10b5-1 Plan Abuse

In the current enforcement environment, the SEC is unlikely to leave any stone unturned in its investigation of insider trading cases. Recently, SEC officials have voiced concerns that corporate executives may be using 10b5-1 trading plans ' a safe harbor unavailable in the scandalous 1980s ' to shield illegal insider trading. Hence, it is prudent that corporate counsel take a fresh look at their clients' use of 10b5-1 plans.

SEC Intended That Rule 10b5-1 Provide Flexibility

In October 2000, the SEC enacted Rule 10b5-1 in order to clarify the law about when corporate executives who may come into possession of material nonpublic information can legally trade. The rule was intended to give executives opportunities to liquidate their stock holdings ' to purchase a home or pay their children's college tuition, for example ' without risk of inadvertently facing an insider trading inquiry.

Specifically, pursuant to Rule 10b5-1, trades made under pre-existing contracts, instructions or written plans adopted in good faith would fall under the safe harbor to 'provide appropriate flexibility to those who would like to plan securities transactions in advance at a time when they are not aware of material nonpublic information ' ' This grant of flexibility mitigated other parts of Rule 10b5-1 that enhanced the potential for exposure to insider trading liability, such as the codification of the SEC's view that 'knowing possession' of inside information was sufficient basis for liability under Rule 10b-5 rather than the harder to prove 'use' of inside information standard that had been favored by some courts. Almost one-third of executives of S&P 500 companies report using prearranged trading plans.

Flexibility May Have Been Abused

According to a study by Assistant Professor Alan Jagolinzer of Stanford University, sales made by insiders relying on prearranged trading plans 'tend to follow price increases and precede price declines generating statistically significant forward-looking abnormal returns.' Dr. Jagolinzer's preliminary study found that sales under prearranged trading plans outperform the markets by an average of 5.6%. Previous results indicated that sales by executives without such plans actually lag the markets. Dr. Jagolinzer also found that 10b5-1 plan participants terminated their plans right before good news more often than would be expected without advance knowledge.

So, has manipulation of 10b5-1 plans been statistically proven? Dr. Jagolinzer will only say that he has identified an 'empirical pattern.' In contrast, the SEC considers these findings to be a bright red flag. In March, the SEC's Director of Enforcement noted the Enforcement Division's interest in the study, saying, 'We're looking at this ' hard ' We want to make sure that people are not doing here what they were doing with stock options. 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.' Subsequent articles in Business Week and The Wall Street Journal have compared the situation to the stock option scandals and suggested that this may be the 'next big wave.'

Why Should You Care?

A thorough prophylactic review of a company's use of 10b5-1 plans is prudent for a number of reasons, especially in light of the possibility of SEC scrutiny. An insider trading investigation targeting a company's executives is an enormous distraction for company management and can bring negative publicity to the company as a whole. For many of the reasons that companies adopt 'blackout' or 'window' policies to curb insider trading, creating standard procedures in the adoption of 10b5-1 plans is now an indispensable corporate governance practice. The failure to create and follow such procedures could result in 'company liability' when a company employee engages in illegal insider trading.

Moreover, inside and outside SEC counsel of public companies can now be criticized for failing to catch warning signs of trading plan abuse. Failures to report detected wrongdoing 'up the ladder' could expose counsel to personal liability.

Prophylactic relief, however, may not be enough. Companies also should be incentivized to investigate historical practices. First, if abusive conduct was reasonably clear to an alert observer, the company could be accused of aiding and abetting the manipulative conduct. If the abuse involves manipulation of the timing of public disclosures, plaintiffs may characterize the timed releases of information as a violation by the company itself. Also, the company is generally in a better position in any enforcement actions where the company has taken proactive steps to detect wrongdoing and self-reported any abuses.

Each company must review its particular facts to determine whether the potential costs of reviewing past practices outweigh any benefits. In any event, rigorous monitoring of future 10b5-1 plan enactments and trades will likely be expected by the SEC and the market.

Assessing Potential for Manipulation

Once a determination is made to review the historical operation of a 10b5-1 plan, reviewers should consider, as a threshold issue, whether they are sufficiently independent from the subject plans and trades to be properly regarded as objective. Attorneys who drafted the plans at issue or participated in disclosure timing decisions should consider recusing themselves lest the conclusions reached be discounted by follow-on observers such as the government, shareholders or auditors.

As in any investigation, the reviewer should have access to all tools available for this purpose, including document review, e-mail review and interviews of fact witnesses. A useful starting point may be to plot plan trades against the stock's trading history to see if patterns of profitable coincidences appear. The following list describes several additional steps that could be taken to reveal some of the 10b5-1 plan abuses that commentators speculate may exist.

The authors continue this discussion in next month's conclusion.

David Washburn, Corporate Partner, Spencer Barasch, Chair of the Corporate Compliance, Investigations and Defense group, and Christopher McRorie, Corporate Associate, are in the Dallas office of Andrews Kurth LLP.

The latest hot topic in corporate executive abuses may be manipulation of trades under prearranged trading plans established pursuant to Rule 10b5-1. Little has been said about the red flags that could indicate abuse of 10b5-1 plans. This article attempts to offer some practical guidance to corporate counsel to ensure that their 10b5-1 plans steer clear of SEC enforcement scrutiny.

D'j' vu

Reminiscent of the 1980s, the heyday of Wall Street protagonist Gordon Gekko, along with real-life Wall Street insiders (and eventual felons) Ivan Boesky and Michael Milkin, who mesmerized the securities industry, today's equity markets are soaring and public companies are reaping extraordinary benefits. Consistent with its response to the 1980s merger and acquisition frenzy made infamous by Gekko's credo that 'greed is good,' the SEC again has made insider trading its top enforcement priority, partly in response to recent skepticism in Congress about the agency's effectiveness in policing the markets for insider trading.

In the current enforcement environment, the SEC is unlikely to leave any stone unturned in its investigation of insider trading cases. Recently, SEC officials have voiced concerns that corporate executives may be using 10b5-1 trading plans ' a safe harbor unavailable in the scandalous 1980s ' to shield illegal insider trading. Hence, it is prudent that corporate counsel take a fresh look at their clients' use of 10b5-1 plans.

SEC Intended That Rule 10b5-1 Provide Flexibility

In October 2000, the SEC enacted Rule 10b5-1 in order to clarify the law about when corporate executives who may come into possession of material nonpublic information can legally trade. The rule was intended to give executives opportunities to liquidate their stock holdings ' to purchase a home or pay their children's college tuition, for example ' without risk of inadvertently facing an insider trading inquiry.

Specifically, pursuant to Rule 10b5-1, trades made under pre-existing contracts, instructions or written plans adopted in good faith would fall under the safe harbor to 'provide appropriate flexibility to those who would like to plan securities transactions in advance at a time when they are not aware of material nonpublic information ' ' This grant of flexibility mitigated other parts of Rule 10b5-1 that enhanced the potential for exposure to insider trading liability, such as the codification of the SEC's view that 'knowing possession' of inside information was sufficient basis for liability under Rule 10b-5 rather than the harder to prove 'use' of inside information standard that had been favored by some courts. Almost one-third of executives of S&P 500 companies report using prearranged trading plans.

Flexibility May Have Been Abused

According to a study by Assistant Professor Alan Jagolinzer of Stanford University, sales made by insiders relying on prearranged trading plans 'tend to follow price increases and precede price declines generating statistically significant forward-looking abnormal returns.' Dr. Jagolinzer's preliminary study found that sales under prearranged trading plans outperform the markets by an average of 5.6%. Previous results indicated that sales by executives without such plans actually lag the markets. Dr. Jagolinzer also found that 10b5-1 plan participants terminated their plans right before good news more often than would be expected without advance knowledge.

So, has manipulation of 10b5-1 plans been statistically proven? Dr. Jagolinzer will only say that he has identified an 'empirical pattern.' In contrast, the SEC considers these findings to be a bright red flag. In March, the SEC's Director of Enforcement noted the Enforcement Division's interest in the study, saying, 'We're looking at this ' hard ' We want to make sure that people are not doing here what they were doing with stock options. 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.' Subsequent articles in Business Week and The Wall Street Journal have compared the situation to the stock option scandals and suggested that this may be the 'next big wave.'

Why Should You Care?

A thorough prophylactic review of a company's use of 10b5-1 plans is prudent for a number of reasons, especially in light of the possibility of SEC scrutiny. An insider trading investigation targeting a company's executives is an enormous distraction for company management and can bring negative publicity to the company as a whole. For many of the reasons that companies adopt 'blackout' or 'window' policies to curb insider trading, creating standard procedures in the adoption of 10b5-1 plans is now an indispensable corporate governance practice. The failure to create and follow such procedures could result in 'company liability' when a company employee engages in illegal insider trading.

Moreover, inside and outside SEC counsel of public companies can now be criticized for failing to catch warning signs of trading plan abuse. Failures to report detected wrongdoing 'up the ladder' could expose counsel to personal liability.

Prophylactic relief, however, may not be enough. Companies also should be incentivized to investigate historical practices. First, if abusive conduct was reasonably clear to an alert observer, the company could be accused of aiding and abetting the manipulative conduct. If the abuse involves manipulation of the timing of public disclosures, plaintiffs may characterize the timed releases of information as a violation by the company itself. Also, the company is generally in a better position in any enforcement actions where the company has taken proactive steps to detect wrongdoing and self-reported any abuses.

Each company must review its particular facts to determine whether the potential costs of reviewing past practices outweigh any benefits. In any event, rigorous monitoring of future 10b5-1 plan enactments and trades will likely be expected by the SEC and the market.

Assessing Potential for Manipulation

Once a determination is made to review the historical operation of a 10b5-1 plan, reviewers should consider, as a threshold issue, whether they are sufficiently independent from the subject plans and trades to be properly regarded as objective. Attorneys who drafted the plans at issue or participated in disclosure timing decisions should consider recusing themselves lest the conclusions reached be discounted by follow-on observers such as the government, shareholders or auditors.

As in any investigation, the reviewer should have access to all tools available for this purpose, including document review, e-mail review and interviews of fact witnesses. A useful starting point may be to plot plan trades against the stock's trading history to see if patterns of profitable coincidences appear. The following list describes several additional steps that could be taken to reveal some of the 10b5-1 plan abuses that commentators speculate may exist.

The authors continue this discussion in next month's conclusion.

David Washburn, Corporate Partner, Spencer Barasch, Chair of the Corporate Compliance, Investigations and Defense group, and Christopher McRorie, Corporate Associate, are in the Dallas office of Andrews Kurth LLP.