Scienter Disclosure

This study examines implications of scienter disclosure through an analysis of voluntary disclosures regarding insiders\u27 Rule 10b5-1 trading plans. Prior theory suggests that disclosing informed traders\u27 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\u27 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. Keywords: Rule 10b5-1; voluntary disclosure; insider trading JEL Classification: D82; G38; K22; M5

Undoing a Deal with the Devil: Some Challenges for Congress\u27s Proposed Reform of Insider Trading Plans

The adoption of Rule 10b5-1 was, in a manner of speaking, a deal with the devil that the SEC and some lawmakers now appear to regret having made. The problem is that, as is often the case with such a deal, it cannot be easily undone. I identify challenges presented by the restrictions on Trading Plan use that Congress has proposed in the Corporate Insiders Act. In light of these challenges, I argue that effective Trading Plan reform cannot be accomplished by simply restricting the use of Trading Plans while leaving Rule 10b5-1(b)\u27s awareness test in place. If there is to be reform, it should be comprehensive. If neither the SEC nor Congress desires comprehensive reform of our current insider trading regime, however, I conclude by offering the consolation that permitting insiders to continue to use Trading Plans strategically may not be so bad after all. Perhaps even a deal with the devil can be worked for the good of investors

Do SEC’s 10b5-1 Safe Harbor Rules Need To Be Rewritten?

We examine the profitability of insider trading under SEC Rule 10b5-1 plans. The plans do work to prevent some informed trading. However, on average, insider trading under the safe harbor plans appears to be motivated by material non-public information. We propose some policy changes to tighten the rule and enable separation of informed and uninformed insider trading

Solving the Paradox of Insider Trading Compliance

Regulators demand the impossible when they require issuers to design and implement effective insider trading compliance programs because insider trading is a crime that neither Congress nor the Securities Exchange Commission has defined with any specificity. This problem of uncertainty is then compounded by the threat of heavy civil and criminal sanctions for violations. Placed between this rock and hard place, issuers tend to adopt overbroad insider trading compliance programs, which comes at a heavy price in terms of corporate culture, cost of compensation, share liquidity, and cost of capital. The irony is that, since all of these costs are ultimately passed along to the shareholders, insider trading enforcement under the current regime has precisely the opposite of its intended effect. This is the paradox of insider trading compliance for issuers, just one more symptom of a dysfunctional insider trading enforcement regime that is in need of a dramatic overhaul. There are a number of conceivable paths to resolving this paradox. The most obvious solution would be for the Securities Exchange Commission to issue a rule or for Congress to promulgate a statute defining insider trading with greater specificity. But while simply fixing definitions to the elements of insider trading under the current regime would improve matters, this Article calls for a more radical solution. It suggests that the current enforcement regime be liberalized to permit insider trading where an issuer approves a trade in advance and has disclosed that it permits such trading pursuant to regulatory guidelines. It argues that such reform would lead to a more rational, efficient, and just insider trading enforcement regime. Moreover, by aligning the interests of issuers, shareholders, and regulators, this reform would also offer the most effective solution to the paradox of insider trading compliance

Anticipating a Sea Change for Insider Trading Law: From Trading Plan Crisis to Rational Reform

The Securities and Exchange Commission is poised to take action in the face of compelling evidence that corporate insiders are availing themselves of rule-sanctioned Trading Plans to beat the market. These Trading Plans allow insiders to trade while aware of material nonpublic information. Since the market advantage insiders have enjoyed from Plan trading can be traced to loopholes in the current regulatory scheme, increased enforcement of the existing rules cannot address the issue. But, simply tweaking the existing rule structure to close these loopholes would not work either. This is because the SEC adopted the current rule as a part of a delicate compromise with the courts in the use versus possession” debate over the proper test of scienter for insider trading liability. The current rule reflects the SEC\u27s preferred test (mere awareness”), but it provides for Trading Plans as an affirmative defense in order to pass judicial scrutiny. Thus, any attempt to simply close the loopholes in Trading Plans while maintaining the awareness test would upset this delicate compromise. Only a comprehensive change to the current insider trading enforcement regime can address the issue. The reform proposed here begins with the recognition that Plan trading is generally done with the firm\u27s awareness and consent. Such trading is therefore a form of issuer-licensed insider trading. Since there are strong arguments that there is no moral wrong or economic harm done by issuer-licensed insider trading, the regulatory regime should openly embrace it as a permissible form of compensation through firm-sanctioned Modified Trading Plans, so long as there is adequate disclosure. Though such liberalization would represent a radical departure from the current enforcement regime, it would be within the SEC\u27s rulemaking authority, and would be consistent with Supreme Court precedent. Most importantly, it would dramatically improve the current enforcement regime in terms of justice, clarity, efficiency, and coherence. It is sometimes said there is nothing like a good crisis for effecting much needed change. The current media attention and public scrutiny over corporate insiders\u27 exploitation of rule-sanctioned Trading Plans may be just the crisis to spur the SEC to adopt a more rational and just approach to insider trading enforcement. The outline for such reform is proposed here

10b5-1 Plans and Earnings Management by High-Level Executives

Using historical firm financial and insider trading information, this paper examines whether high-level insiders manipulate earnings ahead of their own 10b5-1 equity transactions. The empirical evidence suggests that high-level executives appear to manipulate earnings through real activities such as abnormal discretionary expenditures and abnormal cash flows from operations to influence equity prices ahead of their own transactions under Rule 10b5-1. Evidence also suggests that executives appear to be unlikely to engage in earnings management through highly scrutinized means such as accruals. An interpretation of these results is that high-level executives may be using 10b5-1 plans as an offensive tool to trade with the knowledge of inside information, which appears to be in direct opposition to the defensive mechanism that 10b5-1 plans are intended to represent

Insider Trading and CEO Pay

This Article presents evidence showing that boards of directors bargain with executives about the profits they expect to make from trades in firm stock. The evidence suggests that executives whose trading freedom increased using Rule 10b5-1 trading plans experienced reductions in other forms of pay to offset the potential gains from trading. There are two potential benefits from trading-portfolio optimization and informed trading profits- and this Article allows us to isolate them. The data show that boards pay executives in a way that reflects the profits they are expected to earn from informed trades. It also casts some doubt on the existence of the incremental value for optimization trades provided by the Rule. In addition, this Article explores the legal issues associated with paying executives from illegal profits. As a matter of policy, the data seriously undercut criticisms of the laissez-faire view of insider trading most closely associated with Henry Manne. At least with respect to classic insider trading (that is, a manager of a firm trading on the basis of information about the firm where she works), if boards are taking potential trading profits into consideration when setting pay, it is difficult to locate potential victims of this trading. Current shareholders should be at least indifferent to a deal that pays managers in part out of the hide of future shareholders. The firm should also internalize any costs arising from this payment scheme, since future shareholders should take this into account when deciding whether and at what price to buy shares. While there still may be good reasons to prohibit some individuals from trading on material, nonpublic information, the data make the case for classic insider trading much weaker

Insider Abstention and Rule 10b5-1 Plans

Company insiders will typically be in possession of material non-public information (MNPI) about their companies. In order to allow insiders the opportunity to trade, the SEC adopted Rule 10b5-1, which provides an affirmative defense to insider trading liability if the trades are made pursuant to a written plan or trading instruction entered into when the trader was not aware of MNPI. Over the years, there has been considerable concern that insiders were abusing Rule 10b5-1 plans by adopting plans just prior to trading, adopting multiple plans, or even terminating plans when they turned out to be unprofitable. The SEC recently adopted new rules designed to curb some of the more abusive practices, but one significant problem remains: while Rule 10b5-1 plans are supposed to be irrevocable, insiders who back out of plans have so far escaped liability under the central anti-fraud provision of the federal securities laws, principally because a violation of that provision requires an actual trade. The issue of “insider abstention”—insiders who decide not to trade based on MNPI—has long bedeviled insider trading law and policy. Insider abstention is typically undetectable and unknowable, raising insurmountable issues of proof, while the general requirement that fraud be “in connection with the purchase or sale of a security” imposes a rigid legal barrier. But Rule 10b5-1 plans stand on a different evidentiary footing: they are written plans, communicated to third parties, creating a clear record of intent. The only real question is whether legal liability can attach in the absence of an actual purchase or sale of a security. Traditionally, the answer to this question has been no. The SEC staff has stated on a few occasions that cancellation of a Rule 10b5-1 plan would not in itself lead to liability under Rule 10b-5 because terminating a plan would not meet the “in connection with” requirement. However, Rule 10b5 is not the only statutory provision that has been used to prosecute insider trading. The SEC has frequently prosecuted insider trading under Section 17(a) of the Securities Act, a provision that applies not only to the “sale” of securities but extends more broadly to “offers” to sell securities. And criminal authorities have increasingly been prosecuting insider trading under mail and wire fraud statutes that do not have an “in connection with” requirement at all. These other statutory provisions could provide a basis for insider trading liability in the context of a cancelled or terminated Rule 10b5-1 plan

Taming Rule 10b-5-1: The Unfinished Business of \u3cem\u3eTexas Gulf Sulphur\u3c/em\u3e

Insider trading has shaped both the evolution of the Securities Exchange Commission (SEC) and the current state of securities law. The injustice of insider trading, especially as felt by everyday shareholders and investors, mandated action by government regulators. Consequently, the SEC enacted Rule 10b-5—a prohibition and prosecution on any corporate officials’ use of material, non-public information for private profit. In SEC v. Texas Gulf Sulphur Co., Rule 10b-5 grew into the sanction on insider trading that it is known as today. As case law whet Rule 10b-5’s reach on in- sider trading, corporate executives became increasingly concerned that necessary business transactions would be considered fraud. Thus, the SEC promulgated Rule 10b-5-1. Through this safe harbor, corporate officials could again purchase or sell shares in the companies they ran. Although the safe harbor is subject to certain limitations, abuse of Rule 10b-5-1 has become increasingly apparent. This article seeks to critically analyze the shortcomings of Rule 10b-5-1 and investigate potential courses of action that could remediate its insufficiencies