Academic journal article Vanderbilt Law Review

Insider Trading and CEO Pay

Academic journal article Vanderbilt Law Review

Insider Trading and CEO Pay

Article excerpt

This Article presents evidence showing that boards of directors "bargain" with executives about the profits they expect to make from trades in firm stock. The evidence suggests that executives whose trading freedom increased using Rule 10b5-1 trading plans experienced reductions in other forms of pay to offset the potential gains from trading. There are two potential benefits from trading-portfolio optimization and informed trading profits-and this Article allows us to isolate them. The data show that boards pay executives in a way that reflects the profits they are expected to earn from informed trades. It also casts some doubt on the existence of the incremental value for optimization trades provided by the Rule.

In addition, this Article explores the legal issues associated with paying executives from illegal profits. As a matter of policy, the data seriously undercut criticisms of the laissez-faire view of insider trading most closely associated with Henry Manne. At least with respect to classic insider trading (that is, a manager of a firm trading on the basis of information about the firm where she works), if boards are taking potential trading profits into consideration when setting pay, it is difficult to locate potential victims of this trading. Current shareholders should be at least indifferent to a deal that pays managers in part out of the hide of future shareholders. The firm should also internalize any costs arising from this payment scheme, since future shareholders should take this into account when deciding whether and at what price to buy shares. While there still may be good reasons to prohibit some individuals from trading on material, nonpublic information, the data make the case for classic insider trading much weaker.

I. INTRODUCTION .................................................................. 506

II. COSTS AND BENEFITS OF EQUITY COMPENSATION .............. 508

III. BARGAINING ABOUT TRADING ............................................ 513

A. Bargaining About Blackout Windows ..................... 514

B. Bargaining About 10b5-l Plans ............................. 516

1. Unwinding Blackout Windows .................... 517

2. Lowering the Cost of Informed Trading ...... 519

3. Separating Informed and Optimization Trades ......................................................... 520

4. The Completeness of Bargaining ................. 521

IV. DATA ................................................................................. 522

V. EMPIRICAL ANALYSES ........................................................ 526

A. Difference-in-Difference .......................................... 526

B. Plan Versus Nonplan Firms ................................... 533

C. Nonplan Versus Nondisclosure Firms .................... 534

D. Robustness Check ................................................... 535

VI. DISCUSSION ....................................................................... 537

A. The Completeness of Bargaining ............................ 538

B. Securities Law Issues ............................................. 541

1. Insider Trading ........................................... 541

2. Disclosure ................................................... 547

C. Corporate Governance ............................................ 551

VII. CONCLUSION ..................................................................... 554

I. INTRODUCTION

This Article presents evidence showing that boards of directors bargain with executives about the profits they expect to make from informed trades in firm stock. There are two related takeaways. First, the evidence suggests that executives whose trading freedom is increased experience reductions in other forms of pay to offset the potential gains from trading. This result is consistent with (and the flip side of) a study by Darren Roulstone, finding that firms that restrict trading increase compensation to offset the lost opportunities from trading. …

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