Disclosing and cooling-off: An analysis of insider trading rules

Regulating insider trading has long been a controversial issue, balancing the need for fairness and market integrity in financial markets against insiders’ practical needs to trade for non-informational purposes such as rebalancing and liquidity needs. Central to this debate is the U.S. Securities and Exchange Commission’s (SEC) Rule 10b5-1, which provides a legal safe harbor for corporate insiders to trade their company’s stocks under predetermined trading plans before possessing material nonpublic information (MNPI).

Recent controversies, such as the sales by executives of COVID-19 vaccine developers shortly after announcing breakthroughs, have once again highlighted concerns about the potential misuse of Rule 10b5-1 (see the recent Wall Street Journal article “Pfizer CEO Joins Host of Executives at Covid-19 Vaccine Makers in Big Stock Sale”). As a response, researchers and regulators have been exploring ways to improve Rule 10b5-1. In February 2022, for example, the SEC has released a report discussing various amendments to regulate Rule 10b5-1 plans, some of which have been adopted in December 2022 (see the press release by the SEC). Two major rule changes stand out: mandate disclosure and cooling-off periods for insider trading under Rule 10b5-1. This post explores the implications of these rule amendments, drawing on insights from the recent article “Disclosing and Cooling-Off: An Analysis of Insider Trading Rules,” by Deng, Pan, Yan, and Yang (2024) published in the Journal of Financial Economics.

Understanding Rule 10b5-1

Rule 10b5-1 was established by the SEC in 2000 to provide corporate insiders with a legal defense against allegations of insider trading. Under this rule, insiders could establish predetermined trading plans at a time when they were not in possession of MNPI. The rule aimed to distinguish legitimate trading for personal financial management from trades based on confidential, market-moving information.

Despite the rule’s intent, however, over time, concerns emerged that insiders were abusing Rule 10b5-1 to engage in opportunistic trading. The post on the Harvard Law School Forum on Corporate Governance discusses the potential liability for misleading statements and omissions under Rule 10b5-1. This rule holds corporate insiders accountable not only for outright fraud but also for failing to disclose material information that could affect an investor’s decision-making process (see the post “Potential Rule 10b-5 Liability for Misleading Statements and Omissions”).

Similarly, the Wharton Knowledge podcast discusses how corporate insiders might exploit Rule 10b5-1 to disguise opportunistic trades, particularly in the absence of stringent disclosure requirements. The timing of trades, combined with a lack of transparency, can create opportunities for insiders to capitalize on MNPI under the guise of pre-established trading plans (see the post “How Insider Trading Hides Behind a Barely Noticed Rule”). In response, the SEC has introduced two key amendments to Rule 10b5-1: mandatory disclosure of trading plans and the introduction of a cooling-off period.

Mandatory Disclosure

The new disclosure amendment requires insiders to publicly disclose their 10b5-1 trading plans upon adoption, modification, or cancellation. This move towards greater transparency is rooted in the belief that increased visibility into insider activities will deter misuse and promote market fairness. However, as highlighted in Deng, Pan, Yan, and Yang (2024) —who analyze a standard insider-trading model modified to accommodate the two rule changes—the welfare implications are more nuanced.

In particular, if the insider’s information advantage is large, disclosure neutralizes this advantage and hence improves outside investors’ welfare. However, in an environment where the insider’s information advantage is small, disclosure may benefit the insider and hurt outside investors. The reason is that the insider does not possess much private information in this case. The disclosure would help the insider secure better trading terms, leaving outside (often uninformed) small investors more vulnerable to exploitation by informed traders in the market.

Cooling-Off Period

In addition to mandatory disclosure, the SEC has proposed a mandatory cooling-off period amendment, ranging from 30 to 120 days, depending on the insider’s role within the company. This rule mandates a delay between the establishment or modification of a 10b5-1 plan and the first trade under that plan. The cooling-off period is predicated on the idea that over time, the relevance of the insider’s private information diminishes, either because the firm’s fundamentals change or because the information leaks to the market. Suppose, for example, the insider received some private information about his firm. If he can trade right away, he would have a large advantage over outside investors. If, however, there is a mandatory waiting period, then, by the time the insider is allowed to trade, his information advantage is likely diminished.

This intuition seems to suggest that a longer cooling-off period would reduce the insider’s information advantage and hence benefit outside uninformed investors. However, Deng, Pan, Yan, and Yang (2024) show that the implications are more subtle. In particular, the implications of the cooling-off period depend on whether the mandatory disclosure policy is in place. Under the non-disclosure regime, a longer cooling-off period improves the welfare of outside uninformed small traders. Under the disclosure regime, however, the opposite is true: A longer cooling-off period would reduce the welfare of outside uninformed small traders. The reason is that under the disclosure regime, the insider has to disclose his trade in advance and hence he would not be able to generate excess returns, regardless of the cooling-off period length. A shorter cooling-off helps incorporating the insider’s information into prices more effectively, which reduces the chance for outside uninformed investors to be exploited by more informed investors in the market.

Implications for Market Practice

The SEC’s new rules mark a significant shift in the regulatory landscape for insider trading. For corporate insiders and outside investors, these rules bring both challenges and opportunities. These rule changes clarify the conditions for an affirmative defense for a corporate insider. Greater transparency and the mitigation of insider information advantages could enhance market integrity and investor confidence. However, as shown by the analysis by Deng, Pan, Yan, and Yang (2024), which is based on a standard and well understood model of informed trading, the welfare implications are far more nuanced than suggested by the simple intuition. As market participants navigate this evolving landscape, ongoing research, both theoretical and empirical, will be crucial in a better understanding the broader impacts of these regulations.