Research
Public Policy
Alan D. Jagolinzer
Assistant Professor of Accounting
"SEC Rule 10b5-1 and Insiders’ Strategic Trade," Alan D. Jagolinzer, Management Science, February, 2009.
FOR FURTHER INFORMATION: Helen K. Chang, 650-723-3358, Fax: 650-725-6750
Do SEC Rules on Insider Trading Really Protect?
June 2009
STANFORD GRADUATE SCHOOL OF BUSINESS —Insider trading. The words conjure up visions of unscrupulous executives taking advantage of their positions to reap illegal profits in the stock market.
In fact, trading by insiders, individuals who by dint of their management position come regularly into contact with private firm-related information, is a normal, and generally legal, part of the day-to-day workings of Wall Street. What isn’t legal? Trading on material nonpublic information.
The Securities and Exchange Commission has worked to balance the right of executives who hold large amounts of stock in their own company to diversify their portfolios by selling shares from time to time, with the right of the public to invest in a market that functions fairly. After all, the commission’s fundamental premise is that the market should constitute “a level playing field,” in which no investor should have an undue information advantage.
Seven years ago, the commission acted, adopting Rule 10b5-1. Despite its prosaic title, the rule appeared to markedly change the landscape for insiders. Previously, courts in certain jurisdictions would not levy judgment against an insider unless it could be proved that he or she actually used inside information as a basis to trade. Now, merely possessing information at the time a trade is planned is in violation.
The commission’s reasoning was based on a fairly obvious notion: It is “highly doubtful that a person who knows inside information relevant to the value of a security can completely disregard that knowledge when making the decision to purchase or sell that security,” the SEC wrote at the time 10b5-1 was proposed.
But because insiders, like everybody else, have a right to diversify their portfolios by selling shares, the rule established a “safe harbor.” Insiders are allowed to buy and sell via automatic plans that—once they are initiated—function without direct input from the owner. Executives, directors, and employees of large and small public companies regularly sell shares in their companies and notify the investing public by filing notices with the SEC. By trading within the safe harbor provided by the rule, they are better protected from securities lawsuits, which are often associated with the selling of shares by insiders
Because the rule specifies that insiders may not plan trades while in possession of material nonpublic information, many investors and journalists who write about the stock market assume that associated trades are simply random and are in compliance with both the letter and spirit of the regulation.
However, a study by Alan D. Jagolinzer of the Graduate School of Business concludes that 10b5-1 sales timing may not be as random as many might suspect. “If the rule was intended to allow only random trades for the purpose of diversification, it doesn’t appear to be doing that,” he said in a recent interview.
Jagolinzer, an assistant professor of accounting, looked at five years of trading activity, analyzing approximately 117,000 transactions, and found that, on average, insider trades conducted under 10b5-1 outperformed the market by about 6 percent six months after the trades were executed. This association, he said, was statistically very strong, suggesting that, on average, trades appeared more strategically timed than random.
Jagolinzer notes that legal inferences cannot be drawn from his evidence because there is little information available regarding the underlying process that generates these patterns. His study, however, discusses some plausible strategies and provides some evidence regarding selective plan termination that might explain these patterns. For example, insiders might set up their plans to trade profitably with the benefit of long-term information. Insiders also might time the release of certain information—such as the pre-announcement of quarterly earnings—to enhance the profits from previously scheduled trades. Insiders also might selectively terminate their plans to prevent pending scheduled trades from executing unprofitably. The degree to which any of this activity occurs is also potentially confounded by current disclosure rules.
Currently, the SEC does not require insiders who buy and sell under 10b5-1 to disclose the existence of or the details about their plans. Although many do disclose, it isn’t possible to know how many trade without disclosure, nor whether non-disclosed trades appear, on average, to be strategically timed.
Would mandatory disclosure make the rule more effective? “I don’t want to weigh in on policy questions,” said Jagolinzer. “But I think it would allow for broader research and perhaps for better monitoring.” A proposal to make disclosure mandatory was tabled a few years ago.
An interesting question not answered by the research: What effect does voluntary disclosure of insider trading have on the market? “We are also interested in why some firms adopt voluntary disclosure; what separates firms that do from firms that don’t, and how does the market interpret that,” said Jagolinzer.
—Bill Snyder