Insiders with a Curious Edge

How corporate executives seem to be violating the spirit, if not the letter, of a rule meant to prevent insider trading

by Jane Sasseen

The confusion over corporate executives trading on inside information never seems to go away. In 2000 the Securities & Exchange Commission came up with a way to remove the guesswork over when it's legal to trade and when it's not. But a raft of recent trades by executives suggests the plan might not be the cure-all that was hoped for.

The SEC's solution was to create prearranged trading plans, known as 10b5-1 plans for the rule that authorized them. Launched six years ago, they were designed to remove discretion from executives' trades and provide a "safe harbor" from insider trading charges. The rules: Executives can't set up a plan when they possess material inside knowledge, and they must set the dates or prices of their trades in advance.

Reaping Better Returns

But those are the only major stipulations. The SEC never addressed the number of shares sold or the possibility of stopping and starting plans or running multiple plans at once. As a result, executives have far more flexibility than is generally understood. Besides providing legal cover, the plans allow execs to trade around earnings announcements and other significant events. Normally insiders are prohibited from trading on these "blackout dates."

Executives appear to be using their flexibility to the max. People selling shares in 10b5-1 plans generate returns substantially better than would be expected if the trading were truly automatic. As reported in BusinessWeek on Nov. 6, Alan D. Jagolinzer, an assistant professor at Stanford University Graduate School of Business, recently completed a study of roughly 117,000 trades in 10b5-1 plans by 3,426 executives at 1,241 companies. He found that trades inside the plans beat the market by 6% over six months.

Those numbers imply that the rules allow execs to benefit from inside knowledge. "The SEC's intent was to shelter people who didn't have any [material] inside knowledge from liability," says Jesse Fried, co-director of the Center for Law, Business & the Economy at the University of California at Berkeley School of Law, and an expert on executive compensation who has reviewed Jagolinzer's study. "But that outperformance suggests instead that it's the people using what information they have who are most often entering into trading plans." Says Walter Riccardi, deputy director of the SEC's Enforcement Div.: "Setting up a 10b5-1 plan while in possession of material information...could be Securities fraud."

Many Explanations

BusinessWeek examined a database created by Thomson Financial of companies that had suffered a 20% stock slide in the past year and, from that group, focused on the roughly 150 where executives had used 10b5-1 plans and where significant trading—both inside and outside plans—had taken place.

The results? BusinessWeek found a surprising amount of leeway over preplanned trades. At nearly half the companies examined, sales were concentrated in the months leading up to a stock's peak or just thereafter. Frequently, the number of shares sold increased as the stock hit new highs, then trailed off or ended as the stock dove.

There are many possible explanations. One, says Michael Painchaud, president of Market Profile Theorems, a Seattle executive trading tracker, is that top officials often know about a company's prospects long before the information is considered legally "material." Another explanation: Many executives pay close attention to valuation levels and decide to cash out after they've seen a big rise. "Insiders know that institutional traders can be very fickle and that money will go elsewhere if their momentum starts to slow," says Mark LoPresti, who follows executive trades for Thomson Financial. In fact, sales in some plans are automatically triggered when stocks reach certain price targets.

Still, the words "prearranged trading plans" bring to mind a steady pattern of trading over a long period of time. When discussing their plans, companies tend to reinforce that perception, says LoPresti.