July 23, 2019
Securities laws and regulations exist, in part, to make sure securities trade on a level playing field where all investors have access to the same company information at the same time. But while it is unlawful for corporate insiders to trade securities based on nonpublic information, there is plenty of evidence that company executives and officers continue to profit on their inside knowledge despite existing restrictions.
The current Congress is considering several measures to close such loopholes. One of these laws, which would tighten the rules governing prearranged trading plans, is awaiting Senate action after overwhelming approval in the House. Another would end what its sponsor called “decades of ambiguity” by expressly making it a federal crime to trade on wrongfully obtained non-public information.
Here is a brief update of where these bills stand in the legislative process, beginning with the one that is furthest along.
The Promoting Transparent Standards for Corporate Insiders Act
This bill, which passed the House of Representatives with near-unanimous support, would direct the Securities and Exchange Commission to study changes to prevent manipulation of Rule 10b5-1 trading plans, which give corporate insiders an “affirmative defense” against allegations of unlawful insider trading.
Rule 10b5-1, enacted by the SEC in 2000 pursuant to its rule-making authority under the Securities Exchange Act of 1934, defines insider trading as the buying or selling of a security while in possession of “material nonpublic information” about that security or its issuer.
But SEC Rule 10b5-1 also shields insiders who become aware of nonpublic information after they decide to trade but before the trade is executed—who, in other words, don’t base their decision on inside information. By setting up Rule 10b5-1 trading plans that instruct investment professionals to buy or sell stock in certain quantities at prearranged times, executives and board members can often avoid insider trading liability even if they profit from a trade’s timing.
When the Department of Justice, the SEC, or private plaintiffs point to suspicious trading patterns by corporate insiders as evidence that they knew about a fraudulent scheme of which the public was unaware, these executives and officers often successfully present their use of trading plans as evidence to negate their liability—the affirmative defense ensconced in Rule 10b5-1.
Yet almost from the day Rule 10b5-1 trading plans were established, they have been criticized as susceptible to manipulation by corporate insiders. A 2016 study in the Columbia Business Law Review, for example, concluded that insiders often set up, modified, and discontinued plans to capitalize on nonpublic information. Its examination of more than 1.5 million insider transactions registered with the SEC from 2003 through 2013 found that insiders with plans in place profited as much as insiders without restrictions. “Our evidence clearly shows that these safe harbor plans are being abused to hide profitable trades made while in possession of material non-public information,” its authors wrote.i
Looking to close such loopholes, the proposed bill would order the SEC to do a one-year study to determine whether the rule should be amended to allow plans to be established only during issuer-adopted trading windows, limit the ability of issuers and insiders to adopt multiple plans, and restrict how often plans can be modified or canceled. The SEC would be required to consider imposing mandatory delays between a plan’s establishment or modification and the first prearranged trade.
In a rare display of high-level bipartisanship, the bill was co-sponsored by House Financial Services Committee Chairwoman Maxine Waters (D-Calif.) and Ranking Member Patrick McHenry (R-N.C.), and approved by a 413-to-3 vote on January 28, 2019. The Senate version of the bill was referred to the Committee on Banking, Housing and Urban Affairs.
The Insider Trading Prohibition Act
Because there is no express definition of insider trading in the federal securities laws, it has become an example of “judge-made” law, with judges in each successive case relying on previous rulings to discern whether a defendant’s behavior runs afoul of Section 10(b) of the Exchange Act. The Insider Trading Prohibition Act introduced by Rep. Jim Himes (D-Conn.) seeks to codify the law of insider trading.
In Himes’ words, the Act “would make it a federal crime to trade a security based on material, nonpublic information that was wrongly obtained, ending decades of ambiguity for a crime that has never been clearly defined by the law.”
The Insider Trading Prohibition Act goes beyond the individual who trades on insider knowledge. It would make it unlawful to communicate an inside “tip” to someone who may be reasonably expected to trade on it. It defines as wrongful any information obtained through “theft, bribery, misrepresentation or espionage,” in violation of computer data privacy laws, intellectual property laws, or breaches of fiduciary duty or confidentiality.
Importantly, the bill would also remove a requirement in some jurisdictions that the “tippee” know that the “tipper” received a personal benefit from sharing the information, as long as the tippee knew or recklessly disregarded that the information was wrongfully obtained. In Congressional testimony in support of the bill, Columbia Law School Professor John C. Coffee, Jr. called the requirement of showing a benefit to the tipper “a significant barrier to insider trading enforcement” because it is easy to hide and because Wall Street essentially runs on favors. (Coffee serves on a task force formed in October 2018 by former U.S. Attorney Preet Bharara to explore changes in insider trading laws. The task force includes former regulators, prosecutors, judges, academics, and defense lawyers. It has not yet released its report.)
Finally, the bill would authorize the SEC to use its discretion to exempt any individual or transaction from liability under it.
The House Financial Services Committee unanimously approved the measure, with vocal support from Reps. Waters and McHenry. It is awaiting consideration by the full House.
The 8-K Trading Gap Act of 2019
Another loophole exploited by corporate insiders involves the four-day delay between the time a company learns of potentially market-moving information and the time it is required to report that information to the SEC (and thus the public) by filing a Form 8-K.
The so-called “8-K trading gap” was a term coined by current SEC Commissioner Robert J. Jackson, Jr. in a 2015 research paper he published while at Columbia Law School. Jackson and his co-authors concluded that “public-company insiders trade during the 8-K gap—and earn economically and statistically meaningful profits while doing so.”ii His findings echoed a 2012 investigation by The Wall Street Journal, which similarly found “that many executives reaped robust gains when they traded ahead of major announcements.”iii
The bill proposed by Rep. Carolyn Maloney (D-N.Y.) would amend the Exchange Act to require the SEC to eliminate the four-day gap with exceptions for certain transactions entitled to safe harbor protections, such as trades made under Rule 10b5-1 trading plans. The bill was discussed at an April 3 hearing of the House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets, which Maloney chairs.
Stock Buybacks
Research by SEC Commissioner Jackson may also prompt Congressional action on another common practice—heavy sales of company stock by executives following buyback announcements—that while not strictly insider trading, can allow them to profit handsomely.
In December 2018, Sen. Chris Van Hollen asked Jackson to clarify his research after SEC Chairman Jay Clayton commented to the Senate Banking Committee that Jackson’s findings of larger-than-usual insider selling after buyback announcements could be coincidental. Maybe executives sell stock after buybacks, the thinking goes, because they are newly freed of company-imposed insider trading restrictions in place before the announcement, when the executives had possessed nonpublic information.
Share prices typically go up once a company announces that it plans to repurchase its own stock: a buyback announcement is essentially a declaration that the company thinks the stock is trading cheaply; the buyback itself also takes shares off the open market, reducing supply. Swimming in extra cash following the 2017 tax cuts, corporations repurchased a record $806 billion of their own shares last year, according to figures compiled by S&P Dow Jones Indices. SEC rules currently provide a “safe harbor” that reduces liability when companies repurchase their own common stock on open markets.
In a March 2019 letter responding to Van Hollen, Jackson said additional research had shown higher-than-usual insider trading after buybacks regardless of company’s pre-announcement trading restrictions. In his letter, Jackson also noted another “troubling trend.” When insiders sell after a buyback announcement, the company’s “long-term performance is worse,” he said. “This raises the concern that insiders’ stock-based pay gives them incentives to pursue buybacks that maximize their pay—but do not make sense for long-term investors.”
Van Hollen said Jackson’s findings showed “that corporate executives can use buybacks to cash out at high prices to the detriment of their company and investors.” Van Hollen now plans to introduce a bill that would require the SEC to review its current buyback rules.
i See Taylan Mavruk and H. Nejat Seyhun, “Do SEC’s 10B5-1 Safe Harbor Rules Need To Be Rewritten?,” Columbia Business Law Review, Vol 2016, pp. 182-183, and H. Nejat Seyhun and Taylan Mavruk, “SEC Needs to Rewrite its 10b5-1 Safe Harbor Rules,” The CLS Blue Sky Blog, June 2, 2016.
ii See Columbia Law and Economics Working Paper No. 524, “The 8-K Trading Gap,” Alma Cohen, Robert J. Jackson, Jr., and Joshua Mitts, September 7, 2015.
iii See The Wall Street Journal, “Executives’ Good Luck in Trading Own Stock,” by Susan Pulliam and Rob Barry, Nov. 27, 2012.