By influencing the timing of corporate disclosures, corporate insiders trading in the US securities markets may be abusing a rule that protects them from prosecution for insider trading. Although this conduct is not deceptive in violation of federal law, the practice may be a breach of fiduciary duty in some states and SEC rules could be amended to clamp down on that behavior, directly or indirectly.
It has long been the position of the US Securities and Exchange Commission (SEC) that a trade made when an insider is in possession of material nonpublic information (MNPI) about the company is unlawful. In 2000 the SEC adopted Rule 10b5-1 to permit trades by insiders when they are aware of MNPI so long as the trade was preplanned when the insider was not aware of MNPI. Rule 10b5-1 allows insiders to establish a 10b5-1 plan (Plan) administered by a broker where the Plan provides for future transactions in company securities in accordance with specific parameters. A later trade made strictly in accordance with a Plan is not unlawful. Many corporate executives have established Plans to achieve portfolio diversification.
Empirical studies of insider trades made pursuant to Plans have suggested that those trades tend to be more successful than trades by outsiders in the same security. One explanation posited for this success is that the insider, knowing when a trade will occur under the Plan, influenced the timing of corporate disclosure so that the outcome of the trade was more profitable than would otherwise have been the case. For example, the insider knows that a Plan sale is scheduled for a date certain, before the trade occurs she learns some material nonpublic bad company news, and she takes action to delay the disclosure of the bad news until after the trade, so that her sale is made before the release of the bad news causes the market price of the stock to drop. This presents the question whether “disclosure timing” is unlawful when the delay does not violate an SEC mandatory disclosure rule, such as the obligation under Form 8-K to disclose certain events no later than a specified number of days after the event.
Disclosure timing, an undisclosed internal process, does not involve a public misrepresentation or half-truth prohibited by the core SEC antifraud rule, Rule 10b-5(b). “Scheme liability” under clauses (a) and (c) of Rule 10b-5 reaches only conduct that creates a false appearance in the market. Silence by the insider who tampers internally with the ordinary timing of corporate publicity does not create a false appearance. No other securities law statute or rule is violated by the insider’s undisclosed internal machinations, and stock exchange listing rules that require prompt disclosure of material events are not the basis for either an SEC or private claim.
If disclosure timing should be prohibited, the means to address it under the current federal securities laws are limited. A rule adopted under Section 10(b) of the Securities Exchange Act can prohibit only manipulation, such as wash sales, or deception. Undisclosed internal disclosure timing is not a deceptive act, and so it is doubtful that a rule adopted under Section 10(b) that expressly prohibited disclosure timing would be lawful.
Disclosure timing might be reduced by amending Rule 10b5-1 to preclude use of the rule’s defenses by anyone who deliberately engages in disclosure timing. Another, more easily enforced, option at the federal level is to revive an SEC proposal to require corporate disclosure of Rule 10b5-1 Plans. (Today any disclosure about Plans is voluntary, not detailed, and irregular at best.) Disclosure of even limited information about an insider’s Plan could expose the insider’s trades to hindsight scrutiny in light of post-trade corporate disclosures that might suggest there had been disclosure timing. In other words, public shaming.
Turning to the common law, Delaware, where most US public companies are organized, has long recognized a fiduciary duty that prohibits personally profiting by trading in company securities using MNPI, whether or not the trading damages the company. This prohibition on the use of corporate information for personal profit may be breached where the insider uses his knowledge of corporate information to influence the timing of disclosure to improve the outcome of a trade made pursuant to a Plan. The insider would have to account to the company for the profits realized by exploiting MNPI.
If creators of Plans are engaging in disclosure timing and the practice should be curtailed, there are limited means to address it, short of amending the securities laws.
This post is a summary of the paper The Legality of Opportunistically Timing of Public Company Disclosures in the Context of SEC Rule 10b5-1, available here, and a revised version of a posting at the CLS Blue Sky Blog.
Allan Horwich is Professor of Practice at Northwestern Pritzker School of Law and a partner of Schiff Hardin LLP.