A December 2006 academic study suggests that returns on stock sales made pursuant to pre-arranged trading plans intending to comply with SEC Rule 10b5-1 significantly exceed market returns.1 As a result, the SEC is already beginning to examine such plans.2 In addition, class action lawsuits have recently been filed citing the study and alleging securities fraud arising from executives' trading pursuant to Rule 10b5-1 plans. Given the increased attention by the SEC and plaintiffs' firms to Rule 10b5-1 plans, U.S. public companies, their executives, and counsel must carefully monitor such plans to ensure compliance with SEC regulations.
Rule 10b-5 establishes that a person can be liable for securities fraud if he or she trades securities while in possession of material non-public ("inside") information. Rule 10b5-1 provides an affirmative defense to insider trading allegations when such trades are made pursuant to a pre-existing, written trading plan. To qualify for the defense, the plan must be entered into in good faith and while the participant is not aware of inside information. The plan must also satisfy a number of technical requirements, including specifying the number and price of securities to be traded (or a formula for making such determinations) and, in certain cases, prohibiting the participant from later exercising any influence over any person who exercises discretion over how, when or whether to effect the trades.3 Plan participants may, however, cancel a plan, even if the participant is aware of inside information at the time the plan is cancelled.4
The academic study found that trades under 10b5-1 plans beat the market by over 6% during a period of six months, while executives at the same companies who traded without 10b5-1 plans beat the market by only 1.9%. The study concluded that the evidence demonstrates the existence of strategic trading under 10b5-1 plans in which executives effect sales pursuant to such plans before adverse news disclosures. While the study did not conclusively establish illicit intent with respect to such trades, the SEC has acknowledged that it intends to investigate trades under these plans.5 Consequently, companies should consider requiring, as part of their administration of 10b5-1 plans for officers and directors and when using Rule 10b5-1 plans for their stock repurchase programs, that no such plan be adopted when the company possesses material information that has not been disclosed. Also, while such trading plans are operative, companies should be sensitive to the fact that decisions regarding the disclosure of material information will be scrutinized with the benefit of hindsight.
While it is too soon to predict how this increased scrutiny will affect insider sales, it is possible that the SEC will initiate rulemaking to require disclosure of 10b5-1 plans or impose additional conditions to these sales. If the SEC uncovers widespread abuse of 10b5-1 plans, it might amend the rule to, for instance, prohibit executives from engaging in securities transactions under plans until some minimum number of months after a plan has been finalized, or it may remove the Rule's protection if certain other conditions are not satisfied.
In view of the increased scrutiny of these plans, it is important that any 10b5-1 plan adopted by an insider be reviewed for technical compliance with the Rule, to confirm that the plan will operate in a manner consistent with other legal requirements and to ensure that certain planning issues have been considered.
Among the more important considerations are the following:
Trade terms. Important terms to examine include the amount, price and date of the securities trades, and to ensure that such terms cannot be changed except for a complete termination of the plan.
Education. Educate plan participants about the circumstances under which the safe harbor may be unavailable or lost. These circumstances include alteration or deviation from the plan's terms, and because a company's knowledge may be imputed to an executive officer, adoption of a plan at a time when the company had not fully disclosed all material information.
Recordkeeping. Based on the Division of Enforcement's most recent statements, it is likely that the SEC will require participants to document that a particular 10b5-1 plan complied with the Rule and was clearly adopted when the executive did not possess any inside information. Accordingly, companies should consider maintaining a 10b5-1 "record" of relevant facts and information relating to the plan participant, his or her knowledge about inside information at the time the plan was adopted, and other aspects of the plan.
Relationship to other requirements. Counsel must ensure that the myriad of other legal requirements implicated by 10b5-1 plans have been anticipated and addressed.6
Despite the SEC's recent remarks regarding the integrity of trading under 10b5-1 plans, the Rule remains a valuable and legitimate mechanism for the orderly sale by insiders of company stock, particularly by large holders whose personal wealth has become concentrated in employer securities. Without the use of these trading plans, insider trades generally can only be effected within narrow trading windows and in limited amounts. Trading plans have enabled insiders to sell larger amounts of securities over more extended periods of time when trades traditionally would have been restricted. Thus, executive trading plans, when properly designed and disclosed, may reduce market disruption and concern among investors because of the orderly manner in which trades are made pursuant to the plans.
Public companies and executives should seek experienced counsel to advise them on the implementation and review of 10b5-1 plans, including assessing the various issues described above. Special considerations involving trusts, hedging transactions, margin accounts, contemporaneous trades, plan modifications and 401(k) trades also merit particular attention. 1 See Alan D. Jagolinzer, Do Insiders Trade Strategically Within the SEC Rule 10b5-1 Safe Harbor? Stanford University Graduate School of Business, Working Paper, December 2006), available at http://papers.ssrn.com/sol13papers.cfm?abstract_id=541502.
2 See Dionne Searcey & Kara Scannell, SEC Now Takes a Hard Look at Insiders 'Regular' Sales, The Wall Street Journal, April 4, 2007, at C1; Jane Sasseen, The SEC is Eyeing Insider Stock Sales: Business Week Has Learned it is Examining Possible Abuses in Automatic Trading Plans, Business Week, March 19, 2007, http://businessweek.com/print/magazine/content/07_12b4026059.htm.
3 See Selective Disclosure and Insider Trading, Securities Act Release No. 33-7881, Exchange Act Release No. 34-43154, 65 Fed. Reg. 51,715 (August 15, 2000).
4 SEC Division of Corporation Finance, Manual of Publicly Available Telephone Interpretations, Fourth Supplement, Rule 10b5-1, Question 15 (issued May 2001).
5 See Linda Chatman Thomsen, Director, Division of Enforcement, Securities and Exchange Commission, Remarks at the 2007 Corporate Counsel Institute (March 8, 2007), http://www.sec.gov/news/speech/2007/spch030807lct2.htm ("If executives are in fact trading on inside information and using a plan for cover, they should expect the 'safe harbor' to provide no defense.").
6 For a more detailed discussion of planning issues and other legal requirements, see Jones Day Commentary, New SEC Rules Facilitate Insider Trades During Blackout Periods, October 2000, http://www.jonesday.com/pubs/pubs_detail.aspx?pubID=54226.
Libby Kitslaar has been the principal lawyer in a wide variety of U.S. and international M&A and corporate finance transactions, including complex acquisitions and divestitures, restructurings, public offerings, and joint ventures. She serves as outside securities counsel to numerous publicly held companies and has represented public and private companies in a diverse array of industries. Her practice extends from the execution of start-up structuring and formation to exit strategies, including initial public offerings and change in control transactions. In addition to her transactional work, she advises clients and counsels boards of directors on a broad range of corporate governance matters, including Sarbanes-Oxley, executive compensation, fiduciary duty, takeover preparedness, and disclosure policy and related issues. Philip Stamatakos's practice focuses on U.S. and international transactions, including mergers and acquisitions, joint ventures, strategic alliances, commercial agreements and reorganizations. He has been the principal lawyer on more than 100 negotiated merger and acquisition transactions and has coordinated and negotiated several complex multi-country acquisitions. He also provides a number of public companies with general corporate and cross-border counseling, including advice on corporate governance, fiduciary duties, whistleblower investigations and related issues. From 1985 to 1990, he worked in business development and contracts administration with defense contractor General Dynamics in the U.S. and Egypt.