The Rule 10b5-1 Loophole: An Empirical Study

Abstract

This paper is the culmination of an MVP2 Law and Economics Student Fellowship at the University of Chicago Law School, for which the author received the John M. Olin Prize in Law and Economics. It seeks to empirically examine the effects of an insider trading loophole created by the SEC staff's interpretation of Rule 10b5-1. Rule 10b5-1 creates a safe harbor for pre-planned securities transactions (or 10b5-1 plans), so long as the 10b5-1 plans are irrevocable and established prior to the trader's obtaining inside information. But the SEC staff - based on a reading of the Supreme Court's decision in Blue Chip Stamps that was squarely rejected by the Court's recent decision in Dabit - has taken the position that it lacks the legal authority to prevent the cancelation of these 10b5-1 plans. Such a conclusion, as other commentators have noted, creates a loophole that effectively allows for insider trading through the selective cancelation of trades. This paper therefore hypothesizes that the public creation of 10b5-1 plans should have certain empirically verifiable effects consistent with informational asymmetry in the markets for the securities subject to the plans. Based on an econometric analysis of a dataset of 81 NASDAQ-listed companies from 2004-06, the paper concludes the following: (1) that the trading public attaches primary significance to the announcement of a 10b5-1 plan rather than the specified start date of that plan; (2) that insiders make above-market profits using 10b5-1 plans, but do not appear to arbitrarily or continually create such plans; (3) that 10b5-1 plans have a significant negative effect on the liquidity of a firm's shares, and therefore the firm's cost of capital; and (4) that insiders do not appear to increase the volatility of their own firms' shares in order to profit by trading on the basis of material nonpublic information under the protection of the 10b5-1 safe harbor.