Gaming the System: Three 'Red Flags' of Potential 10b5-1 Abuse

Abstract

The SEC adopted Rule 10b5-1 to provide an affirmative defense against allegations of insider trading to executives whose jobs regularly expose them to material nonpublic information. In this Closer Look, we present evidence on the trading behavior of corporate executives using a unique dataset of over 20,000 10b5-1 plans to show that a subset of executives use these plans to engage in opportunistic, large-scale selling that appears to undermine the purpose of Rule 10b5-1. We identify three “red flags” associated with 10b5-1 abuse: 1) short cooling-off periods, 2) plans that cover a single block trade, and 3) plans that are adopted and commence trading immediately prior to earnings announcements.

We ask:
• Would simple modifications to Rule 10b5-1 prevent these abuses?
• Why doesn’t the SEC require disclosure of 10b5-1 plans and the trades made under these plans?
• Does the board or compensation committee monitor executive stock sales under 10b5-1?
• Why don’t they require best practice guidelines to reduce the potential for abuse?

Keywords: CEO compensation, CEO pay, equity compensation, insider trading, insider trading policy, 10b5-1 plans, executive stock transactions, board of directors, blackout window, general counsel approval, suspicious, abuse, red flags, cooling-off periods, block trades, earnings, corporate governance