The Blind Trust: An Executive Diversification Strategy
Case Study: An Executive Diversification Strategy
By: Wilmington Trust

Corporate Executives and insiders who own millions of shares in their companies typically enjoy a very substantial net worth. But with that net worth comes tremendous downside risk. Selling those shares of company stock to achieve diversification and reduce risk is not easy, since federal regulations govern when insiders can sell stock.

There is, however, a solution to this problem - the blind trust. Also referred to as the Executive Diversification and Investment Trust, this strategy enables an insider to give a trustee the sole responsibility to decide on the timing of sales of company stock, without participation by, or knowledge of, the insider. Hence, insiders can achieve diversification, over time, without running afoul of securities regulations.

A brief history
Typically, people think of a blind trust as a way for government officials to avoid conflicts of interest while in office. Such conflicts can arise if officials are involved in passing laws or regulations that may affect their personal investments. The trust is said to be "blind" because, once it is established, the grantor of the trust has no further communication with the trustee and no prior or contemporaneous knowledge of the activities of the trust.

But a little-known fact is that blind trusts can also be used by company insiders - officers, directors or anyone owning 10 percent or more of the company's outstanding shares. A blind trust can enable the sale of insider stock pursuant to Rule 144 under the Securities Act of 1933 without regard to so-called "window periods" which would otherwise constrain the timing of stock sales.

Rule 144 provides a "safe harbor" for the sale of insider securities. Shares owned by a corporate insider remain restricted as to sale as long as the insider is affiliated with the company. Rule 144 allows affiliate stock to be sold to the public if certain conditions are met. Among other things, these conditions include the length of time the insider has owned the shares and limitations on the volume of stock that can be sold.

Window periods
Publicly held companies typically impose blackout periods during which insiders may not trade in company stock. These periods usually begin late each quarter and end after the company's earnings report has been issued. Blackout periods are designed to keep insiders from running afoul of securities regulations, which prohibit trading stock using material, nonpublic information about their firms.

Once the blackout period expires and any inside information that could affect the company's stock has been disseminated to the public, insiders can buy and sell shares. These periods when insiders may trade company shares - known as window periods - limit the ability of insiders to sell shares whenever they wish. Indeed, some companies have very infrequent or no window periods.

A blind trust, however, is an excellent way for insiders to avoid the limitations imposed by window periods. The trustee is given legal power to sell stock under the guidelines of a written plan set out in advance, and the trustee and insider agree not to discuss the fortunes of the company in any respect. The trust, which is best established and funded during a window period, designates a plan to sell shares.

The trustee could, for example, be instructed to sell 10,000 shares per quarter or sell shares worth a certain amount each quarter. The insider determines the level of discretion given to the trustee, but the benefit is the same regardless: the trustee is free to sell the shares without concern for company news, window periods or the grantor's access to subsequent inside information.

Certain options eligible
Insiders and their financial advisors should also know that blind trusts offer the same benefits for exercising non-qualified stock options (NSOs) and subsequently selling the resulting affiliate stock. NSOs can be transferred into a blind trust and exercised by the trustee. (Unlike NSOs, so-called incentive stock options (ISOs) are not transferable, by government definition, and thus cannot be placed in a blind trust.)

A blind trust can be either revocable or irrevocable. However, many people feel that an irrevocable trust is preferable. The reason: dissolving a revocable trust may leave the insider open to allegations that, in taking such a step, he or she wanted to gain a pecuniary benefit based on inside information about the company.

A blind trust should be in effect at least one year, and possibly much longer, in order for the trustee to have an opportunity to sell the stock at the best possible price and at the appropriate times, given prevailing market conditions. It is important for a person setting up a blind trust to have his or her attorney involved, since the attorney will draft the trust agreement and insure that it works as intended. The company's attorney should be involved, too, since he or she typically authorizes the transfer of shares after each trade.

A blind trust is a good way of establishing an ongoing diversification plan. Although it normally receives only initial funding, it can also receive additional grants of affiliate stock and NSOs going forward, as long as insiders remain with their companies.

Although the blind trust has been in existence for many decades, its application to the wealth management needs of corporate insiders in today's economic climate could not be timelier. The blind trust allows insiders to achieve investment diversification and reduce risk - bedrock principles that are appropriate for all investors at all times.

This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.

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