First off- this is not news.  This loophole has been in existence since 2000 but it’s sinister characteristics have not been adequately publicized.  I am including in this post the entire paper I found from the Yale Law Library written by Todd Henderson of the University of Chicago Law School, Alan D. Jagolinzer from Stanford University Graduate School of Business, and Karl A. Muller, III of  The Pennsylvania State University Smeal College of Business.  It’s the most comprehensive analysis of this problem I have found to date although the authors are predictably looking at it from the perspective of protecting their corporate clients not John Q. Public.   Click here for the complete 42 page analysis.

Insiders are prohibited in their buying and selling of securities by an SEC rule known as the “short swing rule”.  The short swing rule mandates that any profits made by trading in securities by insiders (defined as corporate officers, directors, and/or 10% owners) within six months of the trade date must be disgorged and returned to the company.  The common sense behind this legislation dates all the way back to the 30’s when the foundation of our present securities system was created.  The idea is of course to prevent knowledgeable corporate insiders from picking the wallets of unsuspecting public investors.  It’s quite a severe penalty for corporate insiders and one of the reasons why insider buying is so useful to an investor.  On the other hand insider selling is deemed to be fairly worthless.  Or is it?

As conventional wisdom dictates, people only buy for one reason- to make money but they may sell for a multitude of reasons, i.e; daughter’s wedding, downpayment on new house, health calamity, etc.  Furthermore the SEC clouded  the information horizon by passing the 10b5-1 rules that allow corporate insiders to set up trading plans to sell stock at set amounts and set times if they are not in possession of material information.

I quote from the cited article, “The SEC promulgated Rule 10b5-1 in October, 2000, in part, to provide a vehicle through which insiders could more readily diversify their firm-specific holdings. The Rule provides an affirmative defense that reduces trade-related litigation risk for insiders who enter into trade plans when they do not possess material nonpublic information. This affirmative defense allows more trade flexibility because it absolves insiders from having to cancel pre-planned trades or disclose subsequently obtained material nonpublic information before pre-planned trades execute.”

So when I look at insider selling, knowing that it is diminished information to start with, it is further qualified by these 10b5-1 trading plans.  There is ample evidence though that these plans are often abused.  First of all the disclosure of the plan to start with is voluntary on the company’s part.  As an investor I want to know if the founder and management decide they no longer want to own much of their company’s stock.  But the very existence of this plan to divest their shares can be held in the dark and only brought to light as each share is sold in a disclosure AFTER the sale. Worse yet these plans can easily be changed, amended, or dropped all together.  This is in effect an end run around the very insider trading ban the SEC set up in the first place.

This is particularly worrisome today.  There is an enormous amount of insider selling going on in this market and it is very hard to discern what is proper and fully disclosed like Warren Buffett and Bill Gates disclosure they are selling their stocks down to provide for the Gates charitable trusts or just your run of the mill I’m getting the hell out of my company’s stock before the shit hits the fan.  You can’t tell when and where these 10b5-1 trading plans are coming from and companies have no obligation to make them public.  Despite an April 2002 proposal to mandate 8-K disclosure of insiders’ participation in the Rule, the SEC currently does not require public reporting of insiders’ trade plans. If you are concerned about this like me, write your congressman or senator and put some heat on Mary Schapiro, current SEC chairwoman.

Furthermore this article goes on to state the obvious.  In the conclusion, the authors state “Evidence also suggests that insiders’ disclosed 10b5-1 trade is associated with fundamental firm economic shifts that relate to significant declines in returns performance.”

There is ample reason to be concerned that insiders are using these plans to unload stock as it fits their needs and terminate the plans as “inside information” may warrant.  In fact these 10b5-1 plans just reinforce my stated belief- “IT’S NEVER A GOOD THING WHEN INSIDERS ARE SELLING”  Ironically the authors conclude thought that it’s of less strategic value to an investor when the existence of a 10b5-1 plan is disclosed.  It’s almost as if the disclosure of the plan is an admonition to investors.  To quote from Shakespeare, “The lady doth protest too much, methinks.

And as I stated in our earlier blog post, insiders are selling by the droves.