Are prearranged trading plans gamed by insiders?

Prearranged trading plans are designed to keep insiders who trade their own shares out of trouble.

If you’re an officer or director of a public company, this is your worst nightmare: You’re sipping coffee at work one morning when a FedEx package is dropped on your desk. Inside you find a letter from the SEC notifying you of a court date to answer charges of trading on inside information.

A scenario to be avoided for sure. However, here’s the problem:  The U.S. has no insider trading laws. What? I can hear you saying, then how is it that white collar criminals do time for profiting from secret information? Good question.

The fact is that the Securities and Exchange Act of 1934, which regulates the trading of securities, broadly outlawed stock fraud, but made no mention of “insider trading.” And Congress has never defined it. All U.S. laws that govern insider trading have evolved from case law. Which means that over the years, what constitutes insider trading has been a nebulous, shifting concept.

Which is ok if you’re the SEC and motivated to prosecute insider trading – it gives you lots of room to work… But if you’re an executive, and in good faith want to buy or sell stock in your company without getting arrested, it’s disconcerting to not clearly know if your brain contains “material non-public information.”

All U.S. laws that govern insider trading have evolved from case law. Which means that over the years, what constitutes insider trading has been a nebulous, shifting concept.

Enter the pre-defined trading plan. So-called “10b5-1” plans were introduced by the SEC in 2000 to allow corporate insiders to buy and sell shares in their companies without fear of breaking the law.  10b5-1 plans permit executives to trade their own stock by scheduling trades for specific prices or times. Since the trades are set in advance, the plans allow insiders to buy and sell shares despite routinely possessing important, nonpublic information.

So, when a SEC Form 4 filing footnote states that the trade was done “pursuant to a Rule 10b5-1 Plan,” we know that the insider possesses no material, non-public information. Right?

Not so fast. Like everything pertaining to legal vs illegal insider trading, there is uncertainty.

In 2006, an accounting professor at Stanford University named Alan Jagolinzer conducted research on 10b5-1 plans and discovered something. Executives who adopted such plans traded more profitably than their peers that didn’t have a prearranged trading plan. Jagolinzer found that many trades in these plans appeared to be “well timed.” For instance, a prearranged sale occurred just before bad news was announced. Hmmm.

It seems that some insiders found loopholes in prearranged trading plans. Though the executives were locked into when they could sell or buy, it appeared that insiders were somehow gaming their own plans to trade more profitably.

Study: Insiders with prearranged trading plans traded more profitably than peers without plans.

The study asserted that statistically abnormal trade returns realized by executives selling company stock under Rule 10b5-1 plans may be explainable by:

1. insiders’ creation of trading plans before bad news becomes public, so they are able to sell before the news affects the market,
2. termination of plans (and therefore of planned sales) before stock prices decrease, or
3. manipulation of the content or timing of material disclosures after trades have already been planned.

Jagolinzer cited several instances where large stock sales at stock-price highs followed terminations of 10b5-1 plans. He observed that participants’ sales systematically followed positive and preceded negative firm performance, generating abnormal forward-looking returns larger than those earned by nonparticipating colleagues.

It seems that some insiders found loopholes in prearranged trading plans. Though the executives were locked into when they could sell or buy, it seemed that insiders were somehow gaming their own plans to trade more profitably.

So prearranged insider trading plans seem to give some insiders an edge. What are the implications for those of us who analyze insider trading looking for investment ideas? How should we interpret insider trades conducted under 10b5-1 trading plans?

If you’re long a stock and insiders at the company sell shares via pre-arranged plans, I will echo the great Peter Lynch’s advice regarding insider trading of any kind. “Insiders might sell their shares for any number of reasons but they buy them for only one: they think the price will rise.” So, insider selling in your stock is probably just noise, but revisit your analysis just to be sure.

Investors typically react favorably to insiders buying via prearranged plans.

While it’s much less common than selling, corporate insiders do sometimes buy their own shares via prearranged trading plans. As discussed, an executive buying via a 10b5-1 plan presumably is not trading based on “material, non-public information.” But as also noted, neither the SEC, corporate lawyers, the insider or anyone else can clearly define what that is.

Might the insider have insights into his own company stock that you and I don’t? Absolutely. Is her knowledge “material, non-public information?” Who knows? By using a 10b5-1 plan does the insider decrease his changes of running afoul of the SEC? Very likely. Does the prearranged plan guarantee the SEC won’t come calling? No.

In my experience, the market reacts favorably to significant insider buying done via prearranged plans. That’s especially true when it is the first buy conducted under the plan. The initiation of a buying plan signifies that the insider has a bullish outlook on his or her company, and will be buying more shares in the future as part of the plan.

Like all insider buying, purchases via prearranged plans mean an officer, director or 10% holder is putting more skin in the game. That’s most always a good thing.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the article.