July 2007

Stock option backdating scandals have grabbed headlines for quite some time. These scandals were initially identified by academic research that noted unexplained stock movements relative to option grant dates. A similar issue may exist with 10b5-1 plans. The volume of potential insider trading is substantial.

For example, in late July, the former CEO of Quest Communications will be sentenced for insider trading involving more than $100 million of Quest stock, with much of this made through a 10b5-1 plan. Apparently, Quest Communications is not the only company with a cheating 10b5-1 plan. A study by a Stanford Business School professor (Alan Jagolinzer) of over 100,000 trades in 10b5-1 plans by over 3,000 executives demonstrates that those who use these plans significantly outperformed their colleagues who do not have such plans. Professor Jagolinzer concluded that the 10b5-1 trades were occurring “strategically” using insider information, and “trading within the Rule

[10b5-1] does not solely reflect uninformed diversification.” Of course, this would not be possible if insider information were not affecting the establishment, operation, and/or termination of these plans.

The Securities and Exchange Commission (SEC) noted Professor Jagolinzer’s research. The SEC’s enforcement chief indicated that this would be an area for serious scrutiny by the SEC.

Background on 10b5-1 Plans

Rule 10b5-1 under the Securities Exchange Act of 1934 became effective in October 2000. The rule specifically makes trading while in possession of material nonpublic information illegal. The “possession” standard was more onerous than a standard of actual use that some courts enforced. The SEC created the rule to end the use standard because the SEC concluded that it is:

“highly doubtful that a person who knows inside information relevant to the value of a security can completely disregard that knowledge when making the decision to purchase or sell that security.”

To allow insiders to sell their stock for diversification or other personal reasons, the SEC included in the rule an affirmative defense to insider trading allegations when trades are made pursuant to a preexisting written trading plan. The executive must not be in possession of inside information at the time the plan is adopted. For a plan to be effective, insiders must either (i) transfer trade execution authority to an uninformed third party, or (ii) provide an uninformed party with explicit written instructions or a trading algorithm.

However, Rule 10b5-1 allows a plan participant to cancel the plan and related planned trades. The SEC justified this based on the premise that there could not be a violation of securities regulation without an actual trade occurring.

Action Items for Boards of Directors and Their Advisors

As part of their corporate governance obligations, Boards of Directors should scrutinize 10b5-1 plans by company executives. Watch for the following:

1. Plans that allow for rapid and/or larger sales at the beginning of the plan
2. Premature plan termination
3. Modification of an existing plan
4. Plans that appear excessively complicated through trade parameters, price hurdles, hedging, and/or other formulae.

Although not required to do so, Boards should consider requiring public disclosure of the terms of any 10b5-1 plan, including any modification or termination of an existing plan.

Fulcrum Inquiry is a forensic accounting firm. We assist with financial investigations and a wide range of compliance audits.