The SEC Is Eyeing Insider Stock Sales

BusinessWeek has learned it is examining possible abuses in automatic trading plans

Are executives using inside information to boost returns when they sell stock through automatic trading plans? That was the conclusion reached in the first academic study of such plans, as reported by BusinessWeek on Dec. 18. Troubled by those results, now the Securities & Exchange Commission is looking more closely at such trades and whether the rules governing them need to be tightened, BusinessWeek has learned. The way the plans are being used "isn't how they were supposed to work," said a source familiar with the agency's views.

The move comes as broader concerns have grown regarding prearranged trading plans, known as 10b5-1 plans for the 2000 rule that created them. Some investors have begun to track them closely. And revelations about two founders of New Century Financial Corp. (NEW ), the mortgage firm whose stock collapsed after an announcement it would restate 2006 earnings, could raise new questions about such sales: Some months before, the pair sold shares worth $26 million through trading plans.

The SEC's goal in creating automatic trading plans was to allow executives to sell shares without triggering insider trading charges. To gain that legal "safe harbor," however, executives must meet certain conditions. They must set up a trading plan when they don't know of any significant nonpublic information, lay out the dates or prices at which trades will be made in advance, and give up control of the trades to a broker.

Those limited rules allow executives more maneuvering room to time sales than is generally understood. According to the study by Alan D. Jagolinzer, an assistant professor at the Stanford University Graduate School of Business, executives selling shares through 10b5-1 plans do substantially better than would be expected if trading were truly automatic. In a study of roughly 117,000 trades made by 3,426 executives at 1,241 companies, trades made inside plans beat the market by 6% over six months, while those at the same firms who traded outside of plans only topped it by 1.9%.

More often than not, sales made through plans by insiders occur ahead of a stock drop. The rules also allow executives to end plans before they've been fully executed, set up multiple short-term plans, and begin selling immediately after adopting a plan. "I wouldn't have thought the plans allowed this much flexibility," says a source familiar with Jagolinzer's study. "His work clearly raises questions about the trading strategies people are using and if they are going well beyond what was envisioned."

The report has prompted the SEC to undertake a more detailed analysis of 10b5-1 plans. If the commission eventually concludes that problems exist, it could change how it evaluates cases for potential enforcement action; it could also propose tightening the rules governing such trades. Greater public disclosure of an executive's trading strategy, or of the dates when a plan is started or ended, might be required. H. Nejat Seyhun, a finance professor at the University of Michigan's Ross School of Business, also thinks stiffer trading controls are needed: Sales might be banned until six months after a plan is put into effect, for example, or an executive who ends a plan prematurely or makes other changes might lose the safe harbor protection.

The SEC's enforcement officials are also keeping a close eye on 10b5-1 trades, although the agency has yet to challenge a plan by bringing an insider trading case against an executive with one in place. And growing questions about the plans could be fueled by the trades made at New Century. Its shares have plummeted to around $5 in the wake of a Mar. 2 announcement that federal prosecutors are probing its accounting, as well as looking at trading in its securities following New Century's warning in early February that it would have to restate 2006 earnings. Between August and November of last year, two founders, Robert Cole and Edward Gotschall, sold roughly 650,000 shares, at prices averaging just below $40, through automatic trading plans. The company declined to comment. Prosecutors and the SEC would not comment on whether those trades are among those being probed.

Some investors, too, appear to be paying closer attention to such plans. Gradient Analytics Inc., an independent research firm, warned clients last year to steer clear of companies with overly aggressive automatic trading plans. Now it regularly analyzes such plans in recommending stocks to buy or sell. "Plans being instituted are becoming more creative," says Carr Bettis, a former finance professor who co-founded Gradient. "They've been around long enough for people to find ways to use them to their advantage."

By Jane Sasseen

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