News outlets have unleashed an avalanche of allegations of insider trading:
- The Campaign Legal Center filed a complaint against U.S. House lawmakers (4 Democrats, 3 Republicans) for insider trading under the Stop Trading on Congressional Knowledge (STOCK) Act.
- Two regional presidents of Federal Reserve Banks engaged in significant trading that has led to calls for them to resign or be fired, and, this week, they announced their resignations.
- Recently, a former software engineer at Netflix, his brother, and a friend have been charged by the SEC with insider trading as the software engineer used his access to growth in subscriber data for trades before it was made public.
- During the onset of the pandemic, numerous pharma executives, especially Moderna insiders (who sold more than $500 million of shares at optimal times) prompting allegations of insider trading.
- The SEC charged another pharma executive with what is being called “shadow trading” for purchasing stock in a company that his company was soon to acquire.
- A Kodak insider also made a notorious donation of $116 million in stock to a charity he founded timed just as shares peaked (with the leak of a potential government contract) that fell through. (This sort of action, dubbed “insider giving” for the tax benefits, is less regulated at this time, but no less harmful.)
- Similarly, the Wall Street Journal reports that 131 federal judges have decided cases concerning companies within which they own stock (in violation of profession ethics rules), and the Journal found that their decisions were favorable toward a company they own in two-thirds of contested motions.
These articles heighten a sense to ordinary people that the system is rigged; they call for significant action, but major problems remain unattended.
Insider trading consists of buying or selling a security, being in possession of material, nonpublic information (MNPI) about the security, in breach of a fiduciary duty or other relationship of trust and confidence. The action is damaging whether one is the person who shared or “tipped” the information or the person who traded the securities based on the information. The trading can occur in the anticipation of “bad” news for a company, selling before the stock crashes, or it may coincide with the announcement of favorable news and a stock rising to new heights.
As executives and board members regularly are exposed to MNPI, the window of opportunity to trade their own shares without violating insider trading rules is narrow. So, the SEC adopted Rule 10b5-1 in 2000, which allows insiders of publicly-traded corporations to set up a trading plan – whereby the executive sells a predetermined number of shares at predetermined intervals – to facilitate effective selling of personal shares of company stock.
Professor Daniel Taylor of the Wharton School at the University of Pennsylvania has done a deep dive into Rule 10b5-1, and his research has exposed some “cracks” in this system that are ripe for abuse. He and his colleagues reported on some “red flags” in January of 2021:
- An archaic paper-filing system for sales from Rule 10b5-1 plans. A simple remedy is to make them digital and put on the SEC website through the EDGAR portal.
- Rule 10b5-1 requires no interval between the creation of a plan and its execution. A recent study found that more than one-third of the plans adopted in a given quarter saw an insider execute a trade before that quarter’s earnings announcement, avoiding considerable losses. A remedy to restore confidence would be to require a cooling off period of four to six months.
- Some insiders create Rule 10b5-1 plans to effect a single trade. Prohibiting this option makes for a reasonable remedy.
- Some insiders create multiple Rule 10b5-1 plans to run concurrently and cancel all but the most advantageous plans. Prohibiting a single person or entity to have more than one Rule 10b5-1 plan at a time would advance the credibility of the system.
- Currently, the Form 4 disclosures of insider trades lack relevant information. The date of plan adoption or modification provides greater transparency.
- Boards and/or compensation committees may not be giving sufficient oversight to the issue. The board or compensation committee should monitor executive stock sales.
(If you prefer a podcast, Taylor describes the issue here.)
In June, Chairman Gary Gensler acknowledged that “these plans have led to real cracks in our insider trading regime” and asked the SEC staff for recommendations on how to “freshen up” Rule 10b5-1. As well, the Investor-as-Owner Subcommittee of the SEC Investor Advisory Committee has released draft recommendations and discussed the topic at its September meeting.
Even if the studies by Professor Taylor and his peers cannot determine with absolute certainty whether any insiders that avoided losses or otherwise achieved “market-beating returns” actually traded on the basis of MNPI misses the point; insider trades must not only be legal, they must also appear ethical. The current system allows for far too much ethical ambiguity and erodes basic trust in the common good.
“Effective governance is a pillar of sustainable companies,” according to Cindy Bohlen of Riverwater Partners. “Executive alignment with company success is a governance factor considered important by many investors, including Riverwater. It is imperative that insider trading rules allow executives to share in the success of the businesses they run, while at the same time ensuring they are not afforded preferential outcomes given their insider status.”