'Just Trust Me'

The SEC and the Department of Justice (DOJ), which have launched formal investigations into the sale, will surely be less concerned with the workings of Frist's trusts than with his inside knowledge of HCA. To establish criminal liability under the antifraud provisions of the federal securities laws, the government would have to prove, among other things, that Frist traded “on the basis of” material, nonpublic information. The government is not required to demonstrate a causal connection between the possession of such information and the trade at issue –only that Frist was “aware” of material, nonpublic information when the sale was ordered.

The 'General Awareness' Standard Under Rule 10b5-1

This reduced burden arrives by way of Rule 10b5-1, which the SEC adopted on Aug. 24, 2000. Rule 10b5-1 provides that a trade is made on the basis of material, nonpublic information if the trader was aware of the material, nonpublic information when the person made the sale.

Before the Rule, there was a split among the circuits as to what standard should apply when evaluating whether a trade was made “on the basis of” material, nonpublic information. Some courts had held that a trader was liable for trading while in “knowing possession” of inside information. See, eg, United States v. Teicher, 987 F.2d 112, 120-21 (2d Cir. 1993). In Teicher, a criminal case, the court reasoned that, “[u]nlike a loaded weapon which may stand ready but [remain] unused, material information can not lay idle in the human brain.” Id. at 120. The contrary view suggested that a trader would not be liable unless it was shown that he “used” the material, nonpublic information in the course of trading. See, eg, SEC v. Adler, 137 F.3d 1325, 1337 (11th Cir. 1998) (proof of possession provides a strong inference of use); United States v. Smith, 155 F.3d 1051 (9th Cir. 1998) (use must be proven in a criminal case).

In adopting Rule 10b5-1, the SEC considered the two approaches from different circuits and noted the difficulty of distinguishing between a trader's “knowing possession” and “use” of information in the course of making a trade. See SEC Rel. No. 34-43154. Although it found the “knowing possession” standard more apt at “protecting investors and the integrity of securities markets,” SEC Rel. No. 34-42259, “knowing possession” might reach too far: “Sometimes a person may reach a decision to make a particular trade without any awareness of material nonpublic information, but then come into possession of such information before the trade actually takes place. [A knowing possession] standard would lead to liability in that case.”

In Rule 10b5-1, the Commission attempted to resolve this conundrum by adopting a general standard of “awareness,” which it acknowledged is “closer to the 'knowing possession' standard than to the 'use' standard,” and supplementing it with “several carefully enumerated exceptions.” The relaxed definition of trading “on the basis of” material nonpublic information could well help the DOJ prove its hypothetical case against Frist, but the Rule might also have something to offer the beleaguered senator, by way of its “carefully enumerated exceptions.”

Affirmative Defenses under Rule 10b5-1

In certain circumstances, a trader who is aware of material, nonpublic information may negate the presumption that he traded “on the basis of” such information. Rule 10b5-1 provides an affirmative defense to a trader who can show that, before he became aware of the material nonpublic information, he: “1) entered into a binding contract to purchase or sell the security, 2) instructed another person to purchase or sell the security for the instructing person's account, or 3) adopted a written plan for trading securities.” Rule 10b5-1(c)(1)(i)(A).

Furthermore, the trader must show that the contract, instruction or plan: 1) specified the amount and price of the securities, and the date on which they were to be sold; 2) included a formula or algorithm, or computer program, for determining the amount and price of the securities to be purchased or sold and the date on which the securities were to be purchased or sold; or 3) did not permit the trader to “exercise any subsequent influence over how, when, or whether to effect purchases or sales,” and provided “that any other person who, pursuant to the contract, instruction, or plan, did exercise such influence must not have been aware of the material nonpublic information when so doing.” Rule 10b5-1(c)(1)(i)(B).

Finally, the trader attempting to take advantage of one of the affirmative defenses must be able to show that the trade “was pursuant to the contract, instruction, or plan.” Rule 10b5-1(c)(1)(i)(C). The trader will not be able to make such a showing if he “altered or deviated from the contract, instruction or plan … (whether by changing the amount, price, or timing of the purchase or sale), or entered into or altered a corresponding or hedging transaction position with respect to those securities.”

Frist's Blind Trust

It is clear that a “blind trust” would fall within the parameters of the affirmative defense outlined in Rule 10b5-1(c)(1)(i)(B)(3). See Spirgel L: Rule 10b5-1. RealCorporateLawyer.com (April 2004). As the SEC noted in the proposing release for Rule 10b5-1, a person who places securities in a blind trust does not, by definition, make decisions regarding the purchase or sale of the securities in that account. There-fore, as long as the creator of the account established it before becoming aware of material nonpublic information, the “trading decisions (which are made by the trustee of the blind trust) should not be attributed to the person for purposes of potential insider trading liability.” SEC Rel. No. 34-42259. The SEC further clarified this point in the fourth supplement to the SEC Manual of Publicly Available Telephone Interpretations (“SEC Interpretations Manual”). In response to a question regarding the propriety of a blind trust under the Rule, the SEC stated that “Rule 10b5-1(c)(1)(i)(B)(3) contemplates that a person, while not aware of material nonpublic information, may delegate to a third party under a contract, instruction or written trading plan, all subsequent influence over how, when or whether to effect purchases or sales.”

But a problem arises when the creator of a trust exercises subsequent control over the securities, as Frist presumably did via his June 13 instruction to the Trustees. Rule 10b5-1(c)(1)(C) provides that an affirmative defense under Rule 10b5-1(c)(1)(i)(B)(3) is not available where the trader deviates from the terms of the contract, instruction or plan. “Whether or not any terms are set at creation, for a Rule 10b5-1(c)(1)(i)(B)(3) defense to be available, the person is not permitted to exercise any subsequent influence over how, when, or whether a transaction occurs.” SEC Interpretations Manual.

The Rule 10b5-1(c)(1)(i)(B)(3) defense does include some flexibility with respect to the creator of a trust who wants to make subsequent modifications. A person “acting in good faith” may modify a prior plan as long as he does so before becoming aware of material nonpublic information. SEC Rel. No. 34-43154 n. 111. Any subsequent trades would then be considered to be made pursuant to the new plan.

Details of Frist's Trust have yet to emerge. If the Trust when created gave Frist the power to direct the Trustees to sell the Trust's HCA stock, the Trust would not be an affirmative defense under Rule 10b5-1(c), and any liability for insider trading would be determined as if Frist held the stock in his own name. But if the terms of the Trust vested full trading control in the Trustees, it would likely be deemed an acceptable “plan” under the Rule. In that scenario, Frist's recent directive to sell the stock could be viewed as an acceptable modification of the trading plan, unless he “aware” of material nonpublic information regarding HCA at that time.

The Rule 10b5-1(c) affirmative defense explicitly requires that the trading plan or agreement be established or modified before the trader becomes aware of material nonpublic information. See Rule 10b5-1(c)(A). Thus if Senator Frist modified the trust after becoming aware of material nonpublic information about HCA, the affirmative defense would not be available. There has been some

commotion in the media concerning documents that suggest that the trust was never truly “blind,” in that the Trustees regularly appraised him of the HCA sales that were being made. But this in itself is not enough to negate the protection of a blind trust under Rule 10b5-1. It is subsequent control over the assets, not awareness of their quantity or value, that nullifies the Rule 10b5-1(c)(1)(i)(B)(3) affirmative defense. As long as the modification of the trust truly “qualified” under Rule 10b5-1 — that is, as long as it was modified in the absence of awareness of material nonpublic information – the affirmative defense would protect Frist from criminal liability. But if the DOJ believes it can show that he was “aware” of material, nonpublic information about HCA at the time he ordered the sale, the good senator might soon find himself “blindsided” by a criminal indictment.

Senate Majority Leader Bill Frist (R-TN) has publicly defended himself against allegations of insider trading by insisting that he was not aware of inside information when he sold his stock in Hospital Corporation of America (HCA), the hospital chain founded by his father and brother. He has also stated, numerous times since his election to the Senate, that because his HCA securities were in a “qualified blind trust,” he could not even be certain about the extent of his holdings at any given time. Frist's civil and criminal exposure under the securities laws is likely to turn on interpretations of SEC Rule 10b5-1, which addresses trading “on the basis of” material nonpublic information in insider trading cases.

Frist's HCA Transactions

On June 13, 2005, Frist instructed his independent Trustees to sell all of his HCA stock. Two weeks after the sale was completed, HCA issued a negative earnings report, and its stock lost 9% of its value. Frist has insisted that his “only objective in selling the stock was to eliminate the appearance of a conflict of interest,” and that he “had no information about HCA or its performance that was not publicly available.” Nat'l L. J., Oct. 1, 2005. He said his HCA securities had been held in a “qualified blind trust” since 2000 and that the trust prevented him from knowing the extent of his holdings. Frist's position has been undermined by the recent emergence of documents suggesting he received regular updates from the Trustees. But e-mails and other correspondence between Frist, members of his family and his accountants suggest that he began contemplating the sale as early as April, which would bolster his argument that the sale was not related to HCA's negative earnings report.

The SEC and the Department of Justice (DOJ), which have launched formal investigations into the sale, will surely be less concerned with the workings of Frist's trusts than with his inside knowledge of HCA. To establish criminal liability under the antifraud provisions of the federal securities laws, the government would have to prove, among other things, that Frist traded “on the basis of” material, nonpublic information. The government is not required to demonstrate a causal connection between the possession of such information and the trade at issue –only that Frist was “aware” of material, nonpublic information when the sale was ordered.

The 'General Awareness' Standard Under Rule 10b5-1

This reduced burden arrives by way of Rule 10b5-1, which the SEC adopted on Aug. 24, 2000. Rule 10b5-1 provides that a trade is made on the basis of material, nonpublic information if the trader was aware of the material, nonpublic information when the person made the sale.

Before the Rule, there was a split among the circuits as to what standard should apply when evaluating whether a trade was made “on the basis of” material, nonpublic information. Some courts had held that a trader was liable for trading while in “knowing possession” of inside information. See, eg, United States v. Teicher , 987 F.2d 112, 120-21 (2d Cir. 1993). In Teicher, a criminal case, the court reasoned that, “[u]nlike a loaded weapon which may stand ready but [remain] unused, material information can not lay idle in the human brain.” Id. at 120. The contrary view suggested that a trader would not be liable unless it was shown that he “used” the material, nonpublic information in the course of trading. See, eg, SEC v. Adler , 137 F.3d 1325, 1337 (11th Cir. 1998) (proof of possession provides a strong inference of use); United States v. Smith , 155 F.3d 1051 (9th Cir. 1998) (use must be proven in a criminal case).

In adopting Rule 10b5-1, the SEC considered the two approaches from different circuits and noted the difficulty of distinguishing between a trader's “knowing possession” and “use” of information in the course of making a trade. See SEC Rel. No. 34-43154. Although it found the “knowing possession” standard more apt at “protecting investors and the integrity of securities markets,” SEC Rel. No. 34-42259, “knowing possession” might reach too far: “Sometimes a person may reach a decision to make a particular trade without any awareness of material nonpublic information, but then come into possession of such information before the trade actually takes place. [A knowing possession] standard would lead to liability in that case.”

In Rule 10b5-1, the Commission attempted to resolve this conundrum by adopting a general standard of “awareness,” which it acknowledged is “closer to the 'knowing possession' standard than to the 'use' standard,” and supplementing it with “several carefully enumerated exceptions.” The relaxed definition of trading “on the basis of” material nonpublic information could well help the DOJ prove its hypothetical case against Frist, but the Rule might also have something to offer the beleaguered senator, by way of its “carefully enumerated exceptions.”

Affirmative Defenses under Rule 10b5-1

In certain circumstances, a trader who is aware of material, nonpublic information may negate the presumption that he traded “on the basis of” such information. Rule 10b5-1 provides an affirmative defense to a trader who can show that, before he became aware of the material nonpublic information, he: “1) entered into a binding contract to purchase or sell the security, 2) instructed another person to purchase or sell the security for the instructing person's account, or 3) adopted a written plan for trading securities.” Rule 10b5-1(c)(1)(i)(A).

Furthermore, the trader must show that the contract, instruction or plan: 1) specified the amount and price of the securities, and the date on which they were to be sold; 2) included a formula or algorithm, or computer program, for determining the amount and price of the securities to be purchased or sold and the date on which the securities were to be purchased or sold; or 3) did not permit the trader to “exercise any subsequent influence over how, when, or whether to effect purchases or sales,” and provided “that any other person who, pursuant to the contract, instruction, or plan, did exercise such influence must not have been aware of the material nonpublic information when so doing.” Rule 10b5-1(c)(1)(i)(B).

Finally, the trader attempting to take advantage of one of the affirmative defenses must be able to show that the trade “was pursuant to the contract, instruction, or plan.” Rule 10b5-1(c)(1)(i)(C). The trader will not be able to make such a showing if he “altered or deviated from the contract, instruction or plan … (whether by changing the amount, price, or timing of the purchase or sale), or entered into or altered a corresponding or hedging transaction position with respect to those securities.”

Frist's Blind Trust

It is clear that a “blind trust” would fall within the parameters of the affirmative defense outlined in Rule 10b5-1(c)(1)(i)(B)(3). See Spirgel L: Rule 10b5-1. RealCorporateLawyer.com (April 2004). As the SEC noted in the proposing release for Rule 10b5-1, a person who places securities in a blind trust does not, by definition, make decisions regarding the purchase or sale of the securities in that account. There-fore, as long as the creator of the account established it before becoming aware of material nonpublic information, the “trading decisions (which are made by the trustee of the blind trust) should not be attributed to the person for purposes of potential insider trading liability.” SEC Rel. No. 34-42259. The SEC further clarified this point in the fourth supplement to the SEC Manual of Publicly Available Telephone Interpretations (“SEC Interpretations Manual”). In response to a question regarding the propriety of a blind trust under the Rule, the SEC stated that “Rule 10b5-1(c)(1)(i)(B)(3) contemplates that a person, while not aware of material nonpublic information, may delegate to a third party under a contract, instruction or written trading plan, all subsequent influence over how, when or whether to effect purchases or sales.”

But a problem arises when the creator of a trust exercises subsequent control over the securities, as Frist presumably did via his June 13 instruction to the Trustees. Rule 10b5-1(c)(1)(C) provides that an affirmative defense under Rule 10b5-1(c)(1)(i)(B)(3) is not available where the trader deviates from the terms of the contract, instruction or plan. “Whether or not any terms are set at creation, for a Rule 10b5-1(c)(1)(i)(B)(3) defense to be available, the person is not permitted to exercise any subsequent influence over how, when, or whether a transaction occurs.” SEC Interpretations Manual.

The Rule 10b5-1(c)(1)(i)(B)(3) defense does include some flexibility with respect to the creator of a trust who wants to make subsequent modifications. A person “acting in good faith” may modify a prior plan as long as he does so before becoming aware of material nonpublic information. SEC Rel. No. 34-43154 n. 111. Any subsequent trades would then be considered to be made pursuant to the new plan.

Details of Frist's Trust have yet to emerge. If the Trust when created gave Frist the power to direct the Trustees to sell the Trust's HCA stock, the Trust would not be an affirmative defense under Rule 10b5-1(c), and any liability for insider trading would be determined as if Frist held the stock in his own name. But if the terms of the Trust vested full trading control in the Trustees, it would likely be deemed an acceptable “plan” under the Rule. In that scenario, Frist's recent directive to sell the stock could be viewed as an acceptable modification of the trading plan, unless he “aware” of material nonpublic information regarding HCA at that time.

The Rule 10b5-1(c) affirmative defense explicitly requires that the trading plan or agreement be established or modified before the trader becomes aware of material nonpublic information. See Rule 10b5-1(c)(A). Thus if Senator Frist modified the trust after becoming aware of material nonpublic information about HCA, the affirmative defense would not be available. There has been some

commotion in the media concerning documents that suggest that the trust was never truly “blind,” in that the Trustees regularly appraised him of the HCA sales that were being made. But this in itself is not enough to negate the protection of a blind trust under Rule 10b5-1. It is subsequent control over the assets, not awareness of their quantity or value, that nullifies the Rule 10b5-1(c)(1)(i)(B)(3) affirmative defense. As long as the modification of the trust truly “qualified” under Rule 10b5-1 — that is, as long as it was modified in the absence of awareness of material nonpublic information – the affirmative defense would protect Frist from criminal liability. But if the DOJ believes it can show that he was “aware” of material, nonpublic information about HCA at the time he ordered the sale, the good senator might soon find himself “blindsided” by a criminal indictment.