DATELINE: March 4, 2008, Chicago
The securities laws prevent insiders from profiting from non-public information. These laws take two forms. The first is the rule against short-swing profits, with its focus on sales by insiders at a profit within six months of acquiring the stock. The second is the anti-fraud rule found in Section 10b-5 of the Securities and Exchange Act of 1934. These laws prevent insiders from profiting through sales and purchases of stock when they are deemed to or actually possess inside information, but a professor at New York University's Stern School of Business has just published a study suggesting that some chairmen and CEO's of publicly-traded companies may be maximizing the value of their contributions...
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to family foundations by using insider information to time the gifts. David Yermack, a professor of finance, studied a sample of 151 gifts of stock by company insiders to their family foundations. Only gifts that exceeded $1 million were included in the study. Yermack just published his findings in an article entitled Deduction ad absurdum: CEOs Donating Tehir Own Stock to Their Own Family Foundation (February 22, 2008).
Yermack's survey included somewhere around one-quarter of all gifts to charity of publicly-traded stock by chairmen and CEOs between mid-2003 and December 31, 2005—we assume he means gifts of their own company stock. The aggregate value of the gifts studied was $728 million. In summarizing his findings, Yermack writes,
I find a pattern of excellent timing of Chairmen and CEOs' large stock gifts to their own family foundations. On average these gifts occur at peaks in company stock prices, following run-ups and just before significant price drops. The price path of the underlying company stocks forms an inverted V-shape over two month period centered around the reported gift date, with the stock rising and then falling by an abnormal 3 percent and peaking exactly on the reported gift date.
He also examined gifts of stock to other charities besides family foundations—presumably these gifts were limited to gifts of "insider" stock. Yermack found that these gifts were "well-timed," but not quite to the same degree. Specifically, he found that the value of these gifts declined significantly less following the gift than the decline that occurred in value following gifts to family foundations.
Yermack offers two possible explanations for this phenomenon. Under the first one, the insider may not be selling the stock, but he is nevertheless motivated by personal gain. In this case, that gain takes the form of the larger tax deduction that comes with a higher stock value at the time of the gift.
The second possibility involves something more nefarious—the insider is not trading on insider information, but is backdating the transfer to maximize the value of her tax deduction. This is a plausible explanation for two reasons. First, backdating is not unheard of when it comes to CEOs and other top executives. In recent years, we have read countless news reports revealing backdated grants of stock options by well-known corporations and their executives. Second, the reporting rules under the securities laws may facilitate backdating. Under those laws, the executive does not have to report a gift to the SEC until 45 days after the end of the corporation's fiscal year. Sales of stock, on the other hand, must be reported within 2 days after the sale. Yermack suggests that backdating is a plausible explanation because in order to do it, there must be collusion between the donor and the charitable recipient. That would be a problem in the case of a gift to a public charity, but in the case of a gift to a family foundation, the executive controls the foundation. This fact could explain why Yermack found that gifts by executives to charities other than their family foundations were not as well timed.
Policymakers may not like these insider gifts no matter what the underlying rationale or method for making the gift, but the second explanation is the more troubling because it would likely constitute tax fraud.
The ability to game the system is dependent on what types of transactions are covered by the laws regulating insider trading. Yermack points out that the rule prohibiting short-swing profits is triggered by sales or dispositions, which include gifts. As a consequence, the phenomenon that Yermack has detected probably doesn't include short-swing trades. As written, the anti-fraud prohibition on insider trading could cover charitable gifts, but Yermack points out "to date nobody appears ever to have been charged by the SEC with a Rule 10b-5 violation for making an untimely gift of stock." What we find puzzling about the lax SEC enforcement in this area is that the law, at least as outlined by Yermack, would make it relatively easy to bring an action. Yermack writes,
For charitable gifts of stock to be treated as "sales" that trigger anti-fraud insider trading liability, case law indicates a three-part test: (1) whether a change of ownership occurs, (2) whether the donor receives consideration of pecuniary value, and (3) whether such treatment would be consistent with the remedial purposes of the 1934 Act.
He then points out that the lack of a sale for consideration at first might make it difficult to prove that the donor received pecuniary value, but he quickly points out that there is a line of cases indicating that the value of the tax deduction represents pecuniary value. Presumably these cases arose in a different context. Unfortunately, Yermack provides no citations to those case or further explanation. We can only quess why the SEC has apparently chosen not to bring action. Possibly the SEC believes that it will be hard to obtain a favorable outcome because a jury is looking at a defendant who has given the stock to a charity rather than buy another vacation home with the value represented by the stock.
Yermack does raise an intriguing point in a footnote. He notes that the recipient charity might have a cause of action as the counter-party to the transaction. On first impression that sounds odd because the charity is obviously better off as a consequence of the gift. But if we respect the fiction that the gift is a sale, then the decline in value can be viewed as detrimental to the charity. Yermack indicates that the charity could bring an action under the anti-fraud provision—the executive made the gift knowing that the stock would decline shortly thereafter—but probably chooses to refrain from suing out of fear of chilling future gifts. The question Yermack doesn't address is whether the directors have a fiduciary to bring an action. Obviously, the insider, who is also a director of his family foundation, isn't going to sue himself. However, it does open up the possibility of a state attorney general taking action against the director for failure to discharge her fiduciary duty. Such an action would be analogous to one which the attorney general might bring for a failure by the directors to enforce pledges if the decision not to enforce is unsupported by business judgment.
At the end of the day the question is what should policymakers do about this phenomenon. Obviously, Congress could modify the securities laws or the SEC could amend the regulations (assuming it has authority to do so) to bring gifts of stock to charities by insiders clearly within the scope of the prohibitions against insider trading. If backdating is the concern, the reporting requirement for these gifts could be shortened to two days following the gift, aligning the requirement with the one that applies to sales. Another way to put an end to these abuses would be to amend the tax law to deny insiders a fair market value deduction for these gifts when the recipient is a family foundation. Overall, Yermack has written a very interesting article.
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