Midway CEO Zucker's Safe Harbor

In late 2005, the executive traded almost 650,000 shares of company stock, just as it began a precipitous decline. A lucky coincidence?

by Jane Sasseen

Late last year, after a seven-month surge had nearly tripled shares in Midway Games (MWY), CEO David Zucker apparently decided that it was time to lighten his load. On Dec. 8, he filed notice with the SEC that he had set up a prearranged trading plan to sell off some of the shares he had accumulated in the Chicago-based company, best known for its popular Mortal Kombat video game.

And unload Zucker did—with a vengeance. His first trades came on Dec. 19, with the sale of 50,000 shares, bringing in proceeds of $1.1 million. And over the course of the next three weeks, Zucker sold another 50,000 shares virtually every trading day, taking a break only for Christmas and New Year's. By Jan. 6, the date of his last trade, Zucker had sold off some 650,000 shares, reaping proceeds of $12.9 million. He finished with just 163,000 shares remaining, according to SEC filings.

Increased Scrutiny

Zucker's timing couldn't have been more fortuitous. Less than a week after he set up his automatic trading program, Midway's board approved a plan to take charges of $20 million and cut the company's workforce by up to 11%. When that plan was made public late on Dec. 16, a Friday afternoon, Midway's shares began a precipitous slide. From a peak of $23.26 on Dec. 15, its stock fell a stunning 57%, to $9.91, by late February.

It's the sort of insider sale that is drawing increasing scrutiny, because Zucker's trades took place after he filed what is known as a 10b5-1 plan. These prearranged plans, named after the SEC rule in 2000 that authorized them, are designed to let executives sell the shares they have accumulated in their companies without facing charges that they are trading based on their inside knowledge. They provide executives with a "safe harbor" from such charges, but only if they meet several conditions. Most important, executives must set up these plans at a time when they aren't aware of any significant nonpublic information. They also must delineate the dates or the price at which trades should be made in advance, and they must hand over control of the trades to a broker.

But in the face of evidence that insiders who set up prearranged plans appear to be earning outsized gains, such plans are coming under increased scrutiny. A recent study by Stanford Graduate School of Business Assistant Professor Alan Jagolinzer raises questions as to whether insiders are in fact able to tap their inside knowledge when they set up and trade under such plans.

Knowledge Aforethought?

As reported in BusinessWeek on Oct. 26, Jagolinzer has analyzed data on nearly 100,000 trades made between 2003 and 2005 by 2,995 insiders at 1,016 firms with 10b5-1 plans (see BusinessWeek.com, 11/6/06, "Not as Random as It Looks?"). He found that insiders, on average, were able to beat the market by 5.6% with the trades they did within 10b-5 plans.

At a conference on the legal and accounting issues surrounding options dating and trading issues sponsored by Stanford's Rock Center for Corporate Governance on Oct. 30, Jagolinzer elaborated on his view that a preliminary analysis of the data appears to show that such trades may not be as random as intended by the SEC's original rule. "The conventional wisdom among investors is that these are 'uninformed' trades by executives made to diversify," Jagolinzer told the Washington (D.C.) gathering. But the sales activity doesn't appear to reflect "random diversification," he says.

A key reason for the higher performance: More often than not, the sales insiders make in such plans take place just ahead of declines in their companies' stocks. In part, that's because they also sell shares in advance of negative earnings news twice as often as they sell ahead of good news. "What this work suggests is that executives who know that their stock will underperform—either because they know specific bad news is coming up or because they think the market has overvalued it—enter into plans and sell a large fraction of their stock," says Jesse Fried, the co-director of the Berkeley Center for Law, Business & the Economy at the University of California, Berkeley, and the co-author of Pay without Performance: The Unfulfilled Promise of Executive Compensation.