Disclosure of insider trading plans – a puzzle

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.

Comments

[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.