Trading Rule May Contain Loophole for CEOs
A rule that lets executives sell shares in their companies according to a predetermined plan once looked like a way to stop businesspeople from trading on their access to inside information.
But it hasn’t worked out that way, according to a new study.
Almost six years after the Securities and Exchange Commission established the rule, a Stanford University business school analysis of trading patterns has uncovered a statistical link between executive sales under the rule and negative corporate news.
On average, executives participating in the programs initiated 10.4% of their stock sales before a negative earnings report that would send share prices lower. Sales were initiated only 5.2% of the time in advance of positive earnings news.
If the sales pattern was truly random, one would expect those percentages to be about equal, Stanford business professor Alan D. Jagolinzer wrote in the report, which is undergoing peer review. The study examined stock sales at 191 companies from October 2001 to the end of 2003.
Jagolinzer didn’t find any conclusive evidence to prove that executives were gaming the system. But he speculated that executives could be timing the release of corporate news that might have an effect on their stock sales, given that insiders know when their trades are scheduled to occur.
Jagolinzer said regulators should take a closer look at the rule, known as 10b5-1.
The SEC established the rule to encourage executives to set up predetermined plans for unloading shares of stock and options awarded to them as part of compensation packages. Trades planned in advance under an automatic trading program are protected from civil or criminal penalties.
The rule was used by former Enron Corp. Chairman Kenneth L. Lay “to protect up to $100 million in personal stock sales prior to Enron’s demise,” Jagolinzer said.
Corporate governance experts have generally supported the plans. Patrick McGurn, executive vice president of Institutional Shareholder Services in Rockville, Md., said, “there is just less room for mischief” when the timing of stock sales is taken out of the hands of executives.
Keith Bishop, a former head of the California Department of Corporations and a securities law attorney at Buchalter Nemer in Irvine, said there was rarely a good time for insiders to trade. “But this rule is designed to ensure that insiders are not trading on the basis of nonpublic material information,” he said.
When it comes to executive pay, the real money is often in the stock options, which is why the corporate leaders making some of the largest sums rely on the legal protections of 10b5-1 programs.
In a study by Salary.com of executive pay at California’s largest companies, the top moneymakers from options in fiscal 2005 were Terry Semel, chief executive of Yahoo Inc., at $174 million; Countrywide Financial Corp. CEO Angelo Mozilo, $119 million; Bruce Karatz, KB Home’s CEO, $118 million; Carol Bartz, then-CEO of Autodesk Inc., $80 million; and John Thompson, CEO of Symantec Corp., $69 million.
Mozilo, Bartz and Thompson used 10b5-1 plans to manage their 2005 stock option trading, which occurred too late to be examined by the Stanford study because it looked at data from no later than 2003. There are no indications that the executives abused the rule.
A number of Countrywide Financial senior executives and directors employ 10b5-1 agreements to sell stock, said Jumana Bauwens, senior vice president for corporate communications.
The agreements set the terms and conditions under which securities are to be exercised and sold, including the price, quantity and time period. The transactions are then automatically executed using the preestablished terms, and no further trading decisions are made by the executive or director, Bauwens said.
“Since the transactions are predetermined, investors and analysts can be confident that an executive or director is not using insider knowledge when trading company securities,” she said.
Companies are not obligated to disclose whether their executives are taking advantage of the rule or to explain individual trading strategies. Indeed, Countrywide is an exception. Just a fraction of the more than 7,000 public corporations trading on major U.S. exchanges make any disclosure about such trading.
And those that do disclose are reticent to release meaningful information, Jagolinzer said.
Besides confirming that Thompson used the program, Symantec spokeswoman Genevieve Haldeman declined to say more. “We don’t go into the details of the plan,” she said.
A spokeswoman for Genentech Inc. declined to discuss whether CEO Arthur Levinson used the plan to cash in on $66 million in option gains in fiscal 2005.
In his study, Jagolinzer said users of such plans generated significantly better returns, even when their trades were compared with those of other executives within the same company that didn’t employ 10b5-1 agreements to sell stock.
He noted that the rule requires insiders to set up their trading program at a time when they do not possess material nonpublic information.
“So insiders should not be able to systematically” gain higher returns, especially considering that “trades planned in advance are also subject to greater market risk, thereby reducing their profit potential.”
Jagolinzer said he found some evidence that executives “terminate sales plans at a point when prices shift from a downward to upward path,” another method of maximizing profits.
Bishop, the securities lawyer, said he was surprised by Jagolinzer’s findings considering the conditions of the SEC regulation.
Since the period covered in the report, some regulatory changes might have already limited an executive’s ability to manipulate the system, he said. SEC regulations now require that companies disclose important corporate developments within four days after the event compared with the past standard of 15. And the types of developments that must be disclosed have grown in recent years.
“The amount and frequency of disclosure in my practice has skyrocketed,” Bishop said.
However, other corporate governance experts said they were not surprised to learn of research indicating that executives might be manipulating 10b5-1 plans for their gain.
In another study, Corporate Library looked at 17 companies that had awarded large stock option grants to top executives over the last three years.
The Portland, Maine-based shareholder advocacy firm found that the companies tended to set the option grant dates just after a negative earnings report or just before positive earnings news.
“If you wait until after a negative release, the option price is lower and you make more money when the stock goes up. If you set the price before a good release you get an immediate profit,” said Paul Hodgson, a senior research associate at Corporate Library. “No matter the rules, there’s always some way to make a gain.”
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Cashing in options
Stock options are rights to buy shares at a set price in the future and are a major factor in executive compensation. Here’s a look at the CEOs of California’s largest companies who earned the most on stock options last year.
*--* Comapny Gains on options /CEO exercised (in millions) 1. Yahoo/Terry S. Semel $173.60 2. Countrywide Financial/Angelo R. Mozilo 119.02 3. KB Home/Bruce Karatz 118.37 4. Autodesk/Carol A. Bartz 80.45 5. Symantec/John W. Thompson 69.07 6. Oracle/Lawrence J. Ellison 66.89 7. Genentech/Arthur D. Levinson 66.27 8. Cisco Systems/John T. Chambers 61.33 9. Occidental Petroleum/Ray R. Irani 37.56 10. Robert Half Intl./Harold M. Messmer Jr. 37.45 11. Qualcomm/Paul E. Jacobs 30.13 12. Amgen/Kevin W. Sharer 27.87 13. Ryland Group/R. Chad Dreier 23.25 14. Davita/Kent J. Thiry 22.10 15. Xilinx/Willem P. Roelandt 20.84 16. Gilead Sciences/John C. Martin 20.77 17. Golden West Financial/Herbert M. Sandler 20.41 18. Golden West Financial/Marion O. Sandler 20.21 19. Schwab/Charles R. Schwab 16.95 20. Sandisk/Eli Harari 15.66 21. Nvidia/Jen-Hsun Huang 14.71 22. Network Appliance/Daniel J. Warmenhoven 14.59 23. Sempra Energy/Stephen L. Baum 14.12 24. Verisign/Stratton D. Sclavos 14.09 25. Indymac Bancorp/MIchael W. Perry 13.44
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Source: Salary.com
