June 10, 2008

from July/August 2008
by John R. Engen

A Securities and Exchange Commission rule meant to allow corporate insiders to trade company stock without violating insider-trading restraints is coming under tough scrutiny from regulators. And that could be trouble for executives and board members who use it. Rule 10b5-1 lets insiders—including directors—establish plans that systematically sell or buy company shares by setting the amounts, price limits, and time conditions well in advance of any transaction. After the parameters are set, the insider must give up control of the trade to a broker, who will execute the sale or purchase when the terms can be met in the market.

Modifications to the plan are permitted, but only, the rule stipulates, if made in “good faith.” They expressly cannot be made in response to nonpublic information that could eventually alter the share price.

The intention is to help insiders diversify their holdings or cash in stock for big expenditures such as their kids’ college expenses. The rules are designed not only to buffer them against suspicion of insider trading but also to provide what attorneys call an “affirmative defense” against insider-trading charges. That has made the plans popular among executives and board members who get equity as part of their compensation. At about 35% of all S&P 500 companies, says the SEC, at least one person has used a 10b5-1 plan since the rule was enacted eight years ago. But a 2007 academic study, along with some questionable maneuvers by a handful of executives, has investors and regulators wondering if insiders are using the plans to gain an unfair advantage. The study, by Alan Jagolinzer, an assistant accounting professor at Stanford University’s Graduate School of Business, examined some 117,000 trades of insider stock by 3,426 executives at 1,241 companies from October 2000 to December 2005. Rule 10b5-1, he found, appears to enable “strategic” trades that produce returns larger than those earned by insiders who sell their stock under general market conditions and regular insider-trading restraints. According to Jagolinzer’s research, trades under 10b5-1 plans registered six-month returns of 6%, versus 1.9% for those from other insider trades. “Collectively, this suggests that on average, trading within the rule does not solely reflect uninformed behavior,” he says. He found evidence that many plans had been initiated ahead of “adverse news disclosures”—but in adequate time for the stock to be sold before the news became public and the share price dropped. Other plans, he discovered, had been prematurely terminated just before positive performance results.

The stock-option backdating scandal of 2006, which also began with an academic study (by Erik Lie of the University of Iowa), blossomed into a big headache for corporate America. Could the same happen here? Regulators are suggesting that it might. In two speeches last year, Linda Chatman Thomsen, director of the SEC’s enforcement division, warned that the commission will be “looking hard” for evidence of 10b5-1 plan abuse. If an insider is found to have based trading instructions on nonpublic information, the affirmative defense will be lost, she said, leaving the executive or director open to insider-trading charges.

Since then, there have been signs that heavy trading activity through 10b5-1 plans preceded several recent high-profile corporate meltdowns. In one closely watched case under SEC investigation, Angelo Mozilo, 69, chairman and CEO of mortgage lender Countrywide Financial Corp., allegedly established plans in October and December 2006, revised the second one two months later, and used the plans to liquidate some $130 million in shares before the brunt of the subprime-mortgage market’s troubles emerged. Countrywide has since agreed to be acquired by Bank of America—at a price much lower than Mozilo was able to get for his stock. Mozilo has denied any wrongdoing.

“If you go back to the well to amend the plan, that may start to call the ‘good faith’ into question,” says P. J. Himelfarb, a Washington, D.C.-based securities law partner with Weil Gotshal & Manges. “People might wonder what you knew when you modified the original plan.”

For boards, the primary risk is reputational. It’s unlikely that abuse of a 10b5-1 plan would inspire anything so serious as a lawsuit against directors who hadn’t personally violated the rule, attorneys say. But if executives of the company were found to have abused it, that could bring the board under fire for lax oversight.

Already the American Federation of State, County, and Municipal Employees has filed shareholder proposals on the proxies of grocery chain Safeway Inc. and data-storage company SanDisk Corp. that demand stronger controls over 10b5-1 usage and board approval of any plan modifications. SanDisk agreed to tighten controls, and the proxy proposal was withdrawn.

Boards that want to avoid trouble should review the policies and procedures governing 10b5-1 plans. Many companies simply don’t allow the plans; those that do often fail to provide rigorous oversight. To date the SEC has been vague about its definitions of good faith, attorneys say, but common sense and sound judgment should come into play.

If 10b5-1s are permitted, “you need to have some rules surrounding their usage. Who has to approve the plan? How many can you have at once? How long do you have to wait to trade after the plan is implemented?” says James D. C. Barrall, a Los Angeles-based partner specializing in executive compensation for law firm Latham & Watkins.

Another recommendation: Examine the disclosure and modification guidelines. The best practices include filing an 8-K each time a plan is entered or modified, and detailing the terms of the plan. Barrall says plan changes are acceptable as long as they occur during predetermined quarterly periods and aren’t based on information that isn’t publicly available. But it might be wise, he says, simply not to allow changes at all.

“The idea,” says Barrall, “is to put these things on automatic pilot and leave them alone”––however uncomfortable that may make an insider who comes across some important information later on.