April 24, 2009
On March 25, 2009, the Securities and Exchange Commission’s Division of Corporation Finance (the "Division") issued new and revised interpretations regarding the operation of pre-established trading plans and instructions designed to satisfy Rule 10b5-1(c) under the Securities Exchange Act of 1934 (the "Exchange Act"), which provides an affirmative defense from insider trading liability. These revisions were made in the context of the Division updating its Compliance and Disclosure Interpretations ("CDIs") under the Exchange Act to include the Division’s existing Rule 10b5-1 interpretations (which were issued as "frequently asked questions" in May of 2001 and December of 2000). The Exchange Act CDIs are available at http://www.sec.gov./divisions/corpfin/guidance/exchangeactrules-interps.htm.
In the updated interpretations, the Division modified its interpretation relating to
Section 10(b) and Rule 10b-5 liability for plan and trade cancellations and provided new guidance regarding (1) the availability of the Rule 10b5-1(c) defense when cancelling a trading plan or establishing a replacement trading plan, (2) the standard for satisfying the material nonpublic information requirement of the defense, (3) the transferability of a trading plan when a broker responsible for the plan goes out of business and (4) the effect on the availability of the defense of a provision for the automatic reduction in the number of shares repurchased based on other discretionary transactions by the insider. The new and revised interpretations in general endorse some of what have emerged as best practices in Rule 10b5-1 plan design, but reflect a somewhat restrictive view on the availability of the Rule’s affirmative defense. The Division’s new and revised Rule 10b5-1 interpretations are summarized below and reprinted at the end of this client alert.
Cancellation of Plan Transactions / Rule 10b5-1 Trading Plan
The Division reaffirmed its position that the mere termination of a trading plan (and the consequent cancellation of transactions planned thereunder) does not of itself result in liability under Section 10(b) and Rule 10b-5 thereunder, stating that the standard for liability requires that fraudulent conduct occur "in connection with the purchase or sale of a security" (see Question 120.17 reprinted below). However, the Division took the opportunity to reflect recent developments in case law regarding the "in connection with" requirement, noting that it is satisfied when fraudulent conduct "coincides" with a securities transaction. At the time the Division issued its prior interpretation on this subject, the U.S. Supreme Court interpreted the "in connection with" standard more narrowly, requiring a fraud with respect to a purchase or a sale of a security. Since the Division’s initial interpretation, however, the Supreme Court has embraced a somewhat broader definition of the "in connection with the purchase or sale of a security" concept, holding that liability may attach if a fraud "coincides" with a securities transaction. Thus, the Division’s updated interpretation expressly references two cases, SEC v. Zandford, 535 U.S. 813 (2002) and Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71 (2006), as examples of this broader definition. This echoes past comments from representatives of the Securities and Exchange Commission’s Division of Enforcement that they will examine carefully all of the surrounding facts and circumstances whenever a Rule 10b5-1(c) defense is asserted.
Establishment of Replacement Rule 10b5-1 Trading Plan
In addition, the Division supplemented its existing interpretation regarding the availability of the Rule 10b5-1(c) defense for transactions under a new plan if one or more transactions under an existing plan are cancelled (see Question 120.19 reprinted below). As before, the Division takes the position that cancelling one or more transactions under a plan is tantamount to cancelling the plan and entering into a new one and that Rule 10b5-1(c) is available for the new plan if it otherwise satisfies the requirements of Rule 10b5-1(c). The revised interpretation now in addition affirmatively states that an assessment of whether the new plan in this situation satisfies the Rule’s requirement that the person establishing the plan act in "good faith and not as part of a plan or scheme to evade" the prohibitions of Rule 10b5-1(c) will depend on all of the facts and circumstances surrounding both the termination of the old plan and the adoption of the new plan. The Division further notes that among the relevant factors will be the time period between the cancellation of the old plan and the execution of the new plan, thus endorsing the common practice of allowing a "waiting period" in such circumstances. In light of the Division’s interpretation, anyone modifying or terminating an existing plan should consider establishing a sufficient "waiting period" between that action and the entry into a new or modified plan in order to support the availability of the Rule 10b5-1(c) defense. The length of any such waiting period should be considered in light of the facts and circumstances.
Material Nonpublic Information Requirement
The Division also added a new interpretation intended to clarify the material nonpublic information requirement of Rule 10b5-1(c)(1)(i)(A) (see Question 120.20 reprinted below). Specifically, the Division interpreted the Rule to require that a person availing himself or herself of the defense not be aware of any material nonpublic information when the plan itself is entered into. This interpretation is consistent with the widely followed practice among those seeking to avail themselves of the Rule 10b5-1(c) defense. However, the Division’s interpretation rejects other possible readings of the Rule. Thus, under the interpretation, the defense would not be available if a person entered into a plan while aware of material nonpublic information even if that information were publicly disseminated before the commencement of trading under the plan. While it is clearly better to attempt to satisfy the Division’s interpretation, it is possible that a person seeking to avail himself or herself of Rule 10b5-1(c) may argue that the Rule’s language permits a person to claim the Rule 10b5-1(c) defense for a trade that occurs while the person is aware of material nonpublic information as long as the plan is entered into before the person becomes aware of that information.
Transferability of a Rule 10b5-1 Trading Plan to a New Broker
The Division also added a new interpretation which specifically addresses the transferability of a Rule 10b5-1 trading plan to a new broker when the person’s existing broker goes out of business (see Interpretation No. 220.01 reprinted below). This new interpretation is especially timely given the current economic crisis and failure of certain brokerage firms, but may also be helpful in other circumstances where outside forces require an insider to move his or her trading plan to a different brokerage firm. Pursuant to this new interpretation, a person may transfer a Rule 10b5-1 trading plan to a different broker when the broker who has been executing trades under his or her plan goes out of business if the following two conditions are satisfied: (1) the plan transfer is timed so that there is no cancellation of any transaction scheduled in the original plan and (2) the new broker effects transactions in accordance with the original plan’s terms in compliance with Rule 10b5-1(c) of the Exchange Act. Because the failure of a broker may come unexpectedly during a period of plan activity, timing such a transfer in accordance with the Division’s new interpretation will likely require careful advance planning.
Automatic Share Repurchase Reductions
In addition, the Division published a new interpretation to address whether a repurchase plan that allows for automatic share repurchase reductions to the extent the company has repurchased shares in privately negotiated transactions satisfies the requirements of Rule 10b5-1(c)(1) (see Interpretation 220.02 reprinted below). According to the Division’s new interpretation, such a plan will not satisfy Rule 10b5-1(c)(1), because this arrangement "would give the issuer the potential to effectively modify the plan by doing the block trades while aware of material nonpublic information."
This interpretation highlights a tension between the text of Rule 10b5-1(c), language included in the Securities and Exchange Commission’s Rule 10b5-1 adopting release and certain of the Division’s interpretations. On the one hand, this interpretation indicates the Division’s view that a trading plan that allows for automatic modifications based upon actions of the person establishing the plan would not satisfy Rule 10b5-1(c). On the other hand, both a footnote to the Rule’s adopting release as well as several of the Division’s other interpretations suggest that in some contexts a person may be able modify a trading plan and nonetheless continue to rely on Rule 10b5-1(c) for transactions under both the original and modified trading plan.
The Division also distinguishes a plan with an automatic adjustment provision tied to discretionary acts of the person who established the trading plan from a plan in which a broker is granted discretion to reduce share sales under a trading plan to comply with the volume limitations of Rule 144(e) of the Securities Act of 1933. Under another interpretation that the Division did not revise, the Division suggests that a plan that grants a broker discretion to reduce share sales to comply with the volume limitations of Rule 144(e) would qualify for the affirmative defense of Rule 10b5-1(c) as long as the plan satisfies the conditions of Rule 10b5-1(c)(1)(i)(B)(3) of the Exchange Act. The Division’s new interpretation notes that this situation is different from the plan described above, as the issuer repurchase plan involves adjustments based on the discretion of the seller and not adjustments required to satisfy limitations imposed by law.
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15. After the written trading plan described in Q&A 11(a)Question 120.11 has been in effect for several months, the person terminates the selling plan by calling the broker and canceling the limit order. (a) DoesStanding alone, does the act of terminating a plan while aware of material nonpublic information, and thereby not engaging in the planned securities transaction, result in liability under Section 10(b) and Rule 10b-5? No. Section 10(b) and Rule 10b-5 apply "in connection with the purchase or sale of any security." Thus, a purchase or sale of a security must be present for liability to attach. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975).
Answer: No. Section 10(b) and Rule 10b-5 apply to any fraudulent conduct "in connection with the purchase or sale of any security." The “in connection with” requirement is satisfied when a fraud “coincides” with a securities transaction. See, e.g., SEC v. Zandford, 535 U.S. 813 (2002) and Merrill Lynch, Pierce, Fenner & Smith, Inc., v. Dabit, 547 U.S. 71 (2006). [Mar. 25, 2009]
Answer: The cancellation of one or more plan transactions would be an alteration or deviation from the plan, which would terminate that plan. The Rule 10b5-1(c) defense would be available for transactions following the alteration only if the transactions were pursuant to a new contract, instruction or plan that satisfies the requirements of Rule 10b5-1(c). See Securities Act Release
33-No. 7881 (Aug. 15, 2000), at n. 111 and Answer 14, above. fn. 111 and Question 120.16. Moreover, if a person established a new contract, instruction or plan after terminating a prior plan, then all the surrounding facts and circumstances, including the period of time between the cancellation of the old plan and the creation of the new plan, would be relevant to a determination whether the person had established the contract, instruction or plan “in good faith and not as part of a plan or scheme to evade” the prohibitions of Rule 10b5-1(c). [Mar. 25, 2009]
Question: Is the Rule 10b5-1(c) affirmative defense available where a person establishes a Rule 10b5-1 written trading plan while aware of material nonpublic information if the plan is structured so that plan transactions will not begin until after the material nonpublic information is made public?
Answer: No. [Mar. 25, 2009]
220.01 After the written trading plan described in Q&A 105.02 has been in effect for several months, the broker that has been executing plan sales goes out of business at a time when the person is aware of material nonpublic information. The person wishes to continue sales under the plan pursuant to its original terms. The person may transfer plan transactions to a different broker without being deemed to have cancelled the original plan and adopted a new plan if the transfer to the new broker is timed so that there is no cancellation of any transaction scheduled in the original plan, and the new broker effects sales in accordance with the original plan’s terms in compliance with Rule 10b5-1(c). [Mar. 25, 2009]
220.02 A company sought to establish a stock repurchase plan that would comply with Rules 10b5-1(c)(1) and 10b-18. Most shares would be repurchased through open market transactions, but the company intended to negotiate repurchase of at least one large block of stock through a privately negotiated transaction. The company proposed that the plan provide for an automatic reduction in the aggregate number of shares authorized for repurchase under the plan equal to the number of shares, if any, that the company discloses in Form 10-Q, Part II, Item 2 that it has repurchased in privately negotiated transactions. The broker executing plan repurchases would review company filings to determine the amount of any such repurchases that had been disclosed. Because this would give the issuer the potential to effectively modify the plan by doing the block trades while aware of material nonpublic information, the Division staff took the view that the Rule 10b5-1(c) affirmative defense would not be available. Question 120.14, which provides that delegation of discretion to a broker to reduce the number of shares to be sold under a trading plan to comply with the Rule 144(e) volume limitations, was distinguished because the reductions in Question 120.14 reflect limitations imposed by law rather than an exercise of discretion by the seller. [Mar. 25, 2009].
 For instance, in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), which the Division referenced in its prior interpretive response, the U.S. Supreme Court rejected a Rule 10b-5 claim because the plaintiff-offerees had neither purchased nor sold the offered securities. The plaintiff-offerees alleged that they were defrauded into not purchasing the securities because of the defendant’s preparation and distribution of a materially misleading prospectus and overly pessimistic appraisal of the corporation’s securities. The Court, in rejecting the plaintiff’s Rule 10b-5 claim, noted that the private right of action under Rule 10b-5 is limited to actual purchasers and sellers of securities and because the plaintiffs neither purchased nor sold the corporation’s securities, they could not pursue a claim under Rule 10b-5.
 In SEC v. Zandford, the U.S. Supreme Court found that the "in connection with" requirement was satisfied where securities transactions and breaches of fiduciary duty coincided. The defendant-broker, without the knowledge or consent of his investor, engaged in a series of transactions in which he sold securities in the investor’s account and transferred the proceeds to his own personal account. In rejecting the broker’s contention that the "in connection with" requirement was not satisfied because the security sales were merely incidental to the fraud that "lay with absconding the proceeds of the sale," the Supreme Court held that a fraudulent scheme in which securities transactions and breaches of fiduciary duty coincide suffices to satisfy the "in connection with requirement" of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
 In Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, the U.S. Supreme Court reaffirmed its holding in SEC v. Zandford, finding that the "in connection with" requirement was satisfied when a fraud coincides with a securities transaction. In particular, the Court rejected the narrow definition of this term, finding that the requirement was satisfied where the plaintiff-broker held the securities much longer than he would have had he known the true value of the securities. As the court explained, "fraudulent manipulation of stock prices … unquestionably qualifies as fraud ‘in connection with the purchase or sale’ of securities."
Question: Assume that the written trading plan described in Question 120.11 also includes a provision requiring the number of securities to be sold during each month to be reduced, if necessary, to comply with applicable volume limitation under Rule 144(e). What effect does this have on the availability of a Rule 10b5-1(c) defense?
Answer: The analysis depends on the manner in which the adjustment is effected:
(a) First, the written plan could provide for adjustment of the amount of securities to be sold each month based on a written formula specified in the plan within the meaning of Rule 10b5-1(c)(1)(i)(B)(2). Where a written formula specifies one or more of the price, amount and dates of transactions that are all specified in a contract, instruction or written plan, the Rule 10b5-1(c)(1)(i)(B)(2) defense would apply.
(b) Alternatively, the written plan could provide for adjustment of the amount of securities to be sold each month based on a delegation of discretion to the broker. In this case, where one or more of the price, amount and dates of transactions under a contract, instruction or written plan are to be determined based on a delegation of discretion to another person, the availability of a defense depends upon satisfaction of the conditions of Rule 10b5-1(c)(1)(i)(B)(3). [Mar. 25, 2009]
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