Michael Kimelman
Mar 13 · 5 min read

Waters-McHenry Bill Aims To Close Insider Trading Loopholes In SEC Rule 10b5–1

Safely navigating the minefield of insider trading laws has never been a picnic, but it’s likely to become even more difficult, especially considering growing populist anti-Wall Street sentiment and the government’s desire to look like it’s doing something to combat income inequality.

Toward that end, legislators in Washington are considering changes to the law that is currently providing a safe harbor for corporate insiders looking to make preplanned sales of their company’s stock.

House Financial Services Chairwoman Maxine Waters (D-Calif.) and Patrick McHenry (R-N.C.) submitted The Promoting Transparent Standards For Corporate Insiders Act, aka H.R. 624, that seeks to close existing insider trading loopholes in the law.

Not surprisingly, considering the ongoing public backlash against Wall Street, this bill passed by an overwhelming majority of 413–3 in the House.

H.R. 624 mandates that the Securities and Exchange Commission (SEC) carry out a study of Rule 10b5–1 that was passed in 2000 and intended to clarify what it means by insider trading.

Essentially, the rule says anyone with non-public information who executes a trade is committing insider trading.

But it’s more complicated than that. Rule 10b5–1 also says that a trade is not subject to insider trading scrutiny if — before becoming aware of the information — the insider entered into a preplanned, binding written contract to purchase or sell securities or instructed another person to purchase or sell on their behalf.

What these exemptions did was create loopholes that make insider trading defensible in certain situations. It’s worth noting that these exemptions may, in fact, encourage insider trading because 10b5–1 trades significantly outperform the market.

A trading plan created in compliance with 10b5–1 can be canceled at a later time based on non-public information, which is essentially insider trading. The SEC has decided that, if there is no trade, it is not prosecutable, even if the absence of the trade based on non-public information leads to profits or avoidance of losses for the insider trader.

It gets worse. Multiple trading plans can be submitted ahead of time, such as one plan to buy a security and one plan to sell a security, and the insider can opportunistically cancel one of the plans.

Further, executives of a company can strategically release news to the public in order to cause a market movement before a trade is to be executed under their 10b5–1 plan.

Ultimately, these loopholes make 10b5–1 ineffective at preventing insider trading. In-fact, 10b5–1 is being used by insider traders to defend their insider trading — the complete opposite of what the rule intended.

H.R. 624 Has The Potential To Close The 10b5–1 Loopholes

This is where H.R. 624 comes in. H.R. 624 asks the SEC to specifically study whether Rule 10b5–1 should be amended to:

  1. limit trading plans so trades can only be executed during certain trading windows;
  2. limit the ability to issue multiple trading plans;
  3. implement a delay between the adoption of a trading plan and the execution of the first trade, and
  4. limit the frequency of canceling trading plans.

Therefore, H.R. 624 attacks the loopholes in 10b5–1, and will make it much more difficult for insider traders to defend themselves if all goes to plan.

It is important to note that the passage of H.R. 624 has not changed 10b5–1, at least yet. The SEC must first submit a study and proposed amendments to 10b5–1 in the next year to the Committee on Financial Services of the House of Representatives and, the Committee on Banking, Housing, and Urban Affairs of the Senate.

After submitting the study the SEC will then revise Rule 10b5–1 after a period of public comment. Thus, no changes will be seen until at least 2020.

Apple Executive Charged With Insider Trading, Would H.R. 624 Have Prevented This?

Mere weeks after H.R. 624 was submitted the Senior Director of Corporate Law and Secretary of Apple Gene Daniel Levoff was charged with insider trading by the SEC. Apparently, Levoff had had early access to quarterly earnings reports and used it to make $245,000 of profits from 2011–2012 and to avoid $382,000 of losses from 2015–2016.

Levoff was primarily in charge of devising, implementing, and enforcing Apple’s insider trading policy and recklessly violated that policy by using non-public information for personal gain. Explicitly included in Apple’s insider trader policy was a warning that anyone with non-public information was not allowed to trade.

The SEC is now asking that Levoff give up an amount equal to the profits and losses avoided from the insider trading, in addition to paying a civil penalty three times that amount. Also, the SEC is asking the court to ban Levoff from being an officer or director of a public company.

In this case, Levoff personally traded Apple stock after receiving the quarterly report information and before it went public, which violates Rule 10b5–1 even without any amendments from H.R. 624. Rule 10b5–1 only provides protection at this time if trading plans are submitted before non-public information is received.

That being said, Levoff could have theoretically submitted multiple trading plans under 10b5–1, one plan to sell Apple stock and one plan to buy, and then cancel one of the plans after receiving the quarterly report.

If Levoff did that then he would have much a much better chance of getting away with the insider trading. This shows how important it is to close the loopholes in 10b5–1 via H.R. 624.

As part of their due diligence, analysts or PMs should confirm potential investments and/or current portfolio companies have an adequate 10b5–1 plan in place. Apple is a big company, but the fallout from an executive at a smaller company coming under investigation could be terminal.

Michael Kimelman

Written by

Disruptepreneur, speaker and bestselling author | Crypto.IQ | 七転び八起き | Leadership and Resiliency Training

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