SEC Statements Suggest Heightened Insider Trading Scrutiny Even if Using a Rule 10b5-1 Trading Plan
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Recent warnings from the US Securities and Exchange Commission ("SEC") and the US Congress could translate into more aggressive scrutiny of trading plans adopted pursuant to Rule 10b5-1 of the Securities and Exchange Act of 1934 ("Exchange Act").
In a speech delivered on June 7, 2021, SEC Chair Gary Gensler identified several "cracks" in Rule 10b5-1 trading plans that could allow for insider trading.1 A few days later, the SEC released an updated rulemaking agenda, which includes amendments to the affirmative defense against insider trading provided by Rule 10b5-1 to corporate executives and directors2 and, based on his speech, could include imposing a four-to-six-month cooling off period between adoption of the plan and the first trade. Pressure to reform the insider trading law is also mounting in Congress, where a pair of Senators recently reintroduced a bipartisan bill directing the SEC to explore amendments to Rule 10b5-1.3 The House of Representatives also approved a bill, which if passed would clarify insider trading prohibitions.4
Benefits of Rule 10b5-1 Trading Plans
Insider trading prohibitions evolved from case law interpreting the anti-fraud provisions of the federal securities laws. These provisions prohibit trading securities on the basis of material nonpublic information ("MNPI") with an intent to deceive ("scienter") and in breach of a duty of trust or confidence. Corporate insiders typically owe duties of trust and confidence to their employers.
In 2002, the SEC adopted Rule 10b5-1 under the Exchange Act to define when a trade is made "on the basis of" MNPI.5 This new rule also provided an affirmative defense against allegations of insider trading by defining when a trade is not "on the basis of" MNPI.6 For instance, a trade will not be considered "on the basis of" MNPI if, before becoming aware of the MNPI, the person "adopted a written plan for trading [the] securities" and that plan specified in advance the price, amount and dates for the trade.7 Trading plans created under this rule are passive and predetermined written investment instructions, adopted when insiders are not aware of MNPI, and allow holders of such plans to purchase and sell securities of their company during blackout periods, under terms specified in advance.
Since the adoption of Rule 10b5-1 two decades ago, the SEC has brought very few enforcement actions involving Rule 10b5-1 trading plans, but has brought two highly-publicized actions: one against the CEOs of Enron Corporation and one against the CEO of Countrywide Financial Corporation. In 2004, Enron's CEO was charged with fraudulently amending his trading plans while in possession of MNPI regarding the company's deteriorating conditions and subsequently selling his shares.8 Similarly, in 2009, the SEC alleged that Countrywide's CEO created a series of trading plans while he was aware of the poor performance of the company and then illegally traded the company's securities.9
The rule has been subject to criticism over the years, namely for facilitating legal yet questionable trading practices by corporate executives and Wall Street professionals.10
Cracks in Rule 10b5-1 Plans Identified by the SEC
Based on recent studies showing that Rule 10b5-1 plans often lead to abusive insider trading,11 SEC Chair Gensler identified the following cracks in Rule 10b5-1 trading plans and called for reforms:
No cooling-off period between the adoption of the plan and the first scheduled trade. Under the existing rule, there is no requirement for any waiting period between the adoption of the plan and the time of the first planned trade. Chair Gensler is concerned that "some bad actors could perceive this as a loophole to participate in insider trading."12 The empirical research used by the SEC Chair suggests that results from trades without cooling-off periods show more favorable returns than plans with longer waiting periods.13 The SEC Chair also noted that bipartisan support exists for proposals that could impose a four-to-six-month cooling off period.14
No limits on cancellation. Currently, Rule 10b5-1 plans can be terminated even when the insider is in possession of MNPI, which seems "upside-down" to Chair Gensler as "canceling a plan may be as economically significant as carrying out an actual transaction."15 However, as stressed by Chair Gensler, even if permitted, a cancellation can be used as evidence of bad faith, which could jeopardize the use of the Rule 10b5-1 affirmative defense.16
No mandatory disclosure requirement. While some issuers and individuals voluntarily disclose the use of Rule 10b5-1 plans (whether in press releases, SEC periodic reports or insider filings with the SEC), Rule 10b5-1 does not require the disclosure of the adoption, modification, cancellation and terms of Rule 10b5-1 plans. According to Chair Gensler, such mandatory disclosure could promote confidence of the public in the markets.17
No limits on the number of Rule 10b5-1 plans. The Chair observed that since Rule 10b5-1 does not limit the adoption of multiple plans by companies or their insiders, some "may mistakenly think they have a free option to pick amongst favorable plans as they please."18 Chair Gensler therefore asked the SEC staff to consider whether to impose such limits.
Companies Should Expect Enhanced Scrutiny of Corporate Executives' and Directors' Trades and Rule 10b5-1 Trading Plans
The recent focus on insider trading and Rule 10b5-1 trading plans by the SEC and Congress, alongside recent news and empirical reports of potential misuse, all suggest that the SEC will take a more aggressive approach to Rule 10b5-1 plans. This enhanced scrutiny may lead to new rulemaking or request for public comments, as well as Enforcement Division investigations into allegations of insider trading by abusing Rule 10b5-1 plans. SEC Chair Gensler indicated that the agency would "use all of the tools in our toolbox to ensure we are identifying and punishing abuses of Rule 10b5-1 plans."19 The use of data analytics, increasingly used by the agency, will also help identify suspicious trading activity.
While many of the SEC's proposals are generally aligned with best practices for companies and individuals adopting Rule 10b5-1 plans, companies should review their internal policies and procedures regarding their Rule 10b5-1 plans. This should include adopting, alongside or within issuer insider trading policies, clear policies for the adoption and oversight of Rule 10b5-1 plans, including: 1) a limit on the number of plans adopted per individual and their affiliated family members or entities; and 2) a mandatory cooling off period between (a) adopting a plan and trading under such plan, and (b) cancelling a plan and such cancellation going into effect. These elements should be included in addition to the standard confirmation that the person has no MNPI when entering the plan.
So long as issuers adopt, implement and enforce such procedures under the current regulatory framework, Rule 10b5-1 plans should continue to represent a helpful mechanism to protect against insider trading liability, and issuers should take proactive steps to adopt clear policies aligned with such guidance and emphasize them during regular trainings.
1 Chair Gary Gensler, Prepared Remarks – CFO Network Summit (June 7, 2021).
2 Press Release, SEC Announces Annual Regulatory Agenda (June 11, 2021). In a June 23, 2021 speech, Chair Gensler also announced that the SEC will explore amendments to "enhance transparency related to companies buying back their stock." This could include revision of share repurchase disclosure requirements, such as Regulation S-K and Item 703. Chair Gary Gensler, Prepared Remarks at London City Week (June 23, 2021).
3 On June 28, 2021, Senators Chris Van Hollen and Deb Fisher revived the Promoting Transparent Standards for Corporate Insiders Act, which was initially introduced in the U.S. House of Representatives in 2018 and 2019. This bill requires the SEC to carry out a study determining whether Rule 10b5-1 trading plans should be amended to limit abuses. The proposed bill also suggests several amendments, the majority of which the SEC is already considering. Other suggested amendments would limit the timeframe during which an insider can adopt a plan to certain issuer-approved trading windows, and would require boards to adopt policies governing trading plan activities and periodically monitor trading plan transactions. H.R. 1528 Promoting Transparent Standards for Corporate Insiders Act, 117th Cong. (2021).
4 The Insider Prohibition Act was passed in the House of Representatives by a large bipartisan majority of 350 to 75. This Act would add a new Section 16A codifying insider trading law into the Exchange Act. The new Section 16A would make it unlawful for any person, directly or indirectly, to trade in any security while aware of material nonpublic information if the person knows, or recklessly disregards, that such information was obtained wrongfully, or that the purchase or sale would constitute a wrongful use of the information. H.R.2655 Insider Trading Prohibition Act, 117th Cong. (2021), Section 2 (a) – Prohibition on Insider Trading. The statute would also require the showing of a personal benefit to the person trading or tipping the information. Id.
5 According to Rule 10b5-1, "a purchase or sale of a security of an issuer is 'on the basis of' material nonpublic information about that security or issuer if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale." 17 CFR § 240.10b5-1.
6 The anti-fraud provisions are Section 17(a) under the Securities Act of 1933 and Section 10(b) under the Exchange Act and Rule 10b5-1 thereunder.
7 17 CFR § 240.10b5-1(c)(1)(i). The affirmative defense will not be available if the insider cannot demonstrate that the trading plan was entered into in good faith and not as part of a plan or scheme to evade the prohibitions of Rule 10b5-1. 17 CFR § 240.10b5-1(c)(1)(ii).
8 See Litigation Release No. 18776, SEC Charges Kenneth L. Lay, Enron's Former Chairman and Chief Executive Officer, with Fraud and Insider Trading (July 8, 2004).
9 Countrywide's CEO agreed to pay a $22.5 million penalty to settle the SEC charges. According to the SEC, at the time of this settlement, this financial penalty marked the highest penalty paid by a senior corporate executive in a SEC settlement. Press Release, Former Countrywide CEO Angelo Mozilo to Pay SEC's Largest-Ever Financial Penalty Against a Public Company's Senior Executive (Oct. 15, 20210). See also Litigation Release No. 22221, SEC Brings Fraud and Insider Trading Charges Against Three Former Wellcare Executives (Jan. 9, 2012) (alleging corporate executives sold their company's stock pursuant to trading plans established while in possession of MNPI that they were conducting a fraudulent scheme impacting their company's financial results); Litigation Release No. 22419, SEC v. Manouchehr Moshayedi, United States District Court for the Central District of California, Civil Action No. CV12-1179 JST (MLGx) (July 19, 2012) (alleging CEO terminated his Rule 10b5-1 trading plan shortly before selling shares of company while in possession of negative MNPI).
10 Susan Pulliam, Rob Barry, Directors Take Shelter in Trading Plans, The Wall Street Journal (Apr. 24, 2013) (finding that instead of selling a fraction of their shares at regular intervals, executives use the plans to sell heavily in a short time); Susan Pulliam, Rob Barry, Executives' Good Luck in Trading Own Stock, The Wall Street Journal (Nov. 17, 2012).
11 David F. Larcker, Bradford Lynch, Phillip Quinn, Brian Tayan, Daniel J. Taylor, Gaming the System – Three "Red Flags" of Potential 10b5-1 Abuse, Stanford Closer Look Series (Jan. 19, 2021). The research suggests that several characteristics of Rule 10b5-1 plans are potential for abuse as many of them lead to trades associated with "significant loss avoidance and foreshadow considerable stock declines." Id.
12 Chair Gary Gensler, Prepared Remarks see supra note 1.
13 Larcket, Gaming the System at 3, see supra note 11.
14 Chair Gary Gensler, Prepared Remarks, see supra note 1 (citing former Chairman Jay Clayton and current Commissioners Allison Herren Lee and Caroline Crenshaw).
16 Id. At least one court has found that creating, amending, modifying, or cancelling a Rule 10b5-1 plan can itself be evidence of scienter, rather than a defense. See In re Countrywide Financial Corp. Derivative Litig., 554 F. Supp. 2d 1044, 1068–69 (C.D. Cal. 2008).
17 The academic study cited by Chair Gensler found that evidence of Rule 10b5-1 abuse has not been publicly available because the SEC does not require "relatively basic but critical information" about Rule 10b5-1 plans and companies generally opt not to publicly disclose them. Larcket, Gaming the System at 3, see supra note 11.
18 Chair Gary Gensler, Prepared Remarks, see supra note 1.
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