Pros & Cons: Rule 10b5-1

Pros of Rule 10b5-1:

For a senior manager, some of the benefits of having a formal program to manage the sale of your employer’s stock may include:

• Elimination of risk related to insider trading.
• Reduced risk of a concentrated holding.
• An ability to plan sales around vesting (or other) events.
• Tax-efficient transfer of wealth to family, charity, etc.
• Access to liquidity at predetermined future dates.
• An opportunity to construct an optimal investment portfolio.

 

Cons of Rule 10b5-1:

Some of the cons of a Rule 10b5-1 plan are related to the 'flawed legislation':

• Predetermined sales dates may cause for execution (sale) of the stock trade at a price that could be lower than the average price over a period for the executive's stock, on the day of trade execution (i.e. subject to normal market fluctuations).
• 10b5-1 Plans do not need to be filed with the SEC, creating a loophole for executives to exploit (they can later claim that the sale was part of a 10b5-1 disposition, although it may not have been).
• The executive can – at any time – decide to cancel or change the plan (implying an ability to manipulate the sales plan to fit the stock price).
• There is no requirement for how long the plan has to be in place, before trading can begin (meaning that one could e.g. start a 10b5-1 sales plan, and trade later that same day).

Some suggested improvements:

• Companies could be required to disclose the terms of the disposition plan, and trading arrangements, as part of their SEC filings.
• A time limit could easily be implemented, e.g. the plan has to be in place for 30 days before trading can commence.
• Once implemented, the executive cannot have the ability to cancel or change trades.
• The more detailed the plan, the lower the risk of suggested impropriety.
• Executives should ideally be in one plan, and not several at once.

There are several formal groups that use a variety of different methodologies to lobby the SEC to issue proper guidance on some of the issues above.  It is also possible that there may be new amendments to Rule 10b5-1 in the near future.

As usual, the chasm between the intent of the regulation and the knack that 'street-smart' people have in creating and/or finding loopholes around government regulations… is a great divide that is not easily crossed!

What is Rule 10b5-1?

Securities and Exchange Commission

Adopted as part of a set of rules to govern insider trading, Rule 10b5-1 was established by the United States Securities Exchange Commission (SEC) to allow insiders of publicly traded corporations to set up a future dated (trading) plan, to sell their company stock.

Some countries have adopted similar rules, often with more logical naming conventions – e.g. a Canadian ASDP – meaning “Automated Securities Disposition Plan.”

These rules allow major shareholders who are insiders to sell predetermined numbers of shares at predetermined, future dates.  For the purpose of this blog posting, insiders are defined as executives or senior managers with inside information about a publicly traded company, i.e. information that “outsiders” cannot possibly know about.

Why have such rules?   

Quite simply, and by way of an example, to avoid an insider selling his/her company stock at a high price prior to the company making poor financial results public (or another material issue that will cause shareholders to suffer a loss).  Disclosing poor financial results may cause the company stock to suddenly lose value, but this executive had then sold his/her stock PRIOR to the announcement.

To demonstrate the effect of the rule, let’s consider a major shareholder with inside information (e.g. the CEO), who may decide to sell 80,000 shares of his/her employer's equity.  To comply with the 10b5-1 rule, the CEO may decide to sell 10,000 shares at the end of every calendar quarter, for the next 8 quarters, instead of selling 80,000 shares immediately, at one time.  Of course, a large, unexpected sale of company stock by the company's CEO may cause market jitters anyway!

Corporate executives therefore use this rule to avoid possible accusations of impropriety when trading their company stock, because it is unlikely that they could be accused of having knowledge today, of something that may be deemed as inside information in the future, medium term.

The CEO may also elect to sell the shares and donate some (or even all of) the proceeds to a registered charity, further eliminating the possibility of being accused of trading on inside information for personal gain.

Let’s briefly explore the origin and intent of Rule 10b5-1:

The SEC website explains: "Section 10(b) of the Securities and Exchange Act of 1934 makes it unlawful for any person to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe." 

Spooky, and perhaps somewhat vague language... but it was written in 1934!

Later, the SEC adopted 10(b)5, which added that

“It shall be unlawful for any person, directly or indirectly… 

(a) to employ any device, scheme, or artifice to defraud,

(b) to make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or

(c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of a security.”

After that, the SEC adopted Rule 10b5-1 that provides that a person is trading on the basis of material nonpublic information if a trader is "aware" of the material nonpublic information, when making the purchase or sale.  The rule also sets forth several affirmative defenses or exceptions to liability.  The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-existing plan, contract, or instruction that was made in good faith.

So… regulations are intended to provide rules that will protect the public from harm, financial loss, etc.  However, as with any government regulation, there are pros and cons.  In the next post, we’ll explore some of these in more detail.