Voluntary Disclosures Regarding Insiders’ Rule 10b5-1 Trading Plans

This post is from M. Todd Henderson of the University of Chicago Law School.

If a firm insider has private information and intends to trade on the basis of this information, the conventional wisdom is that the insider garners no strategic advantage from disclosing in advance of the trade the information or the intention to trade. This account, however, ignores the potential litigation benefit from pre-trade disclosure of trading plans. If an insider discloses many months in advance the intent to trade at certain times, this can be expected to reduce the likelihood of a lawsuit (either alleging insider trading alone or as an element of a securities fraud suit), since disclosure may rebut any allegation that the insider was acting with the requisite scienter when the trade executed. The insider who pre-discloses may be turning Brandeis’s aphorism that “sunlight is the best disinfectant” on its head – the insider is using transparency for strategic advantage, what we might call “hiding in plain sight.”

In a new paper, entitled Scienter Disclosure, Alan D. Jagolinzer, Karl A. Muller and I show the existence of the strategic advantage from disclosure – what we call “scienter disclosure” – in a study of insider voluntary disclosure under Rule 10b5-1 trading plans. The SEC promulgated Rule 10b5-1 in 2000 to provide an affirmative defense for insiders who pre-commit to trades in the future at times when they do not possess inside information, even if they do possess such information when the trades ultimately execute. There is evidence, however, that Rule 10b5-1 may provide insiders with strategic trade opportunities that generate abnormal trade returns. Insiders may, for example, pre-plan trade based on longer-term nonpublic information because of perceived lower legal risk. Insiders may also strategically modify the content or timing of disclosure to increase profitability of previously planned trades. Finally, insiders may also terminate Rule 10b5-1 plans when they possess material nonpublic information that indicates a hold strategy would be more profitable than allowing pre-planned sales to continue. We show insiders use these features of the Rule to earn abnormal returns.

The paper has two primary findings based on insiders’ voluntary disclosure choices. First, we show Rule 10b5-1 disclosure increases with firm litigation risk and insider strategic trade potential. Firms with higher expected litigation risk and greater opportunities for insiders to earn profits from private information are much more likely to disclose, meaning insiders see disclosure as a litigation prophylactic.

Second, we show Rule 10b5-1 disclosure is associated with greater abnormal returns to insiders’ trades, especially for firms disclosing specific plan details. The SEC intended Rule 10b5-1 to provide insiders greater opportunities (than the normal blackout windows allow) for uninformed, diversification trades, but we present data showing that insiders who use the Rule earn large abnormal returns compared with those not using the Rule, and that these returns are increasing in the amount of disclosure. (The returns are about 12 percent in six months for insiders making specific disclosures.) The intuition here is that disclosure is not just a litigation risk reducer, but also has costs. Making specific disclosures, say about the dates and amounts of trades, provides the most litigation protection but it also raises the costs for insiders who may terminate their plans if it turns out a hold strategy is superior. Therefore, only the most bearish insiders will adopt a specific disclosure strategy, since the termination option is less valuable to them. Insiders making limited disclosures get less litigation protection, but they preserve the termination option. These insiders are less confident of negative private information, so their expected abnormal returns are lower than the specific disclosure group.

The paper also presents findings about the interaction of disclosure choice and firm governance, and makes some preliminary policy recommendations for regulators, firms, and other corporate stakeholders. Most obviously, a disclosure requirement is unlikely to provide much benefit, since it is the insiders not disclosing who are acting the way the SEC intended.

The paper is available here.

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