In Rule 10b5-1 of the Securities Exchange Act of 1934 (“Exchange Act”), the SEC created an affirmative defense to any charge of insider trading “designed to cover situations in which a person can demonstrate that the material nonpublic information was not a factor in the trading decision.” Established as one of the tools to promote trade, the provision created a safe harbor for insider trading when the trade was made according to a contract, instructions were given to another, or a written plan that did not allow an insider to influence or effect subsequent purchases or sales if such a plan was created before the person had inside information.
Under Rule 10b5-1 executives can cancel a trading plan at any time, including the time period when executives already possess inside information and when the termination of the transactions under the trading plan could bring them above-market profits. Therefore, Rule 10b5-1 has been recently criticized because of corporate executives allegedly gaining unfair profits from their insider knowledge.
As mentioned by Craig M. Scheer, a partner at Silver, Freedman, Taff & Tiernan LLP, in his recent publication, “the SEC and federal prosecutors remain as interested as ever in combating illegal insider trading. When used improperly, Rule 10b5-1 trading plans can increase an insider’s liability risk.” According to the studies mentioned in the Wall Street Journal’s article, the corporate executives who buy and sell their own companies’ stock irregularly “were much likelier to record quick gains.” Assistant Professor Alan Jagolinzer of Stanford University considers that sales under prearranged trading plans “outperform the markets by an average of 5.6%.”
Some authors believe that increased scrutiny may result in legislative or regulatory efforts to impose additional requirements on the use of Rule 10b5-1. Some practicing lawyers, including attorneys from Covington & Burling LLP, consider this to be “an unfortunate overreaction if any such additional requirements burden the rule to the point of restricting its legitimate and practical use.”
Recent surveys reveal that most companies do not take into consideration the risk of insider trading liability. According to the survey results on Rule 10b5-1 practices, 69% of companies do not require their insiders to sell shares only pursuant to a Rule 10b5-1 trading plan and only 31% of companies strongly encourage their insiders to do so. Insiders in 82% of companies voluntarily terminate trading plans. Trading plans are not publicly disclosed in 79% of companies. Additionally, 59% of companies allow insiders to trade within one month after adopting a trading plan.
A number of recommendations have been put into practice since 2000, when Rule 10b5-1 was enacted and issuers began implementing their trading plans. Some recommendations are technical to ensure that trading plans are properly documented and include the necessary terms and conditions; to retain copies of all relevant documents in corporate files; to review and update a company’s internal trading policies; to provide training to directors of public companies on the proper use of Rule 10b5-1 plans. Lawyers also recommend routine review of trading plans by a company’s auditors. Other recommendations are substantive: to disclose trading plans in public (which is not required so far) or to put trading plans under the company’s compliance program.
The Council of Institutional Investors (“CII”) proposed that: (1) companies and insiders are allowed to adopt trading plans only within company adopted “trading windows”; (2) multiple and overlapping trading plans are prohibited; (3) mandatory delay (at least 3 months) before adoption of trading plan and first trade; (4) companies and insiders are not allowed to frequently modify or cancel trading plan.
However, some law firms disagree with CII and consider the proposed changes to Rule 10b5-1 to be unnecessary. According to Skadden, when adopting trading plans, “the CII proposal would impose additional limitations that would not necessarily prevent misuse but may well inhibit continued use of Rule 10b5-1 trading plans.”
The aforementioned recommendations should be supported, because their implementation will contribute to increased corporate sustainability and better compliance with securities regulation.
In addition, the following amendments could also be proposed:
1. To set forth trading parameters (e.g. number and volume of sales): either in absolute numbers, prohibiting large transactions, or in ratios to the total amount of shares overall or to the total amount of shares owned by insider. This may also help in creating an affirmative defense, where an executive was not able to sell all his shares in one transaction under the trading plan and had to be “in the same boat” with other stockholders, at least with some amount of shares.
2. To force companies to use pre-selected brokers for trades under the plan: this broker must be preliminary selected in compliance with applicable laws and internal company procedures. The broker shall be liable for any consequences of insider trading if the broker knew or should have been aware of it.
3. To prohibit or limit trades outside the plan: this would place insiders on the same board with other stockholders, who do not possess material information. It would also encourage responsible and thorough structuring of trading plans.
4. To establish a minimum and maximum duration of trading plans: short-term plans may be evidence of taking advantage of insider information; long-term plans (more than 12 months) may be adopted without an intention to trade, because securities market investors with long-term strategies have to modify or revise them to adjust to the constantly changing market situation.
5. To set a list of triggers, or eligibility criteria, to allow possible modification, termination or cancellation of trading plans. The other part of this measure is to prohibit automatic termination or suspension of trading plans (unless it is set forth in the Rule 10b5-1 itself). As discussed above, voluntary and multiple changes of trading plans may be evidence that trading plan was adopted without the intention to trade.