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July 10, 2006

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» Why Adopt a 10b5-1(c) Plan and Not Disclose It? from ProfessorBainbridge.com
Todd Henderson blogs on firms’ decisions to adopt and disclose the existence of corporate insiders’ 10b5-1(c) trading plans:In theory, these plans can decrease expected litigation risk for firms and executives, either through reducing the ability to tr... [Read More]

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Thomas

Some thoughts:

--The decision to enter into any 10b5-1 plan is made by the executive, not by the firm.

--Expected litigation costs might be of less interest to executives than expected litigation losses, due to available indemnification.

--Firms do not have available any mechanism to compensate executives for loss of privacy, etc. But they can limit the availability of trading outside of such plans (which reduces the costs of the plan compared to alternatives).

--The disclosure language you propose wouldn't be effective. No one would expect that all trading be done through a 10b5-1 plan, and no firm would require it. And a generic disclosure likely would not offer sufficient protection about a particular plan--the question would be, has the particular plan been disclosed, as would be necessary to avoid litigation costs.

--Executives are often concerned about disclosing sales plans because those plans signal an intent to sell (as you note), and thus require further explanation or context from the executive (e.g., the generic diversification language often found in disclosures). Executives are sometimes concerned that they will be pressed for additional details about the trading plan, including details such as the minimum sale price and other terms that might reveal the executive's thinking about the "true" value of the stock.

Adam Pritchard

I doubt that the plans need to be disclosed to reduce class action risk -- raw insider selling is not a very important determinant of suit filing, and it is irrelevant to dismissal decisions and settlements. Abnormal insider selling has some influence, but the plan itself, not the disclosure thereof, eliminates this risk. I think the main reason to adopt a plan is to reduce SEC enforcement exposure, and disclosure will not help with this.

A.S.

If the sales pursuant to the 10b5-1 plan are large enough as compared to the stock's float, it is possible that other market participants will change their behavior (i.e., decrease their bid price) on the basis that they know when and how much the seller intends to sell.

That is, let's say the 10b5-1 Plan is that on the first trading day of every month, the seller will sell 100,000 shares. Well, if I'm another market participant, and I know that there's going to be a 100,000 block of shares offered every month, I change my behavior on that basis. In advance of first of the month, I lower the price I'm willing to pay (i.e., the bid price) because I know that someone is going to be selling 100,000 shares. I certainly wouldn't pay a high price today if I know that someone will sell 100,000 shares tomorrow, thereby lowering the price at that time.

We know that an offer to sell a large block of stock is going to depress the price. But if other market participants know that a sale of a large block is coming on X date, they will change their behavior on that basis, potentially hurting the seller.

At least, that is the reason I've been given by certain clients who decided not to make an announcement of a 10b5-1 plan.

ToddHenderson

Some nice comments. Some responses:

First, to the point made by “Thomas” re the concern about signaling intent to sell and the worry that any disclosure will just open the door to more questions, which might lead to the scenario described by “A.S.” This is unlikely. These plans can be very specific, “sell X shares at $Y price on Z day every Q months”; or they can delegate power to a broker to decide; or they can establish an algorithm to calculate when and how much to sell at what price. Regardless of the specificity of the plan, the specificity of the disclosure can be, and often is, general. The disclosures that are made run the gambit from mere existence of the plan to full details. Lawyers (the good ones) tell their clients to disclose the existence of the plan and some information about the volume and timing in order to eliminate surprise, which can lead to litigation or stock volatility, but not too much to raise the concerns about privacy or market anticipatory reaction. A policy of moderate disclosure followed by “no comment” when pressed for details would be at least as good (and likely much better) than the alternative of no communication at all. In other words, telling the market that the CEO plans to sell 100,000 shares in three increments over the course of the year for diversification purposes would provide some litigation risk and volatility risk reduction effects, without raising the market timing concerns.

Second, to the point Adam Pritchard makes about litigation risk. The study I am working on will bear on this question. I will note, for now, however, the intuition that the public disclosure of a plan should discourage, on the margin, the filing of suits since the cost of proving the requisite elements is higher, by definition, in cases in which the trader has an affirmative defense. As a practical matter, several courts have already considered issues that go directly to this question. In In re Netflix, Inc. Sec. Litig., 2005 WL 1562858 (N.D. Cal. June 28, 2005), the court held that trading pursuant to a plan goes against allegation of scienter, and therefore dismissed the case on a motion to dismiss, which is key for defendants who want to avoid the costs of discovery. Importantly, the plan was publicly disclosed. A similar result was reached in Weitschner v. Monterey Pasta Company, 2003 WL 22889372 (N.D. Cal. Nov. 4, 2003). These cases (and others) suggest that the issue is very important at the motion to dismiss stage. Especially since courts at this stage consider only the plaintiff’s complaint on its face, along with (perhaps) publicly filed documents. Every lawyer I've talked to that defends these cases tells me that they urge their clients to disclose to serve as a deterrence to the filing of a complaint in the first place. And until the courts resolve these issues, that seems like the sensible strategy. At least one court has hinted that it won’t consider non-public documents at the motion to dismiss stage. If some courts won't consider non-public trading plans at the motion to dismiss stage, what is the point of having the plan?

Third, as to Thomas’s other points. It does seem that executives are given the discretion to enter into plans in many cases, although not all that we have found. Some firms require executives to use these, while others ban them. Moreover, the decision to disclose need not be the executives. If the litigation risk reduction benefit is primarily the firm’s, although it need not be, there is no reason why the firm couldn’t disclose the plan. There may be a cost—that is, the executive might not want the firm to disclose—but the firm could easily compensation the executive for this.

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