Scienter disclosure

Ever since Louis Brandeis wrote that "sunlight is the best disinfectant," disclosure has been the fetish of American law. Our securities laws and much of corporate law are premised on the assumption that disclosure is a virtual legal panacea -- if individuals are aware of the relevant information, then the opportunities for strategic opportunism will be reduced or eliminated. For this reason, the knee-jerk response to perceived problems in nearly every area of law is increased disclosure.

But there may be a dark side to disclosure. In a paper posted to SSRN today (and discussed here), this issue is explored in the context of Rule 10b5-1 insider trading plans, which provide a litigation prophylactic for insiders who pre-commit to trades. Because disclosure of these plans is not mandatory, firms' voluntary disclosure offers a nice test of the social benefits and costs of disclosure.

My co-authors (Alan Jagolinzer and Karl Muller) and I find, among other things, that insiders who disclose the existence of plans earn significant abnormal returns (about 12% in 6 months) compared with insiders who do not disclose. The intuition here is that disclosure increases the opportunities for strategic trading due to the litigation risk reduction benefits. Our data also show that any attempt to "solve" this problem by requiring disclosure of plan participation is unlikely to succeed because the firms currently not disclosing are the ones least likely to be acting strategically. The full abstract is posted after the jump.

This study examines implications of "scienter disclosure" through an analysis of voluntary disclosures regarding insiders' Rule 10b5-1 trading plans. Prior theory suggests that disclosing informed traders' intent to trade is not strategically advantageous, but this theory does not account for litigation risk reduction resulting from disclosure. Legal precedent regarding Rule 10b5-1 affords legal risk reduction to disclosure, therefore voluntary disclosure offers an interesting theoretical test. Evidence indicates that Rule 10b5-1 disclosure increases with firm litigation risk and insider strategic trade potential. Evidence also indicates that Rule 10b5-1 disclosure is associated with greater abnormal returns to insiders' trades, especially for firms disclosing specific plan details. This evidence suggests that legal risk can compel firms to depart from a non-disclosure strategy and that disclosure might enhance strategic trade. Evidence also suggests that non-disclosing firms are least associated with strategic trade; therefore proposed mandatory Rule 10b5-1 disclosure might not mitigate strategic behavior.

Comments

[FrankMCook]

This really takes me back 40 years. Our third year moot court case involved the purchase of control in a Denver newspaper. Beard and Cook for the defense and Samuelson and Gottshalk for the plaintiffs. Gaubatz had selected the case largely because he was from Colorado.

I remember arguing that 10b5 only required the disclosure of material affecting value and not my "client's" evil plans for the newspaper. Perhaps we were actually right.

[minderbender]

From the USA Today article:

"Also, [Henderson] says, the plans provide a kind of free insurance against a falling stock price because executives can terminate plans without selling if the bad news doesn't come."

If I understand this correctly, it pretty much eviscerates the disclosure requirement. An insider can simply disclose at time t that he or she will sell stock at time t+1. Then, when t+1 rolls around, it's a simple matter of trading on insider information - if the insider information indicates that it is a good time to sell, then sell. If insider information indicates otherwise, then don't sell (terminate the plan). The information might not exist until time t+1, but that doesn't prevent the insider from profiting while enjoying the protection of a plan disclosed at time t.

To put it another way, the disclosure only works if the insider must commit to make the sale regardless of information that arises in the interim.

[d]

minderbender, I think an insider can still "win" by terminating if he/she discloses some information at time t, but doesn't disclose enough details at time t to allow for regular investors to know why the sale(s) never occurred at time t+1. Maybe a limit order never triggered? If the plan details aren't disclosed, then there is no way to unwind this fully.