I’m working on a paper with a professor at Stanford about 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 trade on material, non-public information or providing an affirmative defense even for trades that might be of questionable legality. The litigation prophylactic only works, however, if firms disclose the existence of these plans. Based on data that we have collected, many firms that have adopted these plans made no disclosures about this fact. This seems puzzling.
Before considering the disclosure issue, some background is needed. For many years courts split over the proper standard for proving securities fraud involving transactions by executives of shares in their company’s stock (known as “insider trading”): some required proof of actual “use” of material, non-public information, while others required only that the trader have “knowledge” of this kind of information at the time of the sale. The classic case was one where an insider with material, non-public information at the time of a trade proffered evidence of a need to pay for emergency medical bills or to meet a margin call as a defense to alleged insider trading. In 2000, the SEC issued a rule purporting to resolve this debate, choosing the broader “knowledge” standard. It threw a bone, however, to executives, allowing them to enter into a trading plan at a time when they didn’t have material, non-public information that would cover a set future period. Thus as long as the executive did not possess material, non-public information on, say, January 1, an executive could draft a plan to sell a certain number of shares each month for one year, and this plan would provide an affirmative defense to allegations of insider trading.
One of the many benefits of these plans is that they can therefore reduce expected litigation costs for firms and executives. For example, in 10b-5 actions plaintiffs’ lawyers routinely use insiders’ personal profits from trades as evidence of a motive for the material omission or misstatement. If plaintiffs’ lawyers know that the insider has a strong affirmative defense on the scienter element, they will be less likely to file the case. If the plan is not disclosed, however, the litigation risk benefit is lost, especially since some courts seem unwilling to take judicial notice of non-disclosed plans at the key motion to dismiss stage of securities class actions.
Given the obvious litigation risk reduction benefits from disclosure, why would some firms adopt but not disclose? A few possibilities:
1. Privacy. Some lawyers who counsel firms on these issues tell me that executives are loathe to disclose anything about their trading habits for “privacy” reasons. This doesn’t seem very compelling. Whatever the benefits of privacy to the executive, these should be dwarfed by the benefits to the firm from disclosure, and therefore the firm should be willing to compensate the executive for any privacy costs. Moreover, disclosures can easily be developed to solve both problems: firms could disclose simply that “all executives make every trade according to pre-approved trading plans.” If credible, this should serve the prophylactic purposes and not raise any privacy concerns.
2. Mandatory disclosure. Another rationale for non-disclosure that we have heard is that companies do not want to disclose anything that isn’t required by law. Again, this isn’t very persuasive. Firms should be willing to disclose things beyond those required by law if the benefits exceed the costs. In addition to the benefits described above, disclosure may also be a positive signal about firm type. The costs here, on the other hand, are somewhat elusive. The only thing I can think of is some abstract concern about additional disclosures exposing the firm to potential litigation risk in the hands of skillful plaintiffs’ lawyers. But that concern has no power here, where the very disclosure is an affirmative defense to potential litigation. (If this argument is true, it is a potential indictment of the current mandatory disclosure regime, since it results in serious under-disclosure.)
3. Shielding. Another possibility is that the plans are not effective at reducing the incidence of trading based on non-public information, and perhaps even allow insiders additional opportunities for relatively safe strategic trading. There is at least one paper by my co-author, Alan Jagolinzer (Stanford Business), that discusses how executives might manipulate these plans to capture increased trading opportunities and provides some evidence that they are doing so. More benignly, disclosure likely signals something about an insider’s trading intentions, which could cause a preemptive change in the stock price that might reduce insiders’ profits from forthcoming trades. This latter problem can be solved through generic disclosures, as discussed above. Moreover, even if the shielding explanation (in either case) is plausible, it might explain why some firms adopt but don’t disclose, but this does not explain why firms would adopt and disclose.
We are left with a rather enigmatic equilibrium in which there is enormous heterogeneity in adoption and disclosure practice. Some firms require these plans for all executives, some for only a few, while some don’t permit them at all; some firms disclose details about plans, some disclose only the existence, and some don’t disclose anything. It is undoubtedly the case that every firm’s cost-benefit analysis is different, and the uncertainty surrounding a new and complicated rule may explain some of the difference, but the disclosure practice is seemingly at odds with any coherent market view of the cost and benefit of these plans.
Jagolinzer and I are currently examining the market implications of 10b5-1(c) plan disclosure to try to shed light on these issues. Our attempt to disentangle this puzzle has potentially important implications for not just insider trading laws but also more generally for how the SEC regulates in cases like this. We openly welcome comments or views on firms’ disclosure practices or any 10b5-1(c) related topic.