Academic

Henderson & Jagolinzer on Rule 10b5-1

By Lawrence Solum

M. Todd Henderson and Alan D. Jagolinzer (University of Chicago - Law School and Stanford Graduate School of Business) have posted The Uses and Abuses of Rule 10b5-1 on SSRN. Here is the abstract:

Firm insiders have used Rule 10b5-1, which allows them to pre-commit to trades when they don't possess insider information so they can trade at times when they do, to sell tens of billions of dollars of stock since the SEC promulgated the Rule in 2000. The SEC intended the Rule to permit insiders the opportunity for uninformed diversification trades, but we present evidence that the Rule (as written and as implemented) has several flaws that give insiders increased strategic trading opportunities compared with the pre-Rule world. We present empirical evidence suggesting that insiders using plans outperform insiders not using plans.

The Rule does not require mandatory disclosure of trading plans, so we exploit this as an opportunity to examine the interaction between disclosure choice and trading outcomes. We present evidence showing that disclosure is increasing in firm litigation risk and insider profit-making potential, and that, counter-intuitively, insiders making the most detailed disclosures outperform the market the most. In other words, transparency is not acting as a disinfectant but a false signal of cleanliness. This ability to hide in plain sight is a downside of disclosure that is unappreciated by the existing literature. We also show how the Rule embeds a costless put option for insiders to profit from future bad news, even if very unlikely, and we discuss how this option may or may not be efficient for firms and shareholders.

Finally, we address the public policy implications of the findings that some insiders are using the Rule strategically to increase their profit-making opportunities. We consider various reforms - mandatory disclosure, limiting termination options, etc. - and conclude that the SEC should not act since various market players (D&O insurance carriers, boards, institutional investors, and so on) have the right incentives to reduce strategic abuse of the Rule while maintaining its benign use. We also offer an alternative regulation that would achieve the SEC's stated goal more simply, and discuss the implications of the empirical findings for the general debate about insider trading regulation.

Full post as published by Legal Theory Blog on September 26, 2008 (boomark / email).