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E-MailEliezer M. Fich is Professor of Finance at Drexel University LeBow College of Business, Robert Parrino is Professor of Finance at the University of Texas at Austin, and Anh L. Tran is a Professor of Finance at City University of London Bayes School of Business. This post based on an article forthcoming in the Journal of Financial Economics. Related research from the Program on Corporate Governance includes Insider Trading Via the Corporation (discussed on the Forum here) by Jesse M. Fried.
Securities and Exchange Commission (SEC) Rule 10b5-1 provides corporate insiders at public firms with an affirmative defense against allegations of trading on material non-public (inside) information when they buy or sell their firm’s shares. Under Rule 10b5-1, insiders establish trading plans through which they schedule the purchase or sale of a predetermined number of shares through one or more trades with an independent third-party broker up to two years in advance. Insiders are presumed less likely to be acting on inside information pertaining to the value of their firms’ shares when they schedule trades in advance than when they do not.
In the article titled, When and How Are Rule 10b5-1 Plans Used for Insider Stock Sales?, Fich, Parrino, and Tran (2023) study a sample of 13,930 stock sales by 1,629 CEOs at 1,322 different public firms during the 2013 to 2020 period for evidence on when Rule 10b5-1 plans are used and their effectiveness in mitigating insider trading. Of these stock sales, 8,554 are identified in SEC Form 4 filings as executed through Rule 10b5-1 plans.
The empirical tests indicate that Rule 10b5-1 plan sales by CEOs are more likely at firms that face greater litigation risk. Furthermore, plan trades are more likely during the 40 trading days before a quarterly earnings announcement and are less likely during the 40 days after such an announcement. This evidence is consistent with CEOs choosing to trade under plans when the likelihood of facing accusations of trading on material non-public information is greater. It is also consistent with CEOs using Rule 10b5-1 plans to sell their shares during corporate trading blackout periods, which typically prohibit trading before earnings announcements.
Fich et al. (2023) also examine whether the profitability of CEO stock sales varies with Rule 10b5-1 plan use by computing the cumulative abnormal (stock) returns (CARs) in the 40 days before and the 40 days after the stock sale. The returns for both plan and non-plan sales trace an inverted “V” shape often associated with opportunistically timed stock sales. However, the evidence indicates that non-plan sales are, on average, preceded by a larger average price run-up than plan sales. This difference is consistent with greater opportunistic behavior by CEOs who sell outside of Rule 10b5-1 plans and persists when the analysis is limited to restricted stock sales. Notably, while the level of opportunistic behavior for plan sales is less than that for non-plan sales, examination of the timing of Rile 10b5-1 plan sales suggests that transaction dates are deliberately chosen to increase the absolute value of the gains from the trades.
Fich et al. (2023) also find that the level of opportunism associated with plan sales is relatively large when they focus on sales in which the CEO has a lot of money at stake. In this test, the authors define high CEO incentive stock sales as the 25 percent of sales with the largest transaction value relative to the CEO’s firm-related wealth. When only high CEO incentive stock sales are considered, both plan and non-plan sales exhibit larger increases in pre-sale and larger decreases in post-sale average CARs. Importantly, the level of opportunism associated with high CEO incentive stock sales is similar for plan and non-plan trades.
The study also investigates ways in which CEOs can circumvent the intent of Rule 10b5-1. The analyses reveal that disclosure quality at the selling CEO’s firm tends to improve more during the fiscal year in which a Rule 10b5-1 plan sale takes place than during the fiscal year in which a non-plan sale occurs. The results also suggest that that both non-plan sales and high CEO incentive plan sales are more likely to be timed to benefit the CEO or associated with opportunistic transaction-based earnings management than low CEO incentive plan sales.
Fich et. al. (2023) also report evidence on the elimination of planned Rule 10b5-1 sales. The elimination of a sale can be accomplished by cancelling the plan or by using a limit order within the plan. Because plan cancellations and the use of limit orders are rarely disclosed, the authors identify instances where a sale is likely to have been eliminated by investigating trading patterns of individual CEOs. In contrast to the inverted “V” shape described above, the average CARs for sales that are identified as likely to have been eliminated exhibit a normal “V” shape. This pattern suggests that some CEOs benefit from inside information and avoid losses associated with stock price declines by cancelling a Rule 10b5-1 plan or using limit orders.
Finally, additional tests suggest that opportunism among Rule 10b5-1 plan sales and among non-plan sales is limited in well-governed firms. Notably, however, the same tests also indicate that the governance mechanisms that considered by Fich et al. are not effective at limiting opportunistic behavior associated with high CEO incentive sales within plans.
This study should be of interest to corporate governance policy groups and regulators who are focused on limiting the ability of managers of public corporations to enrich themselves at the expense of their firm’s stockholders. The results suggest that some CEOs successfully exploit weaknesses in the Rule 10b5-1 framework for personal gain.
Download the complete paper here.
