Midway CEO Zucker's Safe Harbor

In late 2005, the executive traded almost 650,000 shares of company stock, just as it began a precipitous decline. A lucky coincidence?

Late last year, after a seven-month surge had nearly tripled shares in Midway Games (MWY), CEO David Zucker apparently decided that it was time to lighten his load. On Dec. 8, he filed notice with the SEC that he had set up a prearranged trading plan to sell off some of the shares he had accumulated in the Chicago-based company, best known for its popular Mortal Kombat video game.

And unload Zucker did—with a vengeance. His first trades came on Dec. 19, with the sale of 50,000 shares, bringing in proceeds of $1.1 million. And over the course of the next three weeks, Zucker sold another 50,000 shares virtually every trading day, taking a break only for Christmas and New Year's. By Jan. 6, the date of his last trade, Zucker had sold off some 650,000 shares, reaping proceeds of $12.9 million. He finished with just 163,000 shares remaining, according to SEC filings.

Increased Scrutiny

Zucker's timing couldn't have been more fortuitous. Less than a week after he set up his automatic trading program, Midway's board approved a plan to take charges of $20 million and cut the company's workforce by up to 11%. When that plan was made public late on Dec. 16, a Friday afternoon, Midway's shares began a precipitous slide. From a peak of $23.26 on Dec. 15, its stock fell a stunning 57%, to $9.91, by late February.

It's the sort of insider sale that is drawing increasing scrutiny, because Zucker's trades took place after he filed what is known as a 10b5-1 plan. These prearranged plans, named after the SEC rule in 2000 that authorized them, are designed to let executives sell the shares they have accumulated in their companies without facing charges that they are trading based on their inside knowledge. They provide executives with a "safe harbor" from such charges, but only if they meet several conditions. Most important, executives must set up these plans at a time when they aren't aware of any significant nonpublic information. They also must delineate the dates or the price at which trades should be made in advance, and they must hand over control of the trades to a broker.

But in the face of evidence that insiders who set up prearranged plans appear to be earning outsized gains, such plans are coming under increased scrutiny. A recent study by Stanford Graduate School of Business Assistant Professor Alan Jagolinzer raises questions as to whether insiders are in fact able to tap their inside knowledge when they set up and trade under such plans.

Knowledge Aforethought?

As reported in BusinessWeek on Oct. 26, Jagolinzer has analyzed data on nearly 100,000 trades made between 2003 and 2005 by 2,995 insiders at 1,016 firms with 10b5-1 plans (see BusinessWeek.com, 11/6/06, "Not as Random as It Looks?"). He found that insiders, on average, were able to beat the market by 5.6% with the trades they did within 10b-5 plans.

At a conference on the legal and accounting issues surrounding options dating and trading issues sponsored by Stanford's Rock Center for Corporate Governance on Oct. 30, Jagolinzer elaborated on his view that a preliminary analysis of the data appears to show that such trades may not be as random as intended by the SEC's original rule. "The conventional wisdom among investors is that these are 'uninformed' trades by executives made to diversify," Jagolinzer told the Washington (D.C.) gathering. But the sales activity doesn't appear to reflect "random diversification," he says.

A key reason for the higher performance: More often than not, the sales insiders make in such plans take place just ahead of declines in their companies' stocks. In part, that's because they also sell shares in advance of negative earnings news twice as often as they sell ahead of good news. "What this work suggests is that executives who know that their stock will underperform—either because they know specific bad news is coming up or because they think the market has overvalued it—enter into plans and sell a large fraction of their stock," says Jesse Fried, the co-director of the Berkeley Center for Law, Business & the Economy at the University of California, Berkeley, and the co-author of Pay without Performance: The Unfulfilled Promise of Executive Compensation.

Executive Discretion

Moreover, others argue that some executives appear to be using the plans to rapidly unload stock in a way that runs counter to the original intent of the 10b5-1 rule. When the rule was written, the expectation was that executives would set up plans to trade shares on a regularly scheduled basis over many months—selling, say, 10,000 shares on the first of every month over the course of the following year.

While many executives certainly do that, Jagolinzer's data suggests that others trade more advantageously. "The rule was set up to give executives a safe harbor so that they could make routine sales without having to worry about insider trading every month," says Stanley Sporkin, a former director of the SEC's division of enforcement now with Weil, Gotshal & Manges. "Now it appears to have been turned into something it wasn't designed to do."

Indeed, Mark LoPresti, who tracks insider trading for Thomson Financial, points out that some executives appear to be setting up plans and almost instantaneously using them to sell off big chunks of stock. "People thought these plans would be used to lock in dates well ahead of the trades," says LoPresti. "But that doesn't appear to be the case; executives still have enormous discretion over when to sell."

Curious Patterns

Still, Jagolinzer's results have drawn skepticism from some quarters. Bruce Carton, who monitors shareholder class action suits for proxy advisor Institutional Shareholder Services, says the advance planning and legal complexities involved in setting up plans leaves him unconvinced they are being widely manipulated. "I find it very unlikely; in my experience, you just don't see a team of executives with matching plans," he says. "Everyone does it as a one-off with their own financial advisors."

Jagolinzer agrees that it's difficult to know from the data alone exactly what explains the insiders' higher-than-expected returns, and he stresses that his results are preliminary. And none of it necessarily implies anything illegal. Yet he argues that the patterns demonstrated by examining tens of thousands of trades are too strong to simply be attributable to chance. "If executives were initiating plans without any inside information, then you wouldn't expect there to be any noticeable pattern in their performance," he says.

In his presentation at the Stanford conference, Jagolinzer cited an unidentified example to demonstrate the patterns that raise questions: the case of a CEO who announced a plan and then sold a huge chunk of his shares within little more than a few weeks, just ahead of a 50% decline in his company's stock.

Fortunate Timing

Jagolinzer would not identify the company involved, but a search through SEC filings reveals that the sales made by Midway's Zucker appear to match that description. Zucker did not respond to several requests for comment.

Zucker's December trades came just ahead of a market rout as investors reacted poorly to the announced restructuring at the money-losing company. Shareholders also feared that continuing problems at the company might lead to a reduction in the controlling stake held by media mogul Sumner Redstone. Purchases made by Redstone had fueled the shares' rise from $8 to $23 since the spring. In late December, Redstone announced that he had transferred his Midway holdings to a company controlled by his daughter as part of an effort to free himself from debt. The combined concerns quickly led to a rout.

The Midway CEO was not the only company executive who decided to diversify his holdings as the stock hit new highs last December. Three other execs at the gaming company also set up automatic trading plans to sell shares—including two who also set them up in the week before the company's Dec. 16 restructuring announcement, according to SEC filings.

No Comment

Miguel Iribarren, a vice-president in charge of publishing, adopted his plan on Dec. 9; on Dec. 20, he sold 15,000 shares for roughly $316,000. Steven Allison, the senior vice-president of marketing, set up his plan on Dec. 13. He sold 21,250 shares on Dec. 22 for nearly $450,000. James Boyle, a vice-president in finance, adopted a plan on Dec. 19. He sold 15,000 shares on the 21st, bringing in $310,000. None of the three made any further trades in their automatic plans.

On Dec. 20, CFO Thomas Powell sold 40,500 shares for proceeds of $842,000. There are no public filings declaring whether or not his sales took place as part of a trading plan. Insiders are not required to disclose if they've set up 10b5-1 plans, though many do because of the legal protections they offer. None of the executives responded to requests for comment.

As Jagolinzer put it in reference to his unidentified company, "Given the proximity of the trades to the stock decline, this is the type of pattern that makes you scratch your head and ask what is going on."

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