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ANALYSIS
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October 1, 2007 12:01 AM ET
Bloomberg
LA LINDA: SEC enforcement chief Linda Thomsen eyes 10b5-1 plans.
Circle those calendars, folks. On Oct. 10, Ms. Thomsen participates in a discussion panel on those 10b5-1 plans at the annual conference of the National Association of Stock Plan Professionals in San Francisco. All eyes will be on her because some lawyers believe that apparent manipulations of the trading plans could expose hundreds if not thousands of executives to potential insider trading liability—triggering an enforcement response from the SEC that could rival its moves on stock option backdating. “It has some of the same earmarks as the option backdating story,” said Jim Barrall, a partner with law firm Latham & Watkins. “It looks like the SEC may be getting ready to do something.” Rule 10b5-1 was issued in October 2000 as part of the larger Regulation FD (Fair Disclosure), which addressed disclosure issues for SEC-registered companies. Part of the rule described conditions under which corporate insiders could establish plans that would allow them to sell their stock systematically without violating insider trading rules. As long as the plans are set up at a point in time when the executive does not have material inside information, the sales (or, more rarely, purchases) of stock can be executed regardless of whatever inside information the executive later comes into possession of. The key is that the terms of the selling plan—including the amounts, price limits and frequency of trades—must be established ahead of time, and the executive can have no subsequent discretion over its operation. “The idea was to give executives a safe harbor to proceed with these prearranged trades.... However, recent academic studies suggest that the rule is being abused,” Ms. Thomsen said in remarks at the Corporate Counsel Institute in March. “We’re looking at this—hard,” she said. “If executives are in fact trading on inside information and using a plan for cover, they should expect the safe harbor to provide no defense.” The key study suggesting possible abuse was published by Alan Jagolinzer, a professor at Stanford University’s Graduate School of Business. Much as the study by University of Iowa professor Erik Lie on employee option granting practices ignited the backdating scandals, Mr. Jagolinzer’s work has been a lightning rod for 10b5-1s. Published last December, his study examined trades executed by 3,426 insiders from 1,241 companies through 10b5-1 plans and the share price performance around the trade execution dates. Based on his limited sample of voluntarily disclosed plan trades (companies are currently not required to disclose the existence of 10b5-1 plans), executives trading through such plans outperformed their peers who did not trade through a plan by 7.4% over a six-month period. “The evidence doesn’t appear to be consistent with random returns,” said Mr. Jagolinzer in an interview with Financial Week. Indeed, just as Mr. Lie’s study revealed suspicious correlations between lows in stock prices and option grant dates, Mr. Jagolinzer’s found unusual patterns centered around 10b5-1 trade execution dates. “These return patterns are similar in nature to those observed in studies that infer strategic behavior related to employee option grants,” he wrote. In other words, the returns appear too good to be honestly earned. The most common form of potential abuse the SEC is likely looking for, say lawyers familiar with compensation and brokerage practices, is the initiation of plans when an executive knows that bad news is going to hit the share price. A telltale sign could be a series of large, rapid sales under a recently launched plan before bad news is disclosed to the market. Alternatively, if an executive is aware of good news that will boost the share price, the one discretionary power he or she has over the plan is to terminate it, with the option of initiating another one after the stock’s rise. “If the SEC hears of patterns of early sales, or frequent terminations and initiations of plans, they’ll likely make inquiries,” Mr. Barrall predicted. “Coming out of the option backdating issue, there’s a lot of sensitivity in the market about these plans,” added Howard Scheck, a partner at Deloitte Financial Advisory Services and a former official in the SEC division now headed by Ms. Thomsen. “We’re getting a lot of inquiries about them.” To date, there is no case law relating to 10b5-1 plans, which are typically set up for executives by securities brokers, not lawyers. Nor has the SEC disclosed any enforcement actions relating to the issue, although federal authorities reportedly have investigated plans set up by Qwest Communications’ former CEO Joseph Nacchio and two senior executives at now-defunct subprime mortgage lender New Century Financial. However, if, as Ms. Thomsen suggested, she has been looking “hard” at these plans, there may soon be other companies and executives at odds with securities regulators. FW
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