Author: Donna Ferrara
From its inception, federal securities law has been anchored in a core tenet: those who seek public investors must provide a fair transaction. This mandates a market in which all material information is disclosed, and no insider benefits from material non-public information.
This tenet has been put to the test repeatedly. For many investors, early access to equity is a major draw. Many corporate executives' compensation is formed by stock, directly or through options. If such transactions are accompanied with access to non-public information, they can be seen as providing insiders with an unfair advantage.
While insider trading has been the subject of numerous enforcement actions and private lawsuits for decades, the Securities and Exchange Commission (SEC) took a stance on compensation packages in the early 2000s. Rule 10b5-1 1 allowed insiders of publicly-traded corporations to set up a trading plan for selling their own stock. It is considered a clarification of Rule 10b-5, created under the Securities Exchange Act of 1934, the primary statute governing investigation of securities fraud.
In brief, the rule sets out the criteria for a permissible purchase or sale of stock for insiders. In relevant part:
- Rule 10b5-1 allows company insiders to set up a predetermined plan to sell company stocks in accordance with insider trading laws.
- The price, amount, and sales dates must be specified in advance and determined by a formula or metrics.
- Both the seller and the broker making the sales must not have access to any material nonpublic information.
- The plan, its implementation and execution must be conducted in good faith.
Transactions conducted in accordance with the Rule were provided an affirmative defense to allegations of insider trading. Yet the shortcomings of the Rule were quickly apparent. Plans could be created at will, applying to a single trade, or established immediately before an announcement of news that would send a stock price soaring or falling.
In perhaps the most egregious instance, the SEC brought an enforcement action against Anthony Mozilo, former CEO of Countrywide Financial 2. According to the SEC complaint, Mozilo established several Rule 10b5-1 trading plans during the period October through December 2006. As the company's share price was rising to record highs, Mozilo adjusted several previously established plans to allow him to sell even more shares. Mozilo exercised over 51 million stock options and sold the underlying shares for total proceeds of over $139 million.
Mozilo paid a $22.5 million penalty and $45 million in disgorgement of ill-gotten gain. The settlement also permanently barred Mozilo from serving as an officer or director of a publicly traded company.3
Despite this high-profile prosecution, commentators noted that insiders circumvented Rule 10b5-1 regularly.4 Insiders used the tactics that Mozilo had, including the use of multiple plans, frequent alterations of plans, and cancelation whenever the plan was insufficiently profitable 5
Recently, the SEC reopened the discussion of Rule 10b5-1. Citing an article by prominent academics 6, the Chair, Gary Gensler, announced the commission's plan to review and possibly "freshen up" the current regulation 7. The three "red flags" for insider trading abuse, mentioned in the article are:
- Plans with a short or no cooling-off period
- Plans that entail only a single trade
- Plans adopted in a given quarter that begin trading before that quarter's earnings announcement.
These features can be implemented without public awareness, as there is no requirement that 10b5-1 plans be disclosed. Moreover, the beneficiaries of these trading plans can cancel or alter them at will.
Chair Gensler stated that these problems must be studied by the SEC with an eye towards amending the current rules, but he noted that even the current regulation impose a duty of good faith on Rule 10b5-1 plans. Abuses such as canceling or altering a plan based on material non-public information would fall afoul of the good faith requirement.
What Does This Mean for Our Clients?
Among commentators and regulators, there is a growing consensus that the current Rule 10b5-1 must be examined in light of the past 20 years of trading under its auspices. While it appears that the rule will be amended in the future, it is also clear that the SEC intends to enhance the enforcement of the current rule.
Many corporations have already taken measures to assure their plans are created and maintained to reflect underlying good faith. These measures include:
- Limits on the number of Rule 10b5-1 plans including the creation of a single plan for all beneficiaries and all relevant plans;
- Creating a plan which cannot be altered or canceled by the beneficiary;
- Avoiding having a plan take effect before disclosure of material events, such as earnings reports, change of key personnel, announcement of major transactions, etc.
- Establishment of a strict cooling off period before transactions can be made.
Such measures will generally meet with the approval of investors, regulators and the public. While the beneficiaries of the plans may consider such restrictions inconvenient, they should recognize that, in the long run, sensible insider trading plans inure to the benefit of all involved.
Doubtless, examination and assessment of 10b5-1 plans will require the expertise of advisors, including counsel, accountants and others. The interests of the involved individuals as well as the corporate entity and shareholders will be implicated. Risk management tools, including but not limited to Directors & Officers Liability, Fiduciary Liability, and other insurance plans should be reviewed by professionals to maximize risk protection. As usual, Gallagher professionals are ready to assist.
1 17 CFR § 240.10b5-1.
4 Mavruk and Seyhun, Do SEC's 10b5-1 Safe Harbor Rules Need to Be Rewritten? Columbia Business Law Review, 133-183, 2016; Daniel J. Morrissey, Taming Rule 10b-5-1: The Unfinished Business of Texas Gulf Sulphur, 71 SMU L. Rev. 883 (2018). Best Laid Plans Gone Awry: Practices for Rule 10b5-1 Trading Plans, https://www.pillsburylaw.com/en/news-and-insights/best-laid-plans-gone-awry-practices-for-rule-10b5-1.html.
5 Wall Street Journal, Executives' Good Luck in Trading Own Stock, available at https://www.wsj.com/articles/SB10000872396390444100404577641463717344178.
6 Larcker, David F. and Lynch, Bradford and Quinn, Phillip J. and Tayan, Brian and Taylor, Daniel J., Gaming the System: Three 'Red Flags' of Potential 10b5-1 Abuse (January 19, 2021). Rock Center for Corporate Governance at Stanford University Working Paper Forthcoming, Available at SSRN: https://ssrn.com/abstract=3769567