We recently published a paper on SSRN, Gaming the System: Three “Red Flags” of Potential 10b5-1 Abuse, that provides evidence that some executives use 10b5-1 trading plans to engage in opportunistic, large-scale selling of company shares.
Federal securities law prohibits corporate executives from trading company securities while aware of material nonpublic information (MNPI). Because executives are regularly exposed to MNPI, those who wish to sell a portion of their holdings to diversify their personal wealth are at risk of violating insider trading laws if they trade in advance of this information becoming public.
In 2002, the Securities and Exchange Commission adopted Rule 10b5-1, which outlines procedures that, if followed, provide an affirmative defense against allegations of illegal insider trading. To qualify for protection under Rule 10b5-1, executives enter into a nonbinding contract that instructs a third-party to execute trades on their behalf according to a written plan––known as a 10b5-1 plan. The plan must be adopted at a time when the executive is not aware of MNPI. Through the plan, the executive specifies a set of instructions or schedule by which trades are to be made, such as the number or value of shares to be transacted, the frequency of transactions, price limits, etc. (See Exhibit 1 for examples of 10b5-1 plans.) Once it is in place, the plan can be modified so long as the executive is not aware of MNPI at the time of the modification. The plan and any associated trades can also be cancelled at any time, regardless of whether the executive is in possession of MNPI. The latter aspect of 10b5-1 plans is particularly controversial, as it has the effect of allowing executives to set up routine sales, and then pause or cancel sales if they know the company will be announcing news that will push the stock price higher.