FPA Financial Planning Perspectives
NEW SEC INSIDER TRADING RULES
EASE PORTFOLIO DIVERSIFICATION
The personal portfolios of corporate executives are typically weighted heavily with company stock, and financial advisors commonly recommend periodically selling some of that stock in order to better diversify the executive’s portfolio. Corporate policies and insider trading rules traditionally have hampered such sales, but now the Securities and Exchange Commission (SEC) has issued new rules that ease the process.
Generally, corporate insiders are limited in their ability to trade company shares for a variety of reasons, including the possession of material, nonpublic information, as well as company-imposed “blackout” periods when no trading is permissible. The new SEC rule, called Rule 10b5-1, allows the executive to prearrange a plan that can more effectively operate under these restrictions. Here’s how it works.
Any 10b5-1 trading plan must be made at a time when the corporate insider does not possess material insider information (what’s “material” remains somewhat ambiguous). Second, the more time the executive can put between creation of the plan and the actual trades, the better. Also, the plan must not conflict with any company insider trading rules, or with other federal or state corporate insider laws, such as “short-swing” trading rules under Section 16 of the Securities Exchange Act of 1934, or Rule 144, which governs insider trading. The plan must be entered into in good faith, provide clear instructions for determining the number of shares, price and date on which the securities are to be purchased or sold, and the plan cannot permit the individual to exercise any subsequent influence over how, when or whether to effect transactions.
Assuming these restrictions are met, the executive can design and implement one of two trading strategies under the new SEC rule. One strategy is a nondiscretionary plan where the insider might specify that a certain number of shares be sold on a particular date. This might be in anticipation of a single event, such as the down payment for a home or the payment of college tuition, or on a scheduled basis such as the last trading day of each quarter for a certain number of quarters.
Should the executive become aware of material, nonpublic information in the interim between the institution of the plan and any given trading date, or upon the trade day itself, the trade can still be executed and the executive should be insulated from any violation of the insider trading rules. This is especially helpful to executives with soon-to-expire stock options which they might not be able to exercise and sell because they’ve suddenly come into material information.
The other strategy is for a third party to execute trades on behalf of the executive at any time the third party deems appropriate according to pre-determined guidelines set by the executive. For example, the insider might specify a threshold price at which a certain number or percentage of stock options is to be exercised and then sold. Or the stocks could be put in a trust and then sold at the third party’s discretion.
The insider can modify the plan, as long as the insider is not aware of material, nonpublic information at the time of the modification. Another favorable element of these plans is that they can be terminated at any time, even if the insider has material insider information at the time. However, some commentators say that a pattern of terminations might jeopardize protection under the new rule, as the SEC mandates that these plans must be entered into in “good faith.”
Each strategy has its advantages and disadvantages. For example, nondiscretionary trading means the executive could end up selling in a down market. Giving discretion to a third party could cause problems if the third party doesn’t manage the trades to the insider’s liking.
This is a new and somewhat complicated rule, so insiders should consult both corporate counsel and their financial advisor in order to be sure they establish a permissible plan and determine the best option. The rule has been used little to date, but some commentators expect the plans to pick up in popularity when the stock market rebounds. [WSJ, company stock file, computer file on stocks]If executed properly, this will allow insiders to better manage and diversify away from their corporate stock, so that their overall portfolio is not so vulnerable to the market swings of their company and their industry.
June 2001— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Rich Chambers, CFP, a local member in good standing of the FPA.
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