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Three Red Flags for Rule 10b5-1 Plans

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February 23, 2021 | Barbara Baksa

Three Red Flags for Rule 10b5-1 Plans

A recent study raises concerns about abuse of Rule 10b5-1 plans and has attracted the attention of three senators and the SEC.

Rule 10b5-1 Plans

Under Rule 10b5-1, individuals can establish an affirmative defense to allegations of insider trading by entering into a written plan to trade securities in advance of when the trades will occur. The plan must be entered into at a time when the insider is not in possession of material, nonpublic information.

If created properly, these plans enable insiders to engage in stock transactions during company blackouts and other times when they would normally be prohibited from trading due to their knowledge of material, nonpublic information. Because the decision to trade is made (and documented) in advance of when the individual comes into possession of material, nonpublic information, the trade is not suspect.

In theory, this sounds reasonable. In practice, however, implementation of Rule 10b5-1 trading plans involves a lot of gray areas. For example, how far in advance does the trading plan need to be entered into to ensure that the insider doesn’t have material, nonpublic information that might be a factor in the insider’s decision to trade? And if the insider can modify the plan or terminate it before the trade occurs, has he/she really made a decision to trade?

The Red Flags

The study, published by academics at Stanford, the University of Pennsylvania, and the University of Washington, identifies three red flags that could signify abusive or opportunistic use of Rule 10b5-1 plans.

1. Short Cooling-Off Periods

A recommended best practice for Rule 10b5-1 plans is to have a waiting or “cooling-off” period before trades can begin under the plan. This establishes some distance between the decision to trade and its execution, which helps demonstrate that the insider’s decision to trade was not based on material, nonpublic information that he/she later became aware of before the trade occurred.

The researchers found that the median cooling-off period for the studied plans was 76 days (less than three months), meaning that in 50% of plans, the plan could be entered into and trades could subsequently start in advance of an earnings release (see red flag #3).  In addition, in 14% of plans, trades commenced in less than 30 days—and in 1% of plans trades commenced on the same day (a very generous interpretation of the word “advance”).

2. Single-Trade Plans

Almost half of the plans in the studied sample involved only a single trade. The researchers note that single-trade plans are economically equivalent to a limit order or date-triggered order and are “inconsistent with traditional financial advice for exiting a concentrated equity position over time.” They are also arguably inconsistent with the SEC’s original expectation for Rule 10b5-1 plans, which was that they would be used to execute regular, ongoing trades.

3. Plans Adopted and Executed Before Earnings Announcements

Almost 40% of the studied plans were implemented and had at least one trade execute in the same quarter, before earnings for the quarter were announced. The authors are concerned that the executives likely have some idea of how the company is performing for the quarter at the time they entered into the plans and that these plans are merely a means of circumventing blackout periods.

The Evidence

In all the above red-flag cases, the researchers found that trades tended to be larger than for other plans. More concerning, the red-flag plans consistently foreshadowed stock price declines that were in excess of industry peers and enabled insiders to avoid losses that they would have experienced had they not sold stock. 

Single-trade plans with short cooling-off periods exhibit the highest loss avoidance, avoiding an industry-adjusted price decline of -4 percent.

The Recommendations

The researchers recommend that the SEC take the following actions:

  • Require a minimum cooling-off period of four to six months.
  • Disallow single-trade Rule 10b5-1 plans.
  • Disallow Rule 10b5-1 plans in which trades begin executing in the same quarter the plan is adopted.

In addition, the researchers call for required disclosure of 10b5-1 plans, including:

  • Disclosure of the adoption, modification, suspension, and termination of Rule 10b5-1 plans, as well as the maximum number of shares to be sold under a plan.
  • Require insiders to indicate on Form 4 when reported transactions are pursuant to a 10b5-1 plan. The SEC already has issued a proposal to add a Form 10b5-1 plan checkbox to Forms 4 and 5 but use of the checkbox would be voluntary.
  • Require Form 144 to be filed via EDGAR. The SEC also has already issued a proposal to require this.

Pharmaceutical Executive Stock Sales

Recent stock sales by the CEOs of Pfizer and Moderna have increased the scrutiny on Rule 10b5-1 plans. Pfizer’s CEO entered into a Rule 10b5-1 plan in August under which a trade was executed in November, the same day Pfizer announced the effectiveness of its COVID-19 vaccination. Moderna’s CEO sold stock just prior to the company’s emergency use authorization filing for its vaccine; the sale occurred pursuant to a Rule 10b5-1 plan that the CEO had modified in May.

The Senators

In response to publication of the study, Senators Elizabeth Warren (D-NY), Sherrod Brown (D-OH), and Chris Van Hollen (D-MD) submitted a letter to SEC acting chair Allison Herren Lee urging the SEC to review and reform its policies for Rule 10b5-1 plans. The letter cites both the Pfizer and Moderna CEOs’ sales and supports the recommendations noted above, particularly four to six month cooling-off periods and required disclosure of Rule 10b5-1 plans.

Most interesting, the senators suggest that the SEC work with Congress to modify the Section 16 short-swing profits recovery rules to cover profits from sales under Rule 10b5-1 plans when there is disclosure of material information that subsequently causes the company’s stock price to decline.

The letter asked for a response from the SEC by yesterday. My guess is that we will be hearing more about this topic in the future.

- Barbara

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