What is Insider Trading, and Does It Need Fixing?

Blog Post | 110 KY. L. J. ONLINE | January 3, 2022

What is Insider Trading, and Does It Need Fixing?

By: Dillon Curtis, Staff Editor, Vol. 110

There are over 82,000 executives in the United States, and these individuals generally receive as part of their compensation the option to purchase stock options from their company.[1] Depending on the company, it may be easy or difficult for the executive to buy or sell their stocks.[2] Each of these executives serves as an insider of the company and are subject to the rules promulgated by the Security and Exchange Commission (SEC) for when and how these stocks can be sold.[3]

By definition, an “insider” in the world of the SEC is a senior executive, board member, or a shareholder with more than 10% of the company.[4] Insider trading by an officer, board member or 10% shareholder is considered a breach of their fiduciary duty to the company, and they could be investigated by the SEC or prosecuted by the Department of Justice.[5]

What are the current laws against insider trading?

Currently, insider trading is regulated by Rule 10b5-1 under the Securities Exchange Act of 1934 which was adopted in 2000.[6] Under the current Rule 10b5-1, insiders in an organization can circumvent liability if: (1) the trade was executed in pursuant of a binding contract, (2) the trade was conducted as an instruction to another person, or (3) the trade was made as part of a preapproved trading plan.[7] The ability to make preapproved trading plans allows executives a great amount of maneuverability to maximize their stock value options.[8] These preapproved plans can be cancelled or modified and there is no waiting period to implement the plan.[9]

Under the current rules against insider trading, highly paid executives like Jimmy Filler—board member of ServisFirst Bancshares Inc. and largest shareholder of Century Bancorp Inc.—are still able to buy and sell their stocks for a profit margin that far outstrips the S&P 500 returns.[10] In theory, these insiders use their enhanced knowledge of the company to beat the stock market which could present them with an unfair advantage compared to the average stock buyer.[11] The company and the insiders also possess the ability to decide on what information should be materially important enough to affect the stock price and release to the public.[12]

 What are the proposed changes?

On Dec. 15, 2021, the SEC released a proposed update to Rule 10b5-1 which would eliminate some of the gaps in the insider trading protections.[13] The changes to the disclosure requirements would institute a cooling-off period for insiders once they have filed their preapproved plan with the SEC.[14]  This 120-day cooling off period after filing or modification of the plan for a director or officer would allow for the production of the quarterly financial statements before the trade took place.[15] Additionally, overlapping trading plans would be eliminated and there would be a limit of one single-trade plan per year.[16] Most importantly, the officers and directors would also be required to provide written certification agreements that expand the good faith requirement.[17] These written certifications directly stipulate that the officers or directors do not have any material nonpublic information of which they are basing the trade off of.[18]

Are these changes necessary and effective?

Overall, these changes could go a long way to eliminating insider trading, but some may argue that insider trading is good for the economy.[19] Although, the individual insiders benefit the most from the trades that are made, the average stockholder can gain access to pertinent information faster in when insiders make a trade.[20] Some companies are starting to gather data on trades that insiders make and distributing this to their customers.[21] This will make the economy more efficient and the active individual stockholder with the newly released information could acquire more money than the inactive investor.[22] However, these points against the enforcement of insider trading do not change the mind of many individuals.[23]

In practice, these new changes to Rule 10b5-1 could be hard to enforce. The requirement to have the executives sign a written agreement may be ineffective, because in theory they should not be making trades based on the current inside information. The only difference with the proposed change is that it would be directly stated instead of implied.

However, the most effective change would be the filing of the proposed plan. By imposing the new cooling off period, the SEC and DOJ could more effectively investigate and prosecute insiders who violate the proposed plan. Having limits on the proposed plan would make it harder for insiders to trade, but there could never be a complete separation of nonpublic information from the insiders.[24] Regardless of what the new SEC rules are, insiders will always possess a higher level of understanding and insight into the functions of the company which would allow the insiders to better manage their stocks in the company compared to an average stockholder.[25]

[1] Liam Vaughan, Most Americans Today Believe the Stock Market is Rigged, and They’re Right, Bloomberg Businessweek (Sept. 29, 2021, 12:01 AM), https://www.bloomberg.com/news/features/2021-09-29/is-stock-market-rigged-insider-trading-by-executives-is-pervasive-critics-say.

[2] Id.

[3] Id.

[4] Insider Trading, Legal Info. Inst. https://www.law.cornell.edu/wex/insider_trading (last visited Dec. 27 2021).

[5] Id.

[6] Security Exchange Commission, Fact Sheet Rule 10b5-1 and Insider Trading: Proposed Rules, https://www.sec.gov/files/10b5-1-fact-sheet.pdf.

[7] Id.

[8] See Vaughan, supra note 1.

[9] Id.

[10] Id.

[11] Id.

[12] Id.

[13] Press Release, Security Exchange Commission, SEC Proposes Amendments Regarding Rule 10b5-1 Insider Trading Plans and Related Disclosures (Dec. 15, 2021) (available at https://www.sec.gov/news/press-release/2021-256).

[14] Id.

[15] SEC Focuses on Potential Misuse of Material Non-public Information in Stock Trades: Proposed Amendments Regarding Rule 10b5-1 Trading Plans and Company “Buybacks”, White & Case LLP (Dec. 22, 2021), https://www.whitecase.com/publications/alert/sec-focuses-potential-misuse-material-non-public-information-stock-trades.

[16] See Vaughan, supra note 1.

[17] Id.

[18] Id.

[19] See Vaughan, supra note 1.

[20] Id.

[21] Id.

[22] Id.

[23] Id.

[24] Id.

[25] Id.