A Closer Look At Trades By Top Brass

Some execs may be abusing an SEC safe harbor rule on insider stock sales

Late last year, after a seven-month surge nearly tripled shares in Midway Games Inc. (MWY ), CEO David F. Zucker apparently decided it was time to lighten his load. So on Dec. 8 he filed notice with the Securities & Exchange Commission that he'd set up an automatic trading plan to sell some of his shares in the Chicago-based company, best known for its popular Mortal Kombat video game.

And unload Zucker did -- with a vengeance. On Dec. 19 he sold 50,000 shares for $1.1 million. Over the next three weeks, Zucker sold another 50,000 shares every trading day, breaking only for Christmas and New Year's. By Jan. 6, Zucker had sold 650,000 shares for $12.9 million.

Zucker's timing couldn't have been better. Less than a week after he set up his trading program, Midway's board approved a plan to take charges of $20 million and cut the workforce by 11%. The news meant Midway's losses for 2005 would be significantly higher than its projected $95 million. After it was made public on Dec. 16, Midway's stock began a precipitous slide. From 23.26 on Dec. 15, it fell 57%, to 9.91, by late February.

A lucky coincidence? Just good timing? Or something more? It's the sort of insider sale that's drawing increasing attention because it came after Zucker created what's known as a 10b5-1 plan. These trading programs, named for the SEC rule in 2000 that authorized them, were designed to create a way for executives to sell shares without facing insider-trading charges.

To get that protection, however, executives must meet several conditions: They must create a plan at a time when they don't know of significant nonpublic information, and they must fix the dates or the price of trades in advance.

But in the face of evidence that insiders who set up such plans appear to be earning outsize gains, these trades are coming under closer scrutiny. A recent study by Stanford University Graduate School of Business assistant professor Alan D. Jagolinzer questions whether executives are in fact able to tap inside knowledge to set up and time the sales they make in the plans.

As reported in BusinessWeek on Oct. 26, Jagolinzer analyzed data on nearly 100,000 trades made by 2,995 insiders who had set up 10b5-1 plans at 1,016 companies from 2003 to 2005. While emphasizing that the results are preliminary, Jagolinzer found that insiders, on average, were beating the market by 5.6%. Insiders appear to be particularly prescient in selling before stock slides, selling twice as often ahead of bad news as good news.

Indeed, some executives appear to be using 10b5-1 plans in a way that runs counter to original expectations. When the rule was written, the assumption was that execs would set the plans to trade shares on a regularly scheduled basis over many months -- selling, say, 10,000 shares on the first of the month over the course of a year.

Instead, some executives are creating plans that quickly sell off big chunks of stock. "The rule was set up to give executives a safe harbor so they could make routine sales without having to worry about insider trading every month," says Stanley Sporkin, a former head of the SEC's enforcement unit. "Now it appears it has been turned into something it wasn't designed to do."

Executives who trade in such a manner do run a higher risk of losing the legal protection afforded by the rule. Take the trades made by Midway's Zucker, who set up his plan just a week before the Dec. 16 restructuring and charges to earnings were announced. The news started a market rout, and with earnings in flux, Zucker may have been vulnerable to insider-trading allegations had he sold shares without a plan. Shareholders also feared that continuing problems might spur Sumner M. Redstone, whose purchases had fueled the stock's rise from 8 to 23 since the spring, to reduce his stake. Zucker did not respond to requests for comment.

Zucker wasn't the only Midway exec who decided to sell shares last December. Three others set up 10b5-1 plans and sold stock then -- including two who also created them in the week before the restructuring was announced.

Plans filed by an insider close to a big announcement raise questions. "The dates sug- gest he was setting the plan up in anticipation of really using the information, of getting cover for trades," says a source close to the SEC. "If that were the case, I don't know if he would get protection."

By Jane Sasseen

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