10b5 -1 Plan Abuse

Reviewers should obtain copies of the plans and review them for compliance with Rule 10b5-1. A reviewer should be satisfied that any required company approvals were obtained for the form of the plan actually adopted and that actual trades were effected in accordance with plan terms. Prearranged trading plans are not required to be disclosed, so reviewers should also look for 'backdated' plans, which may involve accessing the 'metadata' related to electronic copies of the plan, comparing trade dates with the dates of any public announcements that were made and checking Section 16 report disclosures relating to trades that may footnote reliance on the plan.

If the plan was effectuated through the discretionary investment authority of a broker, a reviewer should test the relationship between the broker and the insider. Are they acquaintances? Has the company reimbursed the insider for entertainment expenses involving the broker? If deemed necessary, a review could be made of phone records between the insider or company and the broker. At a minimum, an interview of the broker should occur to ascertain his independence. The reviewer should be satisfied that the broker was not influenced and did not come into possession of any inside information after the adoption of the plan.

Determine Whether an Insider Was Aware of Material Nonpublic Information at the Time the Plan Was Adopted

An essential premise of properly functioning trading plans is that they were adopted when the insider was devoid of potentially market moving information. Reviewers may develop a timeline comparing the dates that prearranged trading plans were being considered and the date ranges that insiders came into possession of pieces of inside information. Often, brokers agreeing to implement a 10b5-1 plan ask the company to certify that no material nonpublic information exists at the adoption of the plan; the existence of such certifications should focus a reviewer on potential company liability for their accuracy.

Insiders are encouraged to build in a substantial delay or 'waiting period' of one to six months between adoption of a plan and initial trading. While there is nothing that automatically disqualifies trades occurring near a 10b5-1 plan adoption, such trades could suggest awareness of inside information if the trade turns out to have been near a high in the stock's price history.

Examine News Release Decisions

Next, a reviewer considering plan trades that specify particular trade dates or timing triggers should examine the role of plan participants in timing material disclosures. Consider whether news releases around the time of plan trades were issued on logical and appropriately identified dates. The reviewer should ask: Who is involved in the decision to release information? Does the record reflect any communication among the relevant parties concerning the release date selected? If a news release was postponed or accelerated, can a legitimate business reason for the change be identified? These inquiries relate not only to 'released information,' but also to information withheld from disclosure.

Some 10b5-1 plans are designed to appear more stringent by restricting trades to open trading windows, which typically open between earnings releases and subsequently filed financial statements. This could put pressure on decisions to push the release of certain details to the financial statements, such as one-time charges that bring earnings per share within guidance or material changes in nonoperating expenses.

Examine Plan Terminations And Modifications

Terminating a plan will not, in and of itself, result in insider trading liability. The SEC, while acknowledging that the 'non-trade' resulting from a 10b5-1 plan termination cannot generally form the basis of liability, has also indicated that 'termination of a plan ' could affect the availability of the [10b5-1 plan] defense for prior plan transactions if it calls into question whether the plan was 'entered into in good faith.” Likewise, compliance with the good faith requirement could be questioned by plan terminations followed shortly by new plans and trades. (Allegations of jumping in and out of 10b5-1 plans were involved in the recent insider trading proceedings against former Qwest International CEO Joseph Nacchio.)

Amendments to a 10b5-1 plan can be even more problematic. Any amendment should be considered the termination of the old plan and the adoption of a new plan. The analysis of whether the insider possessed material nonpublic information must be repeated at the time of the amendment. Multiple amendments will likely give rise to presumptions of bad faith.

Did the insider trade outside of a plan? Adoption of a plan does not necessarily preclude trading outside of a plan. However, trades made outside of the plan do not benefit from the safe harbor and could be indicia of strategic trading, especially if the outside trades seem to hedge against the effects of plan instructions. Reviewers should determine if there were identifiable financial needs or objectives motivating non-plan trades. The absence of extenuating circumstances does not mean that a trade need be considered tainted, but independent justifications for a trade beyond the profit motive can help to assuage doubts of skeptical outsiders.

Interview relevant parties. Any good investigation should involve questioning the people involved about the 10b5-1 transactions. Whoever made trades on behalf of insiders should be asked when the plan was communicated to him and the substance and timing of any communications with the insider or others at the company. The insider should be interviewed to elicit facts surrounding the purpose of the plan and the procedures followed in setting it up. A reviewer may also wish to interview attorneys that reviewed the plan, compliance administrators within the company, decision makers with respect to public disclosure timing and others.

Conclude the investigation. Reviewers should document all steps taken in the investigation and present any conclusions reached to the appropriate body at the company. If the report identifies any potential abuses, recommendations should likely include the engagement of independent outside assistance to investigate more exhaustively.

Best Practices Going Forward

Any report prepared should include recommendations to improve the company's 10b5-1 plan processes going forward. Each of the steps above includes a corollary 'best practice' for future 10b5-1 plan procedures that should be formalized in a written policy. Some examples of policy components that most companies will find useful are:

• The only 10b5-1-related exceptions to the company's blackout policies should be for formally adopted plans that have been reviewed by in-house counsel for compliance with the rule.
• 10b5-1 plans should only be initiated during an open trading window, and the first trade should be delayed until several months after adoption.
• Plans should not be permitted to be amended or terminated early in the absence of extraordinary circumstances.
• Preferably, all 10b5-1 plans would be handled by the same fully independent broker, and in-house counsel would work closely with the broker to ensure that Section 16 reports are timely filed.

Conclusion

It is likely that trades under 10b5-1 plans will come under additional scrutiny in the near future. Companies should take proactive steps today to assure themselves that their own insiders are not likely to get caught up in investigations and that their policies are effective to prevent abuses. Some practical review steps can go a long way to comforting board members and GCs.

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.

Last month, we wrote that the latest hot topic in corporate executive abuses may be manipulation of traders under prearranged Rule 10b5-1. We said that 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 traders to be properly regarded as objective. We continue with a list that describes several steps that could be taken to reveal some of the 10b5-1 plan abuses that commentators speculate may exist.

Ensure That Plans Have Been Properly Adopted And Effectuated

Before becoming aware of material nonpublic information, the insider must irrevocably commit to the trade in a contract, instruction or written plan. With respect to any transaction under the plan, the insider must expressly specify the terms and date; provide a formula, algorithm or program for determining terms and times; or completely relinquish influence over how, when or whether to make trades. All purchases and sales must be made under the 10b5-1 plan; the insider cannot have altered or deviated from the plan or entered into a related hedging transaction. Finally, the safe harbor is not available if the 10b5-1 plan was part of a scheme to evade the insider trading rules or otherwise was not made in good faith.

Reviewers should obtain copies of the plans and review them for compliance with Rule 10b5-1. A reviewer should be satisfied that any required company approvals were obtained for the form of the plan actually adopted and that actual trades were effected in accordance with plan terms. Prearranged trading plans are not required to be disclosed, so reviewers should also look for 'backdated' plans, which may involve accessing the 'metadata' related to electronic copies of the plan, comparing trade dates with the dates of any public announcements that were made and checking Section 16 report disclosures relating to trades that may footnote reliance on the plan.

If the plan was effectuated through the discretionary investment authority of a broker, a reviewer should test the relationship between the broker and the insider. Are they acquaintances? Has the company reimbursed the insider for entertainment expenses involving the broker? If deemed necessary, a review could be made of phone records between the insider or company and the broker. At a minimum, an interview of the broker should occur to ascertain his independence. The reviewer should be satisfied that the broker was not influenced and did not come into possession of any inside information after the adoption of the plan.

Determine Whether an Insider Was Aware of Material Nonpublic Information at the Time the Plan Was Adopted

An essential premise of properly functioning trading plans is that they were adopted when the insider was devoid of potentially market moving information. Reviewers may develop a timeline comparing the dates that prearranged trading plans were being considered and the date ranges that insiders came into possession of pieces of inside information. Often, brokers agreeing to implement a 10b5-1 plan ask the company to certify that no material nonpublic information exists at the adoption of the plan; the existence of such certifications should focus a reviewer on potential company liability for their accuracy.

Insiders are encouraged to build in a substantial delay or 'waiting period' of one to six months between adoption of a plan and initial trading. While there is nothing that automatically disqualifies trades occurring near a 10b5-1 plan adoption, such trades could suggest awareness of inside information if the trade turns out to have been near a high in the stock's price history.

Examine News Release Decisions

Next, a reviewer considering plan trades that specify particular trade dates or timing triggers should examine the role of plan participants in timing material disclosures. Consider whether news releases around the time of plan trades were issued on logical and appropriately identified dates. The reviewer should ask: Who is involved in the decision to release information? Does the record reflect any communication among the relevant parties concerning the release date selected? If a news release was postponed or accelerated, can a legitimate business reason for the change be identified? These inquiries relate not only to 'released information,' but also to information withheld from disclosure.

Some 10b5-1 plans are designed to appear more stringent by restricting trades to open trading windows, which typically open between earnings releases and subsequently filed financial statements. This could put pressure on decisions to push the release of certain details to the financial statements, such as one-time charges that bring earnings per share within guidance or material changes in nonoperating expenses.

Examine Plan Terminations And Modifications

Terminating a plan will not, in and of itself, result in insider trading liability. The SEC, while acknowledging that the 'non-trade' resulting from a 10b5-1 plan termination cannot generally form the basis of liability, has also indicated that 'termination of a plan ' could affect the availability of the [10b5-1 plan] defense for prior plan transactions if it calls into question whether the plan was 'entered into in good faith.” Likewise, compliance with the good faith requirement could be questioned by plan terminations followed shortly by new plans and trades. (Allegations of jumping in and out of 10b5-1 plans were involved in the recent insider trading proceedings against former Qwest International CEO Joseph Nacchio.)

Amendments to a 10b5-1 plan can be even more problematic. Any amendment should be considered the termination of the old plan and the adoption of a new plan. The analysis of whether the insider possessed material nonpublic information must be repeated at the time of the amendment. Multiple amendments will likely give rise to presumptions of bad faith.

Did the insider trade outside of a plan? Adoption of a plan does not necessarily preclude trading outside of a plan. However, trades made outside of the plan do not benefit from the safe harbor and could be indicia of strategic trading, especially if the outside trades seem to hedge against the effects of plan instructions. Reviewers should determine if there were identifiable financial needs or objectives motivating non-plan trades. The absence of extenuating circumstances does not mean that a trade need be considered tainted, but independent justifications for a trade beyond the profit motive can help to assuage doubts of skeptical outsiders.

Interview relevant parties. Any good investigation should involve questioning the people involved about the 10b5-1 transactions. Whoever made trades on behalf of insiders should be asked when the plan was communicated to him and the substance and timing of any communications with the insider or others at the company. The insider should be interviewed to elicit facts surrounding the purpose of the plan and the procedures followed in setting it up. A reviewer may also wish to interview attorneys that reviewed the plan, compliance administrators within the company, decision makers with respect to public disclosure timing and others.

Conclude the investigation. Reviewers should document all steps taken in the investigation and present any conclusions reached to the appropriate body at the company. If the report identifies any potential abuses, recommendations should likely include the engagement of independent outside assistance to investigate more exhaustively.

Best Practices Going Forward

Any report prepared should include recommendations to improve the company's 10b5-1 plan processes going forward. Each of the steps above includes a corollary 'best practice' for future 10b5-1 plan procedures that should be formalized in a written policy. Some examples of policy components that most companies will find useful are:

• The only 10b5-1-related exceptions to the company's blackout policies should be for formally adopted plans that have been reviewed by in-house counsel for compliance with the rule.
• 10b5-1 plans should only be initiated during an open trading window, and the first trade should be delayed until several months after adoption.
• Plans should not be permitted to be amended or terminated early in the absence of extraordinary circumstances.
• Preferably, all 10b5-1 plans would be handled by the same fully independent broker, and in-house counsel would work closely with the broker to ensure that Section 16 reports are timely filed.

Conclusion

It is likely that trades under 10b5-1 plans will come under additional scrutiny in the near future. Companies should take proactive steps today to assure themselves that their own insiders are not likely to get caught up in investigations and that their policies are effective to prevent abuses. Some practical review steps can go a long way to comforting board members and GCs.

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.