Research Underpins SEC Scrutiny of Scheduled Insider Trades
STANFORD GRADUATE SCHOOL OF BUSINESS—High-profile legal cases, alleging misconduct by executives at Countrywide Savings, Novatel, and Qwest, may be prompting the Securities and Exchange Commission to rethink rules that permit scheduled trading by insiders.
One catalyst for this second look is research by Alan Jagolinzer, an accounting professor at the Stanford Graduate School of Business, whose work indicates that prearranged trades allowed under the so-called"Safe Harbor Rule" may be less innocent than they appear.
Rule 10b5-1, adopted in 2000, allows corporate executives to make prearranged trades at specified prices or dates in the future. The idea, explained Linda Chatman Thomsen, director of enforcement for the SEC, was to give executives a safe harbor to proceed with these prearranged trades and"give executives regular opportunities to liquidate their stock holdings—to pay their kids' college tuition, for example—without risk of inadvertently facing an insider trading inquiry."
But citing Jagolinzer's work in a published, Washington, D.C., speech, Thomsen said:"Recent academic studies suggest that the Rule is being abused. The academic data shows that executives who trade within a 10b5-1 plan outperform their peers who trade outside of such a plan … ; it ought to be the case that plan participants should be no more successful on average than those who trade outside a plan.
“The difference seems to be that executives with plans sell more frequently and more strategically ahead of announcements of bad news. This raises the possibility that plans are being abused in various ways to facilitate trading based on inside information. We're looking at this—hard," Thomsen said.
Although Jagolinzer's paper,"SEC Rule 10b5-1 and Insiders' Strategic Trade," was recently published in the February 2009 issue of Management Science, his preliminary work was completed earlier, and the researcher briefed the SEC on his findings in December 2006, four months before Thomsen's speech.
The"harder look" prompted in part by Jagolinzer's research may already be changing the behavior of insiders. Last year, usage of these plans declined, possibly because of SEC scrutiny, according to a Reuters news agency report, which attributed the information to Equilar, a research firm. Stock market declines may also have prompted participants to suspend activity as the year drew to a close, Equilar said.
What's more, the SEC recently released new interpretive guidance that outlines how insiders are expected to comply with Rule 10b5-1 trading plans. A spokesman for the SEC said the commission will not comment further on its use of Jagolinzer's research.
Random—or not? Jagolinzer's recently published study looks at five years of trading activity, analyzing approximately 117,000 transactions, and finds that, on average, insider trades conducted under 10b5-1 outperformed the market by about 3.6 percent six months after the trades were executed. This association, he said, suggests that, on average, trades appeared more strategically timed than random.
In a new follow-up study, conducted with Todd Henderson at the University of Chicago Law School and Karl Muller at Penn State University, Jagolinzer finds that the most profitable preplanned trades are found at firms that voluntarily disclose more detailed information about insiders' trading plans. The authors suspect that providing these voluntary reports reduces legal risk, which allows insiders more strategic trade opportunity.
Jagolinzer notes that legal inferences cannot be drawn from his evidence because there is little public information available regarding the underlying process that generates these patterns. Internal documents would be needed, he said, to substantively pursue any investigation further.
The SEC, of course, is in the position to investigate specific cases and make those judgments. The agency charges, in a recent civil filing, that former Countrywide CEO Anthony Mozilo utilized his private knowledge of how risky the company's portfolio of subprime-mortgage loans was when he established four trading plans that netted him a profit of more than $139 million. He has denied the charge.
Jagolinzer's study discusses some plausible strategies and provides some evidence regarding selective plan termination that might explain the unexpected profitability of 10b5-1 trading patterns.
For example, insiders might set up their plans to trade profitably with the benefit of long-term information or time the release of certain information—such as the preannouncement of quarterly earnings—to enhance the profits from previously scheduled trades. Insiders might also selectively terminate their plans to prevent pending scheduled trades from executing unprofitably.
It's not clear whether the SEC will move further to modify the rules governing preplanned trades nor whether it should, Jagolinzer said."There may be cases where allowing strategic trade opportunities makes economic sense," he said."The Rule seems to provide a useful diversification option for risk-averse insiders," he added,"so the impact of potential changes should be considered carefully."