In 2015, an academic study, reported in the WSJ, showed that corporate insiders consistently beat the market in their companies’ shares in the four days preceding 8-K filings, the period that the researchers called the “8-K trading gap.” The study also showed that, when insiders engaged in open market purchases—relatively unusual transactions for insiders—during that trading gap, insiders “are correct about the directional impact of the 8-K filing more often than not—and that the probability that this finding is the product of random chance is virtually zero.” The WSJ article reported that, after reviewing the study, Representative Carolyn Maloney, a member of the House Financial Services Committee, characterized the results as “troubling” and said she was preparing legislation to address the issue. Five years later, in January 2020, by an unusually bipartisan vote of 384 to 7, the House passed HR 4335, the “8-K Trading Gap Act of 2019.” A substantially similar bill was introduced in the Senate. But then, the bill disappeared into the vapor. Now, a similar bill, the ‘‘8–K Trading Gap Act of 2021,” has been introduced by Maloney in the House as H.R. 4467, and in the Senate by Senator Chris Van Hollen as S.2360. According to Van Hollen, “Time and again we’ve seen corporate executives take advantage of the 8-K trading gap by selling off bundles of shares prior to a major announcement. It’s clear this gap gives corporate insiders a massive unfair advantage over the public….Our legislation will close this harmful loophole and provide fairness to everyday shareholders. I’ll be working with my colleagues on the Banking, Housing, and Urban Affairs Committee to move this legislation at once.” Although Congress certainly has a full legislative plate, with the Dems now controlling both houses of Congress, will the bill finally make its way through Congress?
The study, conducted by researchers at Columbia and Harvard, analyzed over 15,000 8-K filings as well as almost 43,000 reported insider transactions between 2004 and 2014 that occurred within the four business days between the 8-K event and the 8-K filing. The results showed that the insiders could have realized gains (absent the Section 16 prohibitions on short-swing trading) that were about 0.4 of a percentage point over a broad market index. Direct stock purchases (as opposed to option exercises) during the 8-K trading gap could have resulted in estimated gains that were about 1.6 percentage points over the index. In addition, the greater the time lapse between the event and the filing, the better the insiders’ estimated returns, rising to an average excess profit over the index of 1.95 percentage points.
The study determined that open market purchases in the 8-K trading gap were the most profitable types of transactions; open-market purchases by insiders preceded stock price increases in approximately 57% of the transactions. Interestingly, the study showed that trades by insiders in the 8-K trading gap were profitable to a statistically significant extent when the 8-K reflected information about changes in corporate documents or capital structure, M&A transactions, key customer and supplier agreements, exchange listing violations and changes in accountants, but were unprofitable to a statistically significant extent only when the subject of the 8-K was related to a legal issue. (See this PubCo post.)
Some SEC Commissioners, former and current, have previously expressed support for legislation to address the issue. In 2019, at an oversight hearing held by the House Financial Services Committee, former Commissioner Robert Jackson identified three areas where he believed the SEC and/or Congress needed to address regulatory gaps, among them the 8-K trading gap. Citing the academic study discussed above, he advocated legislation that would close the trading gap. (A similar problem occurs, he said, with insider sales after the announcement of stock buybacks. According to Jackson, many insider sales occur just after a buyback is announced, and company performance declines afterward.) In testimony in 2017 before the Senate Committee on Banking, Housing and Urban Affairs, former SEC Chair Jay Clayton, in response to a question from Van Hollen about recent problems with insider trading, said that companies should have controls in place to preclude insider trading by executives and directors. Van Hollen specifically raised the issue of the 8-K “trading gap” shown in academic studies and said that he was working on legislation that would preclude trading by insiders once the company had decided that an event was material and required disclosure. Clayton appeared to approve of the concept and expressed willingness to work with Congress on the issue. Van Hollen also raised the issue of the 8-K trading gap at the hearing before the same committee on the nomination of SEC Chair Gary Gensler, asking Gensler for technical help from the staff on legislation he was preparing to address the gaming that he perceived is allowed under the current rules. Gensler seemed agreeable. (See this PubCo post and this PubCo post and this PubCo post.)
The Senate bill would amend the Exchange Act to add section 10E, which would require the SEC, within one year (hmmm…), to adopt rules that would require a public reporting company to have policies, controls and procedures reasonably designed to prohibit its executive officers and directors from purchasing, selling or otherwise transferring, directly or indirectly, any of the company’s equity securities in specified circumstances. For events covered by the first six sections of Form 8-K, the prohibition would apply from the occurrence of the event to the filing or submission of the 8-K. The first six sections cover events such as entry or termination of a material definitive agreement; bankruptcy; mine safety violations; acquisitions or dispositions of assets and other business combinations; financial results; creation or acceleration of direct or off-balance-sheet financial obligations; costs of exit activities; material impairments; notice of delisting or material noncompliance with a listing standard; unregistered sales of equity; material modifications of shareholder rights; changes in accountants; non-reliance on financials; changes in control; new and departing officers and directors and executive comp; changes to charters, bylaws or fiscal years; suspension of trading under an employee benefit plan; amendment or waiver of codes of ethics; change in shell company status; shareholder voting results; shareholder nominations and various events related to asset-backed securities, among other events.
For events covered by sections 7 (Reg FD disclosure) and 8 (other events) of Form 8-K, the prohibition would apply between the date the company determines that it will disclose the event and the filing or furnishing of the 8-K.
The SEC would be permitted to exempt certain transactions, including transactions that occur automatically, are made under an advance election, or involve a purchase or sale of equity securities under Rule 10b5–1(c), except for a Rule 10b5–1(c)(1)(i)(A)(3) plan that, for any particular 8-K event, was adopted within the prohibition periods described above. The SEC is also required to exempt certain investment companies, as well as events described under sections 1 through 6 of Form 8–K that the company has announced in a press release or otherwise publicly disseminated in compliance with Reg FD.