 exhibited the highest average loss avoidance. (See this PubCo post.)
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