January 22, 2013
A series of recent articles in the Wall Street Journal have focused on corporate executives who traded in their companies’ stock. According to the Journal, some corporate executives who traded in their companies’ stock realized gains or avoided losses during the week prior to significant corporate news. The Journal asserted that a number of these executives realized gains or avoided losses when they used trading plans set up under Securities and Exchange Commission (“SEC”) Rule 10b5-1, as well as when they deviated from those plans in order to make the stock trades.
Shortly thereafter, and likely in response to the Journal‘s initial article, federal prosecutors and the SEC opened insider trading investigations into certain of the reported trades. There have also been some calls for revisions to Rule 10b5-1, including a formal proposal by the Council for Institutional Investors (“CII”), a group of pension funds. The Journal article and the academic studies by financial economists which it cites are similar to articles and studies published in 2006 that sparked widespread internal and government investigations of alleged “stock option backdating.” While it is too early to know whether the situations identified by the Journal reflect actual misuse of Rule 10b5-1 plans, the scrutiny now being applied to trading by executives generally and Rule 10b5-1 plans in particular makes the new year a good time to review the requirements set out by Rule 10b5-1 trading plans and to re-evaluate existing practices.
I. Wall Street Journal Articles on Executive Stock Trading
On November 28, 2012, the Journal reported on its analysis of executives who have traded in their companies’ stock since 2004. The Journal‘s analysis focused on 20,237 executives who traded in their companies’ stock “during the week before their companies made news.” Most of those executives’ trades had mixed results that did not correlate with subsequent news, but the Journal asserted that “1,418 executives recorded average stock gains of 10% (or avoided 10% losses) within a week after their trades,” which “was close to double the 786 who saw the stock they traded move against them that much.” Moreover, the Journal wrote that executives who bought or sold their companies’ stock “irregularly, dipping in and out,” were “much likelier to record quick gains” than those who traded in “a consistent yearly pattern.” The Journal also quoted Lauren Cohen, an Associate Professor of Business Administration at Harvard University and the co-author of a study that found corporate insiders trading “‘statistically much better than we’d expect.'”
The Journal went on to highlight instances where executives recorded gains and avoided losses, some of which were made pursuant to trading plans and others which were not. In particular, the Journal noted that “[e]xecutives can generally cancel a trading plan at any time,” but then cited to another study by Alan Jagolinzer, a Business Professor at the University of Colorado in Boulder, that found “46% of early terminations of 10b5-1 plans calling for share sales occurred within 90 days before the company released positive news” and “only 11% of the terminations of plans that called for share sales came before negative company news.”
A subsequent article on December 11, 2012 reported that the U.S. Attorney’s Office in Manhattan and the SEC were “taking a deeper look into how executives use prearranged trading plans to buy and sell shares of their company stock.” The article observed that while prosecutors and regulators have been “focused mainly on ferreting out traditional insider trading in the financial world, involving outside investors in companies,” they were “turning more attention to trading by corporate executives in their own company’s shares.”
On December 13, 2012, the Journal published another follow-up article, this time noting that “the SEC is facing mounting pressure to tighten its rules.” The article noted that this was not the first time that trading plans have come under scrutiny. In 2007, the SEC’s then-Director of Enforcement said during a speech that trading plans would be scrutinized.
The Journal ran another article on December 31, 2012, which focused on a letter that the CII wrote to the SEC on Rule 10b5-1 plans. Citing the Journal‘s recent reporting, the CII asked the SEC to consider new guidelines for such plans. These guidelines included the adoption of plans only “during company-approved trading windows,” a ban on having “multiple, overlapping Rule 10b5-1 plans,” a “mandatory delay, preferably of 3 months or more, between” adopting the plan and executing any trades, the prevention of “frequent modifications or cancellations,” the “greater disclosure” of Rule 10b5-1 plans, and “making boards explicitly responsible for the oversight of Rule 10b5-1 plans.”
As discussed below, Rule 10b5-1 was adopted after careful consideration and is well-grounded in the precepts of insider trading law. By its very design, the rule is intended to allow transactions to occur at a time when an insider may possess material, nonpublic information, provided that the trading plan was established at a time when the insider had no such information and the other conditions of the rule are satisfied. Thus, it will take time and a careful evaluation of the specific facts to determine whether trading instances highlighted in the Journal‘s articles represent actual misuse of Rule 10b5-1 or instead demonstrate the effectiveness of the rule. Nevertheless, it is important for companies and insiders to understand and comply with the requirements of Rule 10b5-1 if they wish to invoke its protection, and to consider how their trading practices might be viewed in hindsight.
II. What Rule 10b5-1 Permits
Rule 10b5-1was initially proposed on December 20, 1999. The rule was intended to address two separate but related problems. First, would it violate the insider trading rules for an insider to engage in a trade that was prompted by a need to fund pre-existing personal needs and not motivated by inside information in the possession of the insider (i.e., “the possession” standard) or was it necessary to show that the trade was prompted by the information (i.e., “the use” standard)? This controversy was made more acute by conflicting Circuit Court decisions. Second, if mere knowledge or possession of inside information was enough to cause a violation, then under what circumstances could an insider buy or sell stock to address personal financial planning? After a comment period, the SEC issued the final rule on August 15, 2000, with an effective date of October 23, 2000.
The new rule took a hard line on the “possession v. use” debate, but then provided relief. On the one hand, Rule 10b5-1 states that a person may not trade if he or she “was aware of the material nonpublic information when the person made the purchase or sale.” On the other hand, the purchase or sale of a security is not “on the basis of” material, nonpublic information if, “[b]efore becoming aware of the information,” the person had in place a binding contract, instruction to another person, or trading plan for such purchase or sale. This is generally known as the Rule 10b5-1 trading plan defense. This defense was created to ensure that “a person can plan future transactions at a time when he or she is not aware of material nonpublic information without fear of incurring liability.” In doing so, the SEC’s rules sought to permit corporate executives who derive much of their income from grants of stock and options to liquidate some of their shares and diversify their holdings without fear of potential liability. At the same time, however, insiders who sell through plans risk disposing of their holdings at what turn out, in hindsight, to be impropitious times.
A. Requirements of Trading Plan
To be an effective defense against insider trading, a trading plan must meet the requirements set out in Rule 10b5-1.
If all the above conditions are satisfied, then the executive should be able to claim the Rule 10b5-1 trading plan defense. To do so, a purchase or sale must have actually been done pursuant to the trading plan. In addition, the trader cannot alter or deviate from the plan without losing the defense. Neither can the trader enter into or alter “a corresponding or hedging transaction or position” with respect to the securities. Importantly, there is also a good faith obligation for the trading plan; the plan cannot be part of a scheme to evade Rule 10b5-1.
B. SEC Interpretations
Since promulgating Rule 10b5-1, the SEC and its staff have issued supplemental interpretations on some aspects of the rule. Some highlights of this guidance include the following:
When evaluating a defense under Rule 10b5-1, the SEC has said that it will carefully examine all the facts and circumstances surrounding the trading plan to determine whether it was entered into in good faith. If the trading plan was entered into while the trader had material, nonpublic information, the defense may not be available under the rule.
C. Benefits of Having a Trading Plan
One benefit of having a trading plan is that even if a trade occurred while the executive possessed material, nonpublic information, the trade is lawful so long as the trading plan was adopted at a time when the executive had no such information and the other conditions to the rule were satisfied. This defense is available both in SEC investigations and in private actions.
If a trading plan complies with Rule 10b5-1, it can be invoked in securities class action lawsuits where plaintiffs challenging the timing or sufficiency of company disclosures assert in their complaints that insider trading is evidence of intent to defraud. In this context, plaintiffs are trying to demonstrate that executives made trades that were suspicious and unusual. Courts have found that trading pursuant to Rule 10b5-1 plans can defeat plaintiffs’ attempt to do so. However, if the court finds questionable circumstances surrounding the trading plan — such as when a large and profitable trade is made the day after the plan is adopted for reasons unrelated to the plan — then the defense may be foreclosed.
III. Additional Practices to Consider
One of the strengths of Rule 10b5-1 is that it accommodates a wide range of circumstances and, as intended, allows insiders to plan in advance to address their financial goals and needs. Given the varying circumstances under which Rule 10b5-1 may be used, it is difficult to establish conditions or guidelines for its use that go beyond the conditions of the rule itself. Nevertheless, a number of practices have emerged that can be helpful to demonstrate that a Rule 10b5-1 trading plan was entered into in good faith and to avoid misperceptions arising from transactions by insiders. Below are a few measures that companies and insiders should consider when establishing their Rule 10b5-1 plans.
Extremely careful consideration should be given prior to the modification or cancellation of a plan, including a thorough examination of the relevant facts and documentation of any changed circumstances. While it may be lawful to terminate or amend a trading plan in particular circumstances, consideration should be given to how the action and rationale would appear to an investor or investigator. In addition, the SEC staff has stated that amending or cancelling one trading plan may affect its view of whether prior transactions under the plan (if any) or a subsequent plan were effected in good faith.
The heightened interest in corporate executives trading in their companies’ stock — whether by the government, shareholders or other corporate constituents — will probably continue in the wake of the recent Wall Street Journal articles. Investigations of alleged illegal insider trading can be very distracting for corporations and their managers. A sound Rule 10b5-1 plan to which executives adhere can resolve questions quickly and avoid embarrassment. The start of a new year is a propitious time to revisit corporate policies to prevent insider trading and better assure that executives are protected from possible unintended consequences of stock sales.
 Susan Pulliam & Rob Barry, Investors Call for More Disclosure of Executive Trades, WALL ST. J., Nov. 28, 2012, at C1; Michael Siconolfi, Pension Funds Seek Insider Curbs, WALL ST. J., Dec. 31, 2012, at C1; Letter from Jeff Mahoney, Gen. Counsel, CII, to Elisse B. Walter, Chairman, Sec. & Exch. Comm’n (Dec. 28, 2012), http://www.cii.org/CouncilCorrespondence [hereinafter CII Letter].
 See Charles Forelle & James Bandler, The Perfect Payday, WALL ST. J., Mar. 18, 2006, at A1; Peter Lattman, “The Perfect Payday” Morphs Into “The Backdating Scandal,“ WALL ST. J. L. BLOG (May 18, 2006, 8:44 AM), http://blogs.wsj.com/law/2006/05/18/the-perfect-payday-morphs-into-the-backdating-scandal/.
 Id.; see also Dionne Searcey & Kara Scannell, SEC Now Takes a Hard Look at Insiders’ ‘Regular’ Sales, WALL ST. J., Apr. 4, 2007, at C1; Insiders with a Curious Edge, BUS. WEEK (Dec. 17, 2006), http://www.businessweek.com/stories/2006-12-17/insiders-with-a-curious-edge.
 For example, the fact that irregular trades have yielded favorable returns may simply reflect some executives’ use of trading plans with a price threshold that must be met before any trade occurs, whereas other executives may be less price-sensitive and designing plans to consistently affect sales over a specified period.
 Selective Disclosure and Insider Trading, Securities Act Release No. 7787, Exchange Act Release No. 42,259, Investment Company Act Release No. 24,209, 64 Fed. Reg. 72,590 (proposed Dec. 20, 1999).
 Compare United States v. Teicher, 987 F.2d 112, 120-21 (2d Cir. 1993) (knowing possession standard), with SEC v. Adler, 137 F.3d 1325, 1337-39 (11th Cir. 1998) (use standard), and United States v. Smith, 155 F.3d 1051, 1066-69 (9th Cir. 1998) (same).
 Selective Disclosure and Insider Trading, Securities Act Release No. 7881, Exchange Act Release No. 43,154, Investment Company Act Release No. 24,599, 65 Fed. Reg. 51,716 (Aug. 15, 2000) [hereinafter Adopting Release]
 See id. § 240.10b5-1(b), (c)(1)(i)(A). As a practical matter, these contracts, instructions, and plans usually use brokers. See Pulliam & Barry, supra note 1; Allan Horwich, The Origin, Application, Validity, and Potential Misuse of Rule 10b5-1, 62 BUS. LAWYER 913, 925-26 (2007).
 See 17 C.F.R. § 240.10b5-1(b), (c)(1). Rule 10b5-1 also provides a defense for corporate entities when the individual making the investment decision is not aware of material, nonpublic information and the entity has “implemented reasonable policies and procedures” to ensure that individuals making investment decisions do not trade on the basis of material, nonpublic information. Id. § 240.10b5-1(c)(2).
 See 17 C.F.R. § 240.10b5-1(c)(1)(i)(A). In practice, many trading plans fall within several of these categories, for example constituting a written plan that sets some parameters but that grants a broker or other person some discretion in executing the trades.
 SEC Exchange Act Rules, Questions and Answers of General Applicability (Feb. 13, 2012), http://sec.gov/divisions/corpfin/guidance/exchangeactrules-interps.htm [hereinafter SEC Interpretations]. Interpretations relating to Rule 10b5-1 were last updated on Mar. 25, 2009. This is Interpretation 120.20.
 Id. This is Interpretation 120.17. It is consistent with the Supreme Court’s holding in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), that there has to be an actual purchase or sale of a security for liability to be imposed under Section 10(b) of the Securities Exchange Act of 1934, i.e., not trading is not unlawful.
 This view was confirmed by the SEC when it adopted Rule 10b5-1, when it stated in the Adopting Release, supra note 25, that “a person acting in good faith may modify a prior contract, instruction, or plan before becoming aware of material nonpublic information. In that case, a purchase or sale that complies with the modified contract, instruction, or plan will be considered pursuant to a new contract, instruction, or plan.”
 See 17 C.F.R. § 240.10b5-1(c)(1)(ii); see also SEC v. Mozilo, 2010 WL 3656068, at *20 (C.D. Cal. Sept. 16, 2010) (denying defendant Mozilo’s motion for summary judgment on insider trading counts because the SEC presented evidence that defendant “was aware of material, non-public information at the time he adopted or amended these trading plans,” “made misleading statements with scienter during 2006 and 2007, when the plans were adopted and the trades were executed,” and that “these trading plans were significantly out-of-line with his prior trading plans or practices”).
 See, e.g., Mannkind Sec. Actions, 835 F. Supp. 2d 797, 813 (C.D. Cal. 2011) (“Although the timing of the sale appears suspicious, Plaintiffs do not rebut Defendants’ contention that it was pre-determined pursuant to a 10b5-1 plan. Accordingly, the Court finds that Defendant Pfeffer’s sale of stock does not provide support for Plaintiffs’ pleading of scienter.”).
 See, e.g., In re Novatel Wireless Sec. Litig., 830 F. Supp. 2d 996, 1025 (S.D. Cal. 2011) (“The Court finds Souissi’s use of 10b5-1 was particularly questionable because he sold 110,000 shares the day after entering his 10b5-1 plan, for proceeds of over $2.2 million. He did so because, in his opinion, an ‘open-window’ insulated his trades. Improper use of 10b5-1 trading is evidence of scienter. Based upon the foregoing, the Court finds that [there is] a genuine issue of material fact precluding summary judgment.”) (internal citations omitted).
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