Most everyone knows that trading on the basis of material non-public inside information is likely to get you in trouble with the law, but charitable giving on the basis of MNPI—maybe not so much. As reported in this article in the WSJ, a new study from a group of business and law school professors looked at “insider giving,” or, as the study authors describe it, “opportunism posing as, or at least muddled with, ordinary philanthropy.” In essence, according to the WSJ, with insider giving, the donor “tim[es] the donation of a stock to a charity around inside information about the stock. That way, you take a tax deduction before bad news sends the share price tumbling or after good news sends the price higher—and the gift delivers a bigger deduction than you would have gotten otherwise.” The donation is not only tax deductible, it’s also exempt from capital gains tax that would be due on the appreciation in value upon the sale. One of the authors characterized these donations to the WSJ as “suggest[ing] more than chance….The fact that large shareholders can determine or choose—with pinpoint accuracy—the average maximum price over a two-year period when they give gifts is surprising.’” The study authors argue that the practice is “far more widespread than previously believed,” and relied on by insiders, including large investors. Insider giving, they conclude, “is a potent substitute for insider trading.” It’s worth remembering that it was a study reported in the WSJ about stock option backdating that kicked off the option backdating scandal of the mid-2000s (see, e.g., this news brief, this news brief and this news brief). Could “insider giving” be the new option backdating scandal?
The study looked at 9,858 gifts of common stock by large shareholders (beneficial owners, direct or indirect, of more than 10%) in 1,655 U.S. public companies from 1986 to 2020, excluding officers and directors, or any insider with both officer and large shareholder titles. (The authors note that they previously studied the use by corporate executives of inside information to maximize the value of their gifts.) Those gifts represented about 2.1 billion shares valued at $50 billion, with an average dollar value gifted per company of about $30 million. The study found that large shareholders’ gifts “are suspiciously well timed. Stock prices rise abnormally about 6% during the one-year period before the gift date and they fall abnormally by about 4% during the one year after the gift date, meaning that large shareholders tend to find the perfect day on which to give.” According to the authors, the “average maximum stock price occurs near the day of the gift.”
The choice, they suggest, is that “large shareholders are either lucky or they engage in timing games around their gift giving.” But the data, they say, suggests more than random chance—the “results are almost certainly not the result of luck.” Nor is it likely to be talent in trading. Looking at shareholders’ abnormal profits when they engage in open market sales and purchases during the same period, the authors find that the “data reiterates that large shareholders are not especially skillful traders, in general.” However, the authors contend, the shareholders “show a prescience in giving that they do not exhibit in ordinary trading.”
While insider giving may appear on the surface to be rather harmless—the authors quote a 1988 SEC release indicating that insiders’ gifts “represent less likelihood for opportunities for abuse”—the authors claim that it undermines a number of policies: a large tax deduction is awarded for a small gift; an insider misuses MNPI; the sale of the shares by the charity donee “is substantially the same as if the insider had simply engaged in illegal insider trading…and donat[ed] the proceeds.” Moreover, “gifts appear to be abused far more often than sales, at least when large shareholders are concerned.” And because these gifts “currently face low risk of enforcement or prosecution,…insiders have likely felt safer utilizing material non-public information in that domain.”
The authors describe three “manipulative strategies” that they believe donors can use to secure tax benefits from their gifts: information, that is, using MNPI to time a gift to maximize the tax deduction; influence, that is, pressuring management to delay (or accelerate) disclosures; or backdating, misreporting the date of the gift and claiming the deduction associated with that date. The first two strategies, they say, “depend on a close relationship between shareholders and management.” The backdating strategy, the authors indicate, can be layered on top of other strategies to augment the insider’s gains.
The authors’ research leads them to “identify information leakage as the most important cause of these results: executives seem to provide large shareholders with material non-public information, who then use it to time gifts. We also find a second explanation to be supported, though its magnitude is smaller—backdating. The telltale sign of backdating is that the givers’ extraordinary luck tends to grow alongside the delay they take in reporting the gift. A donor who waits a few weeks to report a gift can cherry pick the very best date to retroactively claim their gift was consummated. That is precisely what we find.”
The authors attribute the widespread use of “manipulative gifts” to lax regulation and enforcement. While many believe that insider giving is perfectly permissible, the authors contend that that “is an overstatement—numerous state and federal laws constrain manipulative gifts. However, there is no doubt that the law of insider giving is less clear and developed than the law of insider trading.” And insider giving transactions seem less likely to be detected. In part, that may be because gifts do not require Section 16 reporting on Form 4 (which are due two business days after the transaction), but may be delayed until the annual Form 5, not due until 45 days after fiscal-year end (although gifts can be reported earlier on a voluntary basis).
In discussing the legal landscape, the authors discuss the application of various disclosure, transaction and reporting rules in the context of gifts. For example, Reg FD does not prohibit selective disclosure unless it is reasonably foreseeable that the person (not a market professional) will purchase or sell the issuer’s securities on the basis of the information, and, the authors acknowledge, there is substantial uncertainty about its application in the gift context. However, under state law, they argue, “selective disclosure to a shareholder can violate an officer or director’s fiduciary duty if the disclosure is not in the interests of the corporation,” regardless of whether it results in a sale or a gift.
As for transaction rules, many believe that, because Rule 10b-5 requires a purchase or sale of a security, Rule 10b-5 does not apply to gifts. The authors, however, disagree, contending that, although the issue is not settled, “it is likely that the mainstay of insider trading enforcement—Rule 10b-5—applies to manipulative gifts.” While they acknowledge that Rule 10b-5 does require a purchase or sale of a security, they point out that it requires only that the transaction be “in connection with” the sale: “As long as a manipulative gift is ‘in connection with’ a subsequent sale, a 10b-5 insider trading action should be available.” They view that distinction as “significant because stocks are not heirlooms, kept on the recipient’s mantle forever: recipients of gifts tend to sell the stock.” For example, they suggest, the insider could control the charity—think, e.g., family foundations—and cause it to trade. Or the donor could “tip” the charity to sell the shares, with a personal benefit in the reputational benefit that the donor receives or in the tax write-off that the donor claims. Insider giving could also potentially lead to liability under Federal mail and wire fraud statutes, which do not require sales, they argue. Nevertheless, they recognize that the laws surrounding insider giving are more murky and less well established than the laws of insider trading under Rule 10b-5.
With regard to potential reporting violations, the authors note that backdated gifts “necessarily involve fraudulent filing of a Form 4 or 5.” They also contend that gifts on the basis of MNPI “can constitute illegal valuation abuse” for tax purposes.
But, the authors ask, do shareholders really play these games? The authors believe that “large investors have and exercise a much wider degree of access than commonly appreciated.” Based on the evidence they found, the authors conclude that large shareholders are “frequently exploiting their access to corporate management to give the perfect gift—with plenty of backdating utilized as well.” To address these issues, the authors advocate that the SEC provide guidance that gifts are subject to the same reporting requirements as sales and clarify that Rule 10b-5 and Reg FD already apply to prevent insider giving. They also suggest that the tax code be amended to treat a gift as a realization event: then the donor would pay taxes on capital gains at the time of the gift. A possibility to address backdating is to require charities to immediately liquidate any gifted securities, but that may introduce other problems.
For questions about securities litigation, you can contact Jessica Valenzuela Santamaria, Koji Fukumura, Luke Cadigan or Sarah Lightdale