While trawling Wikileaks I came across this press release.
A confidential memo obtained by Wikileaks shows that not only has the U.S. Securities and Exchange Commission created an insider trading loophole big enough to drive a truck through, but that Wall Street is taking full advantage of it, establishing 'how-to' programs and even client service divisions to help well-heeled clients circumvent insider trading regulations.
Apparently the SEC has Rule 10b5-1 which was created to clarify what constitutes insider trading. Now, it appears that JP Morgan (and probably other financial firms) has found loopholes that legitimate some forms of insider trading. JP Morgan has established a program through its JP Morgan Private Bank to allow wealthy clients and executives to profit from their inside knowledge in a perfectly legal manner.
From a Business Week article talking about 10b5-1 plans.
The SEC's solution was to create prearranged trading plans, known as 10b5-1 plans for the rule that authorized them. Launched six years ago, they were designed to remove discretion from executives' trades and provide a "safe harbor" from insider trading charges. The rules: Executives can't set up a plan when they possess material inside knowledge, and they must set the dates or prices of their trades in advance.
But those are the only major stipulations. The SEC never addressed the number of shares sold or the possibility of stopping and starting plans or running multiple plans at once. As a result, executives have far more flexibility than is generally understood. Besides providing legal cover, the plans allow execs to trade around earnings announcements and other significant events. Normally insiders are prohibited from trading on these "blackout dates."
Executives at companies know the truth about companies much earlier than other investors, especially those investors who leave the day-to-day management to mutual funds and the like. Classic insider trading, notionally speaking, is the idea that people inside companies profit from inside knowledge and doing things like dumping shares before a announcing a bankruptcy/significant loss or cashing out at the (internally known) high of a stock. It also is about limiting wild market swings based on the movements of these insiders (If CEO A is suddenly selling a huge chunk of shares that is a signal for you to sell your shares). Essentially, if you have knowledge because of your position at a company, you are not allowed to unduly profit from that knowledge. It seems that these 10b5-1 plans can allow just that.
The Business Week article further discusses empirical evidence showing that these plans allow the executives the ability to earn substantial returns when compared to those not in these plans.
Executives appear to be using their flexibility to the max. People selling shares in 10b5-1 plans generate returns substantially better than would be expected if the trading were truly automatic. As reported in BusinessWeek on Nov. 6, Alan D. Jagolinzer, an assistant professor at Stanford University Graduate School of Business, recently completed a study of roughly 117,000 trades in 10b5-1 plans by 3,426 executives at 1,241 companies. He found that trades inside the plans beat the market by 6% over six months. By contrast, executives at the same firms who traded without the benefit of plans beat the market by only 1.9%.
So it is obvious that these plans are beneficial to insiders in that they offer more 'flexibility' in managing their personal shares of company stock. By allowing this 'flexibility' the SEC is legitimating some form of insider trading (or non-trading as the case may be).
Wikipedia offers some insight into SEC Rule 10b5-1:
After Rule 10b5-1 was enacted, the SEC staff publicly took the position that canceling a planned trade made under the safe harbor does not constitute insider trading, even if the person was aware of the inside information when canceling the trade. The SEC stated that, despite the fact that 10b5-1(c) requires trades to be irrevocable, there can be no liability for insider trading under Rule 10b-5 without an actual securities transaction, based on the U.S. Supreme Court's holding in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975).
Did you get that? Securities law is written so that inside trades are known quantities and irrevocable, unless they are made through one of these plans, in which case, the trade can be canceled even if the insider is using their knowledge to cancel the trade. Ah the perfect storm of confusion whereby by profits can be made by stealing from suckers.
From the JP Morgan brochure regarding their 10b5-1 plans. (Download)
A PrISM is a prepaid variable forward securities contract
- A PrISM (Principal Installment Stock Monetization strategy) allows
a client to receive attractive upfront liquidity (typically 80-90% of
the stock value) and allows for flexibility in the reinvestment of
the proceeds.
- Client defers taxes on underlying shares until the maturity of the
transaction (assuming that they deliver shares).
- The client protects their position below the hedged value and
retains all participation in the upside appreciation up to a
predetermined upside limit.
- Client retains all dividends (optional) and voting rights during the
term of the PrISM.
What is a PrISM?
- While similar to collar plus a loan,
- Generally provides more cash upfront
- No interim cash payments are required
- At maturity, Client pays, in cash or shares, an amount that
varies with the stock price:
- If stock price at maturity < hedged value, market
value of the shares
- If hedged value <stock price at maturity < upside <br>limit, hedged value of shares
- If the stock price at maturity > upside limit, hedged
value of shares plus appreciation above upside limit
Key Risks
- Stock appreciation is capped at the upside limit.
- Shares are pledged for the duration of the VPF
and
Rule 10b5-1 allows corporate insiders to adopt pre-arranged stock trading plans to buy or sell a
specified number of shares of company stock. Transactions under the plan will be disclosed
through filings with the Securities and Exchange Commission.
I'm not fully understanding how these plans work so my editorializing may be a bit suspect. But what I gather from the JP Morgan document is that the insider pre-arranges to sell stock to the bank at a specific price. The bank then advances the cash for this future sell. After a period of time, the insider is required to make good by either selling the stock or returning the cash. The problems come in how this allows insiders to manipulate the transactions. Further if there is no actual selling of securities, then it does not constitute trading (which would mean no need to actually report anything). So these plans exist, it seems to me, to allow hedging and liquidity to these insiders. But the question becomes what kind of abuse is occurring due to these plans? It seems that this is unknown. I would be interested in informed speculation in the comments or even an explanation by someone who knows more.
JP Morgan was singled out by this whistleblower through Wikileaks, but I am certain plans like JPM's exist throughout the banking and financial sector. Given the SECs heroic lack of oversight, it would not be surprising to see that this rule is being fully abused. Also Wikileaks reports that JP Morgan has devoted significant resources and talent to help these insiders set up and manage these accounts. How much help do you get as an investor?
We should contact our legislators and specifically the financial and banking committees to overturn or stop this rule. Given the attitudes of the current crop of executives running corporations, it would seem likely that they are using this rule to game the market and thereby are causing real harm to investors, especially 401k holders. If not that, then it still gives an unfair advantage to insiders and should be undone.
UPDATE: Doing more research I have found an explanation of Prof Jangolizer's research about insiders doing better under 10b5-1 plans and what it could possibly mean. Essentially, insiders may be using these plans to time the markets. (link/pdf)
The preliminary results of the study suggest that the timing of trades under 10b5-1 plans is not always left to chance. Based on the data compiled by the study, insiders participating in 10b5-1 plans beat the market by 6% over six months, while those who did not participate in such plans beat the market only by 1.9%.5 These statistically significant results are indeed surprising if 10b5-1 plans are being employed in a way that does not take advantage of material insider information.
The higher return enjoyed by some 10b5-1 trading plan participants may be related to the finding that a substantial proportion of randomly selected 10b5-1 trading plan initiations take place in a way that does not seem random. Specifically, Professor Jagolinzer found that many of the trade initiations seemed to take place ahead of negative news —i.e. before the price was about to drop—rather than in advance of positive news releases.
To understand how insiders can time the market in a supposedly automatic plan, remember that, even though 10b5-1 plans are pre-determined and automatic in many ways, insiders typically retain some flexibility under the plans. For example, insiders can often terminate a plan on relatively short notice. Professor Jagolinzer’s research observes that early 10b5-1 plan terminations are not implemented randomly, but rather tend to precede declines in stock prices. Thus it may be the case that some insiders are terminating their 10b5-1 trading plans when they know bad news is coming that will temporarily depress the stock price before a scheduled sale. Indeed, as a technical matter, it is not illegal for an insider to terminate a 10b5-1 trading plan, even if the insider is in possession of material non-public inside information at the time of the plan termination.
In addition, it may be the case that some plans are being implemented at a time when insiders are arguably aware that good news may be forthcoming before the date of the first scheduled sale. Another possible explanation could be that insiders are manipulating the timing of public disclosure of material information to correspond favorably to trading dates in their 10b5-1 trading plans. Although these sorts of explanations are admittedly no more than conjecture at this point in time, these types of minor adjustments may explain the results of Professor Jagolinzer’s research.
Update #2: Doing more research.
SEC Rule 105b-1 was made in Oct. 2000. It is therefore came into being while Larry Summers was Treasury Sec. and can be seen as part of the deregulatory push that was occurring then. In April of 2002 the SEC proposed mandatory disclosure of these plans, but that proposal has been tabled, meaning all that has to be disclosed is the existence of the plan, and not any of the arrangements regarding the mechanics of the possible stock sell. From a paper by Henderson, Janlinzer, and Muller
In April, 2002, The SEC proposed mandatory disclosure, through 8-K filings, of insiders’ use of Rule 10b5-1 trading plans. Specifically, the proposal suggested disclosure of the name and title of the director or executive officer, the date on which the director or executive officer entered into the 10b5-1 plan, and a description of the contract, including duration, the aggregate number of securities to be purchased or sold, and the name of the counterparty or agent. The proposal also suggested disclosure if the director or executive officer later terminated or modified a plan. The proposal was tabled indefinitely, so there is currently no requirement for firms or insiders to provide detail regarding whether or how they participate within their trading plans. Many firms, however, choose to disclose information regarding insiders’ trade plans and there is substantive variation in disclosure detail regarding insiders’ trade plan structures. These disclosure choices are inherently interesting because they potentially offer insight into firms’ and insiders’ utilization of the Rule.
The paper goes on to discuss what insiders do disclose and how that affects the strategic trading of company stock. The lack of uniform disclosure requirements means that insiders engage in selective disclosure in a further effort to manipulate the market and minimize litigation risk (like lawsuits from peeved shareholders).