The D & O Diary
An "Exotic Permutation" of Rule 10b5-1 Trading Plans
The Wall Street Journal is reporting again on the alleged misuse of Rule 10b5-1 trading plans. In its latest article on the topic, the newspaper examines what an SEC spokesman called an “exotic permutation” on the use of trading plans – that is, outside directors’ use of trading plans to allow investment funds they own or manage to trade in company shares.
In a November 2012 article entitled “Executives’ Good Luck in Trading Own Stock” (here), the Journal took a look at the way corporate officers’ use of trading plans facilitated profitable trades in their company stock. The newspaper’s analyzed thousands of trades by executives. Among other things, the newspaper found numerous instances where executives, trading in company shares pursuant to Rule 10b5-1 plans, managed to extract trading profits just before bad news sent share prices down or to capture gains with purchases executed just before unexpected good news.
In an April 24, 2013 article entitled “Directors Take Shelter in Trading Plans” (here) the Journal examined trades by outside directors pursuant to Rule 10b5-1 plans. The Journal found that directors’ use of the plans has jumped; the newspaper identified 2.210 nonexecutive directors who reported using the plans to sell stock since 2006. The Journal found that rather than use the plans to sell a fraction of their shares at regular intervals, “some directors use the plans to sell heavily in a short time.”
The Journal found that from 2006 through 2011, nearly a quarter of nonexecutive directors with trading plans sold more stock in one month under the plans than in the surrounding two years. Some used their plans “to unload all or the bulk of an investment fund’s holding in a company, in a spate of selling.
The article includes a detailed discussion of the share sales of a director of one specific company. The director had joined the company’s board when two funds managed by his private equity firm had invested in the company. Under a plan established in November 2011, one of the two funds sold 83% of its holdings in a series of trades during every trading day between January 3, 2011 and February 1, 2012. The trades during that period constituted 25% of the stock’s trading volume. Six days after the last trade, the company announced disappointing financial results and the company’s share price slumped. The article describes in detail the complaints of one of the company’s shareholders to the director and to company management about the trades. The article also reports the director’s explanation that the fund sold the shares in order to address a debt issue and that the private equity firm’s other fund had not sold any of its shares.
The use of trading plans by directors as a means to facilitate their investment funds’ trades in company shares was not really what the SEC had in mind when it promulgated the rule. An SEC spokesman quoted in the latest Journal article conceded that the Rule did not prohibit directors from using the plans to allow outside investment funds to trade shares, but added that the use of plans in this way also “wasn’t specifically contemplated.” The SEC spokesman described the use of plans in this way as an “exotic permutation.”
Insider trading has been an enforcement focus of the SEC and of the DoJ for some time now. So it came as no surprise after the initial Journal article late last year that the question of possible misuse of Rule 10b5-1 trading plans sparked interest with regulators. The SEC launched investigations in connection with trading activities at several of the companies mentioned in the prior Journal article.
The more recent Journal article notes that the plans “have drawn the attention of law enforcement” and reports that prosecutors have urged compliance executives “to be vigilant about trading by directors who also run investment funds.” Given the SEC”s interest in the examining the issues mentioned the prior Journal article, it seems likely that the SEC also will look into the use of trading plans described in the more recent article as well.
There is more than a small amount of irony in these concerns about Rule 10b5-1 plans. The Rule was established more than a decade ago to allow executives (whose wealth often is entirely locked up in company shares) to trade in the company’s stock without incurring possible liability under the securities laws.
There are in fact a number of cases in which courts have held that the inference of scienter that might otherwise arise from insider sales is rebutted when the sales were executed pursuant to Rule 10b5-1 trading plans. Refer here and here for a discussion of recent cases where defendants were able to rely on the Rule 10b5-1 trading plan in order to have the securities claims against them dismissed.
There is no doubt that these various allegations involving insider trading plans have put the plans in a negative light. However, as discussed here, a well-designed and well-executed plan can still provide substantial liability protection by allowing insiders to trade in their holdings of company stock without incurring securities liability exposure. Notwithstanding these recent developments, a well-designed Rule 10b5-1 plan remains an important part of securities litigation loss prevention.
There have been a number of law firm memos recently advocating the use of Rule 10b5-1 plans and providing points on proper implementation of the plans in light of the recent questions that have been raised about the plans. For example, the Covington & Burling law firm recent published a memo entitled “Rule 10b5-1 Trading Plans: Avoiding the Heat” (here). The Wilson Sonsini’s March 2013 memo entitled “Rule 10b5-1 Trading Plans: Considerations in Light of Increased Scrutiny” notes that “the aggressive use (or misuse) of Rule 10b5-1 trading plans is likely to become a significant area of focus for regulatory enforcement and securities lass action plaintiffs” and suggests steps companies can take to avoid problems.
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