US company founders and executives are hearing the jingle of cold hard cash this holiday season.
Profiting from a historic run up in share prices, US corporate insiders sold a record $69 billion (€61 billion) in shares this year, up 30 per cent from 2020, and 79 per cent more than the 10-year average. Almost 50 of these corporate bigwigs have pocketed more than $200 million each.
They are certainly in the money, but are they also in the know? Some of them say they are diversifying their holdings; others are seeking to avoid rising state tax levies or fear that US tax rates will increase next year. Such insider selling is also a red flag at a time when soaring indices mask the fact that more than 1,380 companies are trading at or near 12-month lows.
Here's why. Corporate executives are barred from insider trading just like the rest of us. But someone who runs a company is almost always in possession of "material non-public information" that would make it impossible to sell. So the US Securities and Exchange Commission created a special exemption in the early 2000s. Insiders who set up a preprogrammed sales schedule, known as a 10b5-1 plan, can sell even if they do know something material. Facebook founder Mark Zuckerberg has used one to sell shares almost every weekday this year.
The theory is that automated, pre-planned sales are unlikely to be taking unfair advantage. The reality, in some cases, is something else entirely.
A study of 10b5-1 trading by 10,123 executives at more than 2,000 companies found that rather than involving long-term strategies, half the “plans” involved just one trade. Even more dubious, almost 40 per cent started selling within 60 days, including 14 per cent that cashed out in the first month. Such short-term trades were not only much larger than those by plans that waited longer, but also, on average, avoided losses of 2.5 per cent because the executives sold shares before or as the company’s share price declined.
"The plans that tend to be most opportunistic and abusive are those that go into effect on Friday and sell on Monday," said the study's co-author Daniel Taylor, head of the Wharton Forensic Analytics Lab.
Defenders
Corporate defenders point out that the SEC has brought very few actual cases against company executives for abusing their 10b5-1 plans. But there are strong historical reasons to be cynical about the potential for companies to manipulate the laws to line executive pockets.
Back in the mid-2000s, more than 130 companies, including McAfee, United Health and Broadcom, were scrutinised by the SEC for unusually timely grants of stock options to top executives. In the most egregious cases, companies secretly backdated the options to pick the lowest possible share price, thus ensuring that the recipients made the most money. More than 25 senior executives were criminally convicted and dozens more lost their jobs.
SEC chair Gary Gensler last week finally introduced some reform proposals. In a sign of just how problematic these 10b5-1 plans are, the two Republican commissioners, who are generally sceptical of new regulations, joined the three Democrats in proposing a four-month cooling-off period before trading could start. Companies would also have to make public their internal safeguards to prevent insider trading. Officers and directors would have to personally certify that they were not aware of inside information when they adopted their plans.
All of this is long overdue. The SEC has been worried about the potential for abuse since at least 2007. The whole point of granting shares or stock options to top employees is to align their interests with investors. The more they benefit or suffer personally from share price moves, the more likely they are to act in the best interest of shareholders. But the laxity of the current rules around stock selling plans has turned them into no-lose propositions.
However, the changes don’t go far enough. The academic study spotlighted another problem that these new reforms don’t fully address. Right now, unscrupulous executives can put in place plans to buy or sell, or both, and then secretly cancel. Moreover, the insider selling disclosure rules are much looser for overseas companies listed in the US. That’s fine for European companies that face tough requirements at home, but earlier this year, executives from several big Chinese companies were able to cash out quietly ahead of a big crackdown.
Eliminate the exception
The SEC wants to eliminate the insider trading exception for overlapping plans and limit executives to one single-sale plan per 12 months. But there would still be no way to know when someone cancelled planned sales at short notice. Opponents say the additional reporting would be burdensome, but that misses the point. Companies that don’t allow their executives to cancel plans abusively would not face new requirements, and surely the rules for foreign issuers could be written to focus on those who do not already report in a timely way.
Right now, markets feel frothy and many companies are starting to report disappointing earnings and forecasts. Corporate insiders who have reaped the rewards of a bull market should no longer be allowed to slip out the backdoor before bad news hits. The best gift the SEC can give investors is to strengthen and push through its reforms as quickly as possible. – Copyright The Financial Times Limited 2021
