Trouble on the horizon

When the SEC talks, corporations had better listen, but one message many companies seem to be missing lately is 10b5-1 plans that allow executives to safely trade their companies’ stock, may be trouble. Apparently executives can – and possibly do – benefit from insider trading under protective cover. The SEC is beginning to change its opinion on such plans and is looking into the practice for evidence of abuse.

Perhaps SEC investigators will find problems, or maybe not. But as recent stock options scandals still remind everyone, there are dishonest people in management and on boards, and insider trading is quite alive. No company can afford to find that someone is playing fast and loose with the rules, or have itself wrongly perceived as doing so. A board must ensure that it is above reproach in all ways when it comes to 10b5-1 plans.

Companies have shown a lot of interest in 10b5-1 plans because of traditional regulatory checks on when executives can buy and sell their shares. ‘It is an extremely valuable tool that enables them to transact without suspicion of insider trading, when handled properly,’ says Walter Ricciardi, deputy director of enforcement at the SEC. The idea is to give executives, with legitimate reasons, a chance to sell stock and diversify their holdings. The executive may be near retirement or need money for a child’s college education. ‘It may be that you have a lot of your personal wealth in the issuer’s stock,’ says Ian Hartman, a partner at Dechert

Executives have always been able to sell stocks at ‘safe’ times: at fixed periods of time after an earnings announcement or other times of year, when everyone presumably has the same information as the manager. But an executive liquidating a significant amount of holdings, or selling during a close period, could trigger a market assumption that something is wrong, driving down the price for all shareholders. The logical solution is to sell the stocks in an incremental fashion over a period of time. A 10b5-1 plan allows this without the need to force the executive to wait for the four times a year after the company releases quarterly and annual results. Furthermore, it provides an affirmative defense against charges of insider trading and fraud.

Since the 10b5-1 rule was first introduced in 2000, though, the country has seen continuing corporate scandals, including the latest wave of stock options abuses. Up until recently, there hadn’t been significant attention on the plans. ‘The 10b5-1 issue has been a sub-issue of other situations where there’s been a bunch of stuff going on,’ says Suzanne Hanselman, who is a partner at law firm, Baker & Hostetler.

But that seems to be changing, as a growing number of people have begun wondering if 10b5-1 plans might be the next grounds for insider trading and fraud investigations. A now-widely-quoted Stanford study (see Jagolinzer textbox) found that participants on average had results that were better than what should have been possible. Although the study had some limitations and explicitly said that the findings were not necessarily a sign of illegal activity, it helped set off a preliminary SEC investigation into whether executives were somehow gaming the system to their own advantage, just as the statistical analyses of stock options set off the whole backdating scandal.

Where there’s smoke, there’s fire

Jagolinzer’s work wasn’t the only trigger. Although he won’t go into specifics, Ricciardi admitted that there were other factors in the decision. There have been public allegations that the CEO of Countrywide Mortgage – deeply mired in the sub-prime credit meltdown – has unduly profited from his 10b5-1 plan as the credit crisis has hammered the company’s shares. The SEC has made no specific allegations of illegal activity so far, but as Phillip Stern, a former SEC enforcement official and co-chair of Neal Gerber Eisenberg’s white collar criminal, regulatory and internal investigative services practice, notes, it’s ‘enough to warrant looking to see if there is.’

Think again of Ricciardi’s words: ‘when handled properly’. That means the company and executive set up the plan in advance during a time when the executive has no material non-public knowledge that might offer an edge in current or future trading. Although the plans are supposed to execute trades out of the control of any individual executive, there are ways around it.

To better understand the dangers, consider the structure of a 10b5-1 plan. An executive has three choices: set trades on a strict timetable, so that they take place on given days no matter what the market is doing; create limit orders, so that there would be a transaction whenever stock hit pre-determined prices; or have a broker handle the program, making all transaction decisions without any input from the executive into question.

Gaming the system

That leaves a few ways in which an executive can influence the performance of a plan by making it effectively work like a trade benefiting from inside knowledge. The key would either be knowing that news would send the stock down and selling before it came out or buying after, or knowing that a communication of good news would send stock prices up, and so buying before it came out or selling after. Even though the actual transaction decisions are theoretically not in the hands of the executive, it is possible to affect conditions so that they might as well be.

One way to influence the results of a 10b5-1 plan is to end or modify it and then start a second one. Another is to have a brokerage execute the trades, but feed the broker information. Both are problematic for the would-be inside trader, as the former activity can stick out like a sore thumb, and the latter creates an accomplice who might spill the beans.

But there are more subtle approaches that can gain similar ends. An executive can set the start of the plan with an eye to something that he or she knows will happen in the future. If the knowledge is available far enough in advance, any connection between the plan and the insider information could appear tenuous, or even non-existent. For example, if a major contract is up for renewal in six months but the likelihood of that happening is remote, set up the plan two quarters ahead and have it kick in one quarter before the bad news becomes publicly available.

There is an even stealthier tactic: change the timing of information to accommodate the plan. At first glance, this might seem ridiculous, as it should alert other managers and the board of the irregular behavior. But remember that backdating often took place with the knowledge of board members. David Furbush, a partner at Pillsbury, offers another possible scenario:

A CEO with a perfectly legitimate 10b5-1 plan, adopted without insider information and carefully followed, hears of bad news on the 12th of a month. The routine stock sale is scheduled for the 15th.

‘The executive might say, I’m not sure we have all the facts. Let’s make sure we’ve investigated this. Go back and double-check that, check with this person,’ Furbush explains. ‘He can say that in a way that sounds perfectly plausible. Nobody around him might necessarily know that it’s not for some ulterior purpose.’

For the public and investors to notice any of the more understated frauds, they would need the details of the plan and would have to remember to check when trades were supposed to happen and compare them against corporate information disclosures. That creates a catch-22 situation: people forget and may not be diligent enough to trace things back without an outside indicator that something is wrong, and the most likely indicator — action by the SEC — which might have waited for someone to complain.

And even with the statistical anomaly Jagolinzer found, there are those in the industry who think that any reports of a problem are overblown. ‘We’ve probably seen thousands of trading plans over the years,’ says Greg Besner, president of Restricted Stock Systems (RSS), a software and service provider focusing on restricted and controlled stock plans. ‘Over 90 percent of the trades that are put in place by these trading plans are limit orders.’ It would be difficult to time a limit order placed in advance, as it depends on the stock hitting specific levels. Of those limit orders, only about 40 percent were executed last year. People at RSS actually recognized the details of one plan that Jagolinzer’s paper mentioned. ‘For that example, the stock may have under performed for the year or any period of time, but that person’s [plan had] limit orders placed week after week, or month after month.’

According to Nancy Grunberg, a partner at Venable and former assistant director in the SEC’s enforcement division, not all preliminary sweeps that the agency undertakes actually turn into full-blown investigations of specific companies. ‘They feel if there isn’t something there, we’ll find something else to investigate,’ she says.

But the SEC is investigating, and in an atmosphere of suspicion of corporations, it doesn’t take much for rumors to start and stock prices to drop. Boards and management must create plans and controls to ensure that questions are unlikely to arise in the first place. Making the board aware of the details of 10b5-1 plans and ensuring that its decisions not even give a mistaken impression of impropriety is a step that the SEC’s Ricciardi says ‘might be very smart’ as a way of avoiding investigation.

Make timing a group effort

Another way to avoid accusation of impropriety is having a committee – comprising managers, the corporate general counsel, and possibly board members – to consider the release of information rather than leaving it to the discretion of one executive. ‘Do we have the full story?’ asks Kevin Woltjen, a partner with Strasburger & Price. ‘There are times the company wants to release information and there may be disagreement among the executive ranks. Identify the procedures employed and maintain records concerning the decisions that were followed. In the event that a coincidence does occur, it’s helpful for a company to be able to explain the action it took.’

A couple of obvious practices are to not change plans or to stop one and start another in its place. Avoiding a broker’s discretion eliminates the potential charge that an executive was actually in control. Keep stock purchases to exercising options and not to buying from the market, as the former is a contract already in existence and so generally not subject to insider trading charges. ‘You’re not engaging in a transaction with a third party who doesn’t have access to information,’ Furbush says. ‘It’s between you and the company.’ Certainly disclose any 10b5-1 plan to the public, and not just select ones, otherwise it can lead to the natural question of: why this and not that?

Yet another protection, according to Furbush, is to structure a plan with a high-trading frequency. ‘I like to see people sell as often as weekly,’ he says. ‘The more often you sell and the smaller the amount [of stock at any one time], the less likely you’re going to be tempted to do something, and the less likely that someone will suspect something.’ He also suggests waiting at least a quarter between establishing the plan and having transactions start.

The idea isn’t to panic, and, fortunately, companies generally are not – yet. And some knowledgeable sources suggest that the SEC is not ready to take imminent action, but that doesn’t mean it won’t. That means most corporations have enough time to fully review their 10b5-1 policies and activities and put controls and policies into place to keep any plans on track and beyond the interest of any investigator.