sec sealThe SEC promulgated Rule 10b5-1 nearly 16 years ago to allow executives (whose wealth often is entirely locked up in company shares) to trade in their company’s stock without incurring possible liability under the securities laws. The Rule provides an affirmative defense against allegations of improper trading. In many cases defendants have  relied on the existence of a Rule 10b5-1 trading plan in order to have the securities claims against them dismissed (for example,  here and here). However, the Rule has also been subject to criticism, and some have questioned whether corporate executives are abusing their plans in order to shield questionable trading.


A recent academic study corroborates the view that the plans “are being abused to hide more informed insider trading.” The study, by Gothenburg University Professor Taylan Mavruk and  University of Michigan Business School Professor H. Nejat Seyhun and entitled “Do SEC’s 10b5-1 Safe Harbor Rules Need to Be Rewritten?” (here) concludes that “safe harbor plans are being abused to hide profitable trades made while in possession of material non-public information.” The authors suggest a number of revisions to the Rule in order to “prevent further abuse.” The authors summarized their findings in a short June 2, 2016 post on the CLS Blue Sky Blog (here).


In order to test whether or not trades pursuant to Rule 10b5-1 plans were being abused to hide improper trades, the authors created and analyzed a database consisting of over 1.5 million insider trades between 2003 and 2013. The database consisted of both purchase and sales transactions, as well as both plan and non-plan transactions.


Based on their analysis of the data, the authors reached a number of conclusions.


First, the authors concluded that planned transactions are profitable. Indeed, the very first transactions from the plans show “significant abnormal profitability,” which the authors interpret to suggest that “many plans are set up at a time when insiders possess material non-public information.”


Second, the authors found that irregularities in trading patters – such as irregular trading intervals as well as irregular trading volumes – are associated with “greater abnormal profitability,” which the authors interpreted to suggest that “insiders could be modifying, canceling or setting-up new plans which deviate from their original planned trades when they subsequently acquire material non-public information.”


Third, the authors found that trading profitability increased with trading volume under the plan, which the authors interpreted again to suggest that “insiders have material non-public information when they set up the plans since trading volumes are determined when the plans are set up.”


From these observations the authors concluded that “safe harbor plans are being abused to hide profitable trades made while in possession of material non-public information.”


The authors propose a series of revisions to the Rule in order to “prevent further abuse of the SEC’s safe-harbor rule” and to “stop insiders from using planned transactions to hide trades based on material, non-public information.”


First, the authors suggest that the first trade pursuant to a plan must be scheduled no less than six months after the plan is filed, in order to increase the likelihood that if the plan is set up when insiders possess material non-public information that the scheduled trades will not be able to exploit the insider’s informational advantage.


Second, the authors propose that if a trading plan is modified after its initial set up that the six-month rule would apply to any future planned trades.


Third, the authors suggest that the Rule should be modified so that the trading plan cannot be based on prices, formulas, or computer programs, and require further that plans’ trading decision cannot be conditioned on future stock price or future market conditions. Instead, the plans should require insiders simply to submit the number of shares to be purchased or sold and the dates of the proposed transactions.


Fourth, the authors propose that the details of the plans must be disclosed publicly so that both the SEC and investors can verify that the executives are actually complying with their own proposed rules.


The evidence these authors have assembled suggesting that Rule 10b5-1 trading plans are being abused to shield improper trades is troublesome. The fact is since the Rule’s inception, the use of trading plans has been an important part of the toolkit to try to help corporate executives to trade in their company shares without incurring securities law liability. Indeed, notwithstanding the authors’ findings, a well-designed and well-executed plan can still provide substantial liability protection by allowing insiders to trade in their holdings of company stock.


That said, the authors do make a good case for the Rule’s reform. The changes the authors suggest would definitely restrict the flexibility available to executives in setting up their plans, in ways that undoubtedly would make it less attractive to executives to lock themselves into a plan. However, if the fact that trades were made pursuant to a plan is the logically rebut the inference that trades were made based on nonpublic information, some revision to the Rule may be required.


The authors’ proposed changes seem appropriate, but there have been other proposed revisions to the Rule, some of which are not among the revisions the authors suggest. For example, following the SEC enforcement action involving former Countrywide Angelo Mozilo, in which it emerged that Mozilo had secured enormous profits by executing trades pursuant to four overlapping trading plans, it was proposed that the Rule should be modified so that there is only a single plan, rather than multiple plans.