Insider Trading Loopholes Need to Be Closed

During a game of golf, a senior executive mentions to a friend that his company is about to merge with a larger competitor. He says that anyone who buys stock now will make a big profit. In exchange for the tip, he asks his friend to purchase shares for him, too.

That's not the plot of an episode of “Billions” — it’s the kind of real-life scenario that spawned securities laws prohibiting corporate executives from trading on inside information. The Securities and Exchange Commission doesn’t just enforce the rules, it makes them. It’s been more than two decades since the SEC made major changes to insider trading rules, and it's well past time to revisit whether investors are sufficiently protected, or if the rules are being abused.

In revisiting these rules, it’s important to keep in mind that senior executives are routinely exposed to inside information (what’s officially considered material nonpublic information) just by doing their jobs. If they were permitted to trade on that information ahead of shareholders and the public, it would undermine confidence in the markets. But since many executives receive a significant portion of their compensation in stock, they need to be able to sell shares — whether to pay expenses, diversify their investments or just generate cash — without running afoul of securities laws.

To address this dilemma, 20 years ago the commission developed Rule 10b5-1, which allows senior executives to establish a formal plan setting forth a pre-established formula that would trigger stock sales. As long as the plan was adopted while the executive didn't have inside information, the rule provides an affirmative defense for planned trades against any allegations of insider trading.

Once in place, the plan can be modified as long as the executive is not aware of inside information at the time of the modification — and those modifications generally need not be disclosed to the SEC or the public. The rule provides that the plan and any associated trades can also be canceled at any time, regardless of whether the executive is in possession of inside information. It's that aspect of these plans that's particularly controversial, as it allows executives to set up a routine sale and then pause or cancel it if they know the company will be announcing news that will move the stock price — and to do so in secret, without public disclosure.

For example, the golfing senior executive could set up a plan to sell shares before a previously announced merger is finalized. If the executive eventually learns that the merger is delayed and is likely to close after the scheduled sale, he can cancel the transaction, and instead sell shares after the deal is finalized (when prices are higher). Alternatively, if the executive eventually learns that the announced merger is going to fall through, he could let the planned sale go ahead at inflated prices prior to the disclosure of the bad news. In either case, the executive is able to sell at the most advantageous price. This raises the possibility that, in contravention to the SEC’s intention, the rule could be used aggressively to facilitate opportunistic trading. 

A recent study  that analyzed more than 20,000 10b5-1 plans and associated trades found evidence suggesting that these plans are susceptible to abuse because they could be adopted and implemented on a short timetable. More than one-third of the plans adopted in a given quarter executed a trade before that quarter’s earnings announcement, avoiding considerable losses. Loss avoidance appeared concentrated among plans that executed a single trade within 60 days of plan adoption.

The potential for abuse could be addressed in part by adopting “good corporate hygiene” recommendations. In particular, echoing former chairman Jay Clayton, the commission should consider imposing a mandatory "cooling off period" of four to six months between the adoption or modification of a plan and the first planned trade. If implemented, empirical evidence suggests this approach would eliminate a considerable amount of opportunistic trading.

In addition, the commission should consider requiring corporate insiders to disclose publicly whether their trades are planned, and either (i) disclose the plan or (ii) disclose the plan adoption (or modification) date and the total amount of shares covered by the plan. Often this information is already provided to a company’s general counsel, and thus wouldn't be burdensome to disclose.

Finally, the SEC should consider requiring that 10b5-1 plans entail multiple transactions spread out over time that constitute a regular, pre-established program of buying or selling. A plan that executes a single trade is in many ways no different from a single limit order with a price trigger, or date trigger. The commission should consider disqualifying such plans from the affirmative defense.

Concerns about the SEC’s insider trading rules have been around for years, and have been brought back into the limelight following recent congressional hearings. Tighter rules on the disclosure and use of planned trades will protect investors and level the playing field. We look forward to working with the commission and staff to revisit insider trading rules. The less our real-life markets resemble a plot from “Billions,” the better.

Daniel Taylor, who co-wrote this article, was a coauthor of the study

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Caroline Crenshaw is a commissioner at the U.S. Securities and Exchange Commission.

Daniel Taylor is an associate professor at the Wharton School and director of the Wharton Forensic Analytics Lab.

©2021 Bloomberg L.P.

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