Everybody knows that insider trading is illegal. It has become a cottage industry in financial circles to manage and control access to "material nonpublic information," or MNPI for short. But "information" -- to say nothing of MNPI -- is one of those vacuous words that hides as much as it tells. Correctly put, one is guilty of insider trading when one trades while in possession of material nonpublic facts without first disclosing them to the contra party. Anything can be information. However, only concrete facts that can be proved with evidence really matter for insider trading. Within the chasm between "information" and "fact" lies today's tale.
Two decades ago, the SEC promulgated Rule 10b5-1. It is still the only formal affirmative defense to an insider-trading charge. Rule 10b5-1 permits someone who has insider knowledge to buy and sell affected shares. However, the rule requires that the plan be put in place at a time when the trader has no insider knowledge. In theory, trades are set up when the trader is ignorant and go off automatically in the future. If done right, the trader is protected from insider-trading charges even if he acquires insider knowledge when the trades are executed.
These trading plans are used extensively by corporate executives to trade the stock of their own companies. A recent survey showed that as many as 57% of Fortune 500 executives have Rule 10b5-1 trading plans. https://www.bofaml.com/content/dam/flagship/institutional-retirement/id20_0905/ documents/00-63-1595NSB_NavigatingCoStock.pdf. Corporate executives set up these plans during so-called "open trading windows." Trading windows are a legal gimmick that exploit what I said earlier, that only material facts can be the basis of an insider-trading charge. Public companies must file periodic reports with the SEC, and otherwise report significant news to shareholders. The rules require that those reports contain all material facts about the company. So, follow the logic: if all material facts about a company are disclosed in public filings, then there are no undisclosed material facts for corporate executives to have. For a short time after the public filings, corporate executives know no more about their own companies than the rest of us.
And, I have a bridge for sale.
Everybody knows that corporate executives know more about their own companies than we do, even during open trading windows. What they don't have during an open window are concrete facts about their own companies -- the kind of facts that need to be disclosed in SEC filings and that are needed to prove insider trading. This is where the distinction between "information" and "facts" becomes interesting.
In 2006 and 2007, research by Stanford professor Alan Jagolinzer showed that executives trading in Rule 10b5-1 trading plans outperformed the market by up to 10%. This led to a spate of news articles bemoaning how executives were "gaming" the system by using these trading plans. All that publicity led the SEC's then-Director of Enforcement Linda Chatman Thomsen to speculate about "the possibility that plans are being abused in various ways to facilitate trading based on inside information." She sounded the SEC alarm: "We're looking at this -- hard." https://www.sec.gov/news/speech/2007/spch030807lct2.htm
She should have said "long and hard." After Thomsen made her remarks on March 8, 2007, the issue vanished into whatever black hole devours random SEC musings. Then, 14 years later, on June 7, 2021, SEC Chairman Gary Gensler announced that he'd asked the SEC Staff to "make recommendations . . . on how we might freshen up Rule 10b5-1." https://www.sec.gov/news/speech/gensler-cfo-network-2021-06-07. Gensler's announcement gives us the opportunity to revisit an old question: why exactly do corporate executives trading in Rule 10b5-1 plans outperform the market?
In his announcement, Gensler focused on four aspects of trading plans under Rule 10b5-1 that he thought could cause problems. Three of them are practically meaningless. He complained that Rule 10b5-1 plans can be canceled at any time, which they can. In theory, this would allow executives to cancel plans when things are looking good, but keep them selling if things look bad. However, we saw no evidence of executives canceling plans willy-nilly. Most of the time, plans were canceled by the issuer on account of impending news. Gensler also complains that there are no required disclosures connected with Rule 10b5-1 plans. However, whenever an executive who is a Section 16 insider actually sells stock, he must file a Form 4 with the SEC, and that Form 4 typically discloses the existence of a trading plan. Finally, Gensler notes that there are no limits on the number of plans that an executive can have at any one time. However, brokerage firms typically will only permit an executive to have one active plan at a time, so this too seems like a solution looking for a problem.
But Gensler's first proposal -- that there be a "cooling off" period between the time a plan is made and the first trade is executed of his long as 4 to 6 months -- is worth considering. We would expect corporate executives to have ideas, hunches, plans, gut instincts, and other such soft knowledge about where their companies are heading, and that knowledge would provide them a trading advantage even if none of it is concrete enough to be called a "fact." In 2011 Professor Jagolinzer made another interesting finding: executives who trade on their own during open trading windows outperform fellow executives who needed to obtain general counsel's permission to trade, by the same 10% margin. It seems that those who needed to get general counsel approval before they traded were inhibited, either by their own consciences or by more conservative general counsel advice, not to trade on the soft information about their companies they undoubtedly had. On the other hand, those executives who relied entirely on an open window policy more freely exploited their soft information, and so gained an advantage over their peers. The hope is that during a cooling off period whatever soft information an executive has when he puts the plan in place dissipates or becomes disclosed by the time trades occur.
Maybe it will or maybe it won't. But at least a cooling-off period addresses a real issue. Everybody knows that executives understand their companies better than we do. No one should be shocked that they have a 10% edge. In fact, one should be shocked, as I am, that the best edge they can muster is only 10%. Corporate executives should be able to do better than that, and if they can't, then they are grossly overpaid. But everybody knows that, too.
Aegis Frumento co-heads the Financial Markets Practice of Stern Tannenbaum & Bell, New York City. He represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations). He has decades of experience representing SEC, CFTC and FINRA regulated firms and persons in regulatory enforcement investigations, hearings and lawsuits. Drawing on his five years managing the Executive Financial Services Department of Morgan Stanley Smith Barney, Aegis has rare depth of experience in the securities and corporate governance laws affecting senior executives of public corporations. When not litigating, Aegis enjoys working with new and existing broker-dealers, registered investment advisers, and private equity funds, covering all legal aspects from formation to capital raising. Those clients now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises, including the use of cryptosecurities to represent equity and debt interests.
Aegis's long and distinguished career includes having been a Managing Director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP. He graduated from Harvard College in 1976 and New York University School of Law in 1979. Aegis is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments. He is the current Chairman of the New York City Bar Association's standing Committee on Professional Responsibility.
NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of BrokeAndBroker.com Blog.