Insider trading plans: A new D&O underwriting concern?

For several years, directors and officers underwriters have viewed corporate insiders’ adoption of so-called “Rule 10b5-1 plans” as evidence of good corporate governance and as a positive underwriting factor. However, recent academic research and regulatory comments suggest that those plans may be subject to increased scrutiny. They also raise the possibility that D&O underwriters may be reassessing their perspective on such plans.

For years, corporate insiders faced the dilemma of how to trade their personal shares in their company’s stock without creating potential insider trading liability.

In 2000, the U.S. Securities and Exchange Commission (SEC) promulgated Rule 10b5-1 to provide corporate officials with a “safe harbor” within which to trade their shares. The rule creates an affirmative defense against an accusation of improper insider trading if the corporate official has traded pursuant to a predetermined trading plan. The written plan should not permit the insider “to exercise subsequent influence over how, when and whether to effect purchases or sales.”

A December 2006 study by Alan Jagolinzer, an accounting professor at the Stanford University Graduate School of Business based in California, took a hard look at actual trading under Rule 10b5-1 plans. He studied roughly 117,000 trades in Rule 10b5-1 plans entered into by 3,246 executives at 1,241 companies. He found that trades inside the plans beat the market by 6 percent over a period of six months, by contrast to executives at the same companies who traded without plans and who beat the market by only 1.9 percent during that same period.

Specifically, Jagolinzer found that “a substantial portion of randomly selected 10b5-1 plan initiations are associated with pending adverse news disclosure” and “early sales plan termination is, on average, associated with pending positive firm performance.”

In other words, Jagolinzer identified trading patterns suggesting that insiders initiated plans to sell shares ahead of anticipated price declines, locking in sales at the higher, pre-decline price. He also found that insiders terminated plans and refrained from selling shares prior to the company’s release of positive news that would be expected to drive the share price higher. Jagolinzer found that the plan participants’ stock sales “tend to follow price increases and precede price declines, generating statistically significant forward-looking abnormal returns.”

A Dec. 16, 2006, Business Week article following up on Jagolinzer’s study also found several instances of “impeccable” timing and “curious patterns.”

For example, the article found several instances of massive sales at stock price peaks, followed by plan terminations. The article noted that “despite the ‘pre-arranged’ nature of the trading plans, executives have enormous flexibility to start, stop, restart and amend them at will.”

As one analyst observed, “if executives are ending plans and starting new ones with each trade, how does that differ from simply trading outside a plan?”

None of this been lost on the SEC. In a March 8, 2007, speech, SEC Enforcement Division Director Linda Chatman Thomsen said Jagolinzer’s analysis raises the possibility that plans are being abused in various ways to facilitate trading based on insider information.

“We’re looking at this — hard. We want to make sure that people are not doing here what they were doing with stock options. If executives are in fact trading on inside information and using a plan for cover, they should expect the ‘safe harbor’ to provide no defense,” Thomsen is quoted as saying on the SEC Web site.

A March 19, 2007, Business Week article, reporting on Thomsen’s speech and her suggestion that the SEC will be looking at improper trading inside trading plans, reported that the SEC is scrutinizing insider trading at the many financially troubled subprime lenders, and particularly is looking at trading by officials at those companies pursuant to Rule 10b5-1 trading plans.

It is far too early to predict a trend, much less the arrival of the next scandal. But the combination of academic research, press attention and most significantly, regulatory scrutiny, suggests that Rule 10b5-1 plans will be an area of increasing attention in coming months.

An important additional factor to keep in mind in assessing the seriousness of this issue is that the current options backdating scandal first originated with an academic study, that was followed later by press attention and regulatory action.

Such issues present a challenge for D&O underwriters. Certainly, trading plans structured and implemented according to the original intent of the rule should still afford the protection for which the rule was designed. However, insiders who are starting or stopping plans, or running multiple plans, could face unwanted regulatory scrutiny.

As a result, D&O underwriters will no longer simply accept that a trade was made pursuant to a plan as an explanation for an the timing of a particular purchase or sale.

Underwriters will also want to know when the individual’s plan started and whether the individual has multiple plans, or has had prior plans that started or stopped.

Underwriters will also be keeping an eye on the SEC’s activity in this area, to gauge where this issue may be headed.