Insiders at public companies essentially have two options for buying and/or selling their companies' stock. The first is to conduct the transactions in the open market. That is, they can buy or sell securities through a broker just like any other retail investor. The second option is to conduct the transaction on a systematic basis through what is called a 10b5-1 plan. This Securities and Exchange Commission (SEC) rule permits a systematic form of insider trading that is not only legal, but can also be beneficial for both the insiders (and their companies) and individual investors. Read on to learn more.
What is a 10b5-1 plan?
Rule 10b5 is one of the most important acts put forth by the SEC. This rule makes it unlawful to defraud, mislead or operate in any fraudulent manner in transactions of securities on national exchanges.
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This rule was also enacted to prohibit the purchase or sale of a security on the basis of non-public information. Any trade made with material non-public information, or insider information, is deemed as insider trading and is illegal under Rule 10b5.
In 2000, the SEC made an administrative ruling, known as 10b5-1, or 10b5-1 (c), which allows for a defense against the insider trading rule as long as the individual can determine that no non-material insider information was used as the basis for the trade.
This ruling created a situation where insiders could create a trading plan in advance of a trade if they set a specific date or price at which to effect a transaction (either a purchase or a sale). When that event transpired, it triggered the trade. These trading plans are known as 10b5-1 plans.
For example, executives may want to purchase shares throughout the calendar year. To do so, they (under the plan) purchase a fixed number of shares at specified dates, such as the first trading day of the month. The transaction is automatic. The insider will be safe even if he or she has insider information at the time of the sale, as long as the plan was set up when no material non-public information was known.
Conversely, if an insider wants to diversify his or her holdings but doesn't want to sell a large portion of stock at any one time for fear that it might send the wrong message to the investment community, the individual may set up a plan that liquidates 1,000 shares per month over the next year. Again, the trades are automatic and take place at a set point in time.
Benefits for Insiders
There are several benefits of 10b5-1s for both insiders and individual investors:
A Better Appearance
Because a 10b5-1 is a pre-set systematic method of accumulating and/or disposing of shares, the possession of insider information becomes essentially irrelevant. By definition, this will help stem accusations of insider trading and/or front running after a trade is consummated. In short, for executives at high profile companies that are frequently the target of shareholder suits and almost always subject to scrutiny from the investment community, this system can be invaluable.
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