The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

As reflected in the most recent dismissal motion rulings in the Countrywide subprime securities lawsuit, the proper use of a Rule 10b5-1 trading plan can provide a substantial defense to allegations of securities law violations. In her April 6, 2009 opinion (here), Central District of California Mariana Pfaelzer dismissed the insider trading allegations against certain individual defendants whose trading plans were in order. However, she refused to dismiss the insider trading allegations against Countrywide CEO Angelo Mozillo, whose plan was ‘unusually modified," demonstrating that merely having a plan is by itself not enough, if the plan is not structured properly or has been altered.

This difference in outcome underscores the need for certainty about what plan features and practices will afford the desired protection under the Rule. In a March 25, 2009 update (here), the SEC’s Division of Corporate Finance updated its Exchange Rules Compliance and Disclosure Interpretations (C&DI) to provide additional guidance on Rule 10b5-1.

As reflected in an April 17, 2009 DLA Piper memo (here) discussing the SEC’s recent updated guidance, the update "comes at a time of heightened and well-publicized scrutiny by the Enforcement Division of the SEC regarding trading activity in and around Rule 10b5-1 plans." According to the law firm memo, the updated C&DI includes "some important new guidance."

As discussed in the memo, the updated guidance clarifies that "the cancellation of one of more plan transactions" affects the availability of the affirmative defense under the Rule, because the cancellations represent an alteration of or deviation from the plan. Similarly, the facts and circumstances surrounding the creation of a new plan after the cancellation of a prior plan needs to be evaluated to determine the "good faith" intent of the person creating the plan.

The updated guidance also clarifies that the affirmative defense is not available if a person establishes a plan while in the possession of material nonpublic information, even if the plan is structured so that the transactions will not begin until after the information is made public.

The SEC’s issuance of updated guidance is instructive and helpful, because Rule 10b5-1 plans can be a very important tool for individuals to use to try to limit their liability when they trade in the personal shares in company stock. As discussed at greater length here, the Eighth Circuit’s October 16, 2008 opinion in the Centene Corporation securities litigation underscored the fact that these plans are still a good idea, notwithstanding some of the concerns that recently have been raised. In that case, the court held that there could be no inference of scienter from insider sales made pursuant to Rule 10b5-1 plans.

Melissa Klein Aguilar has an April 21, 2009 article in Compliance Week (here) discussing the SEC’s updated guidance. Hat tip to Bruce Carton at the Securities Docketfor the tweet that alerted me to Aguilar’s article.

New ERISA Litigation Study: A frequently recurring question is whether I know where to find good statistical information about ERISA litigation. Unfortunately, the publicly available resources in this area are limited.

However, as reflected on the Susan Mangiero’s Pension Risk Matters blog (here), on April 15, 2009, Pension Governance Incorporated and its partner Michael-Shaked Group debuted a new study of over 2,400 ERISA cases that were filed between January 1, 2005 and August 31, 2008. A copy of the study can be found here.

The study reports a number of interesting findings, including in particular the fact that "ERISA lawsuits are increasing in number and complexity in terms of combinations of allegations." The study also breaks down the ERISA cases in the study database by type of allegation; by Circuit; by disposition; and by distribution of outcomes. The study also analyzes top litigated ERISA Code sections.

This new study is a great resource, which I hope the authors will continue to update and publish. I also hope that in future updates, the authors might consider publishing aggregate settlement data, along the lines that NERA and Cornerstone publish with respect to securities class action cases.

And Finally: At least according to a story that is making the rounds on the Internet (here), Demitrius Soupolos of Stuttgart, Germany, and his former beauty queen wife, Traute, were unable to have children because, as he was advised by his doctor, Soupolos is sterile. So Soupolos paid $2,500 to his neighbor, Frank Maus, already the father of two children, to impregnate Traute.

About three times a week over the course of six months -- a total of 72 different times -- Maus "attempted to impregnate" Traute. When Traute did not become pregnant, Maus had his own medical exam.

Turns out that Maus, too, is sterile, which "shocked everyone but his wife, who was forced to confess that Maus was not the real father of their two children." Soupolos has now sued Maus to get his money back. Maus’s defense? He did not guarantee conception, only that he would give it "an honest effort." The news articles do not report on how things stand now between Maus and his wife.

All of which makes me wonder, shouldn’t somebody look into whether there is something in the water supply that is causing the men in the neighborhood to become sterile? And do you suppose Soupolos will ask Maus’s wife for the name of the father of her children?

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Following closely on the heels of the denial of the motion to dismiss in the Countrywide case earlier this week (about which refer here), on December 3, 2008, Judge Dean Pregerson of the Central District of California issued an opinion (here) denying the defendants’ motions to dismiss in the New Century Financial Corporation securities class action lawsuit.

Background

New Century was at one time the largest subprime mortgage lender. However, on April 2, 2007, the company filed for Chapter 11 bankruptcy protection. In a development with significance for the securities lawsuit, in March 2008, the New Century bankruptcy examiner filed a report (refer here) finding, among other things, that the company had "engaged in a number of significant improper and imprudent practices related to its loan originations" that "created a ticking time bomb that detonated in 2007."

The lead plaintiff in the New Century securities lawsuit is the New York State Teachers’ Retirement System. The plaintiff filed a consolidated class action complaint on September 14, 2007, and the defendants moved to dismiss. On January 31, 2008, as discussed here, Judge Pregerson granted the motions dismiss without prejudice, but the dismissal focused entirely on the organization and complexity complaint and the court’s difficulty in evaluating the basis of the plaintiff’s claims. Thereafter, the plaintiff’s filed a second consolidated amended complaint (refer here, referred to below as the amended complaint) and the defendants again moved to dismiss.

The amended complaint names as defendants certain officers and directors of New Century; its former auditor, KPMG; and the investment banks that underwrote certain New Century securities offerings. The complaint alleges that the defendants

misrepresented New Century’s ability to repurchase defaulted loans; overvalued its residual interests in securitizations; falsely certified the adequacy of its internal controls, loan origination standards, and the quality of its loans; and failed to identify these problems in public statements, registration documents, audits, or elsewhere.

Further background regarding the case can be found here.

Judge Pregerson’s Opinion

In his December 3 opinion, Judge Pregerson first considered whether the amended complaint remedied the organization and clarity issues for which he had previously granted the defendants’ motions to dismiss. While noting that the amended complaint is "truly massive" and commenting that he "questions whether the Complaint provides a manageable road map for litigation," he nevertheless concluded that the amended complaint was "responsive to the concerns" and that he was "now able to evaluate whether the allegations sufficiently state a claim." He also recognized that the PSLRA’s "stringent pleading requirements appear to invite both parties to throw everything and the kitchen sink into their respective pleading."

In turning to the merits, Judge Pregerson examined whether the plaintiffs could rely on the "group pleading doctrine," under which "group published documents" (e.g, press releases) for which there is not identified author can be considered the collective work of those with direct involvement in the company’s day-to-day affairs.

After reviewing the relevant case law, and noting that the Ninth Circuit had not expressly rejected the doctrine, Judge Pregerson joined the "majority of other courts in the Circuit" and held that "group pleading" is not longer viable under the PSLRA. He dismissed the plaintiff’s allegations that were made in reliance on the group pleading doctrine. However, he also noted that because the amended complaint alleges attributed misrepresentations that do not rest on the doctrine as to each of the officer defendants, his holding regarding group pleading "does not preclude any of the Officer Defendants from liability."

Judge Pregerson then addressed the 10b-5 allegations in the amended complaint. He concluded that the amended complaint adequately alleged falsity as to loan quality and underwriting and as to financial reporting and internal controls. Interestingly, in concluded that the allegations concerning loan quality and underwriting standards adequately alleged that the statements were false and misleading when made, Judge Pregerson expressly noted that other district courts in the Ninth Circuit had "found similar statements regarding loan quality and underwriting to provide a basis for actionable securities law violations," citing the Countrywide and Accredited Home Lenders decisions. (Refer here regarding the Accredited Home Lenders decision.)

On the issue of scienter, Judge Pregerson found that the amended complaint

sufficiently alleged facts giving rise to a strong inference that the Officer Defendants were at least deliberately reckless in making misrepresentations as to loan quality, internal controls and various financial statements.

Judge Pregerson noted that "the confidential witness statements describe a staggering race-to-the-bottom of loan quality and underwriting standards," noting that "the witnesses catalog an explosive increase in risky loan product." The allegations

are sufficient to infer a deliberately reckless set of statements telling the public one thing when New Century was doing something quite different – the loans were poor, not great quality; the underwriting was all but absent, not strict; and the internal controls were slack rather than searching.

Judge Pregerson also found that the insider trading allegations supported his finding of the adequacy of the scienter allegations, as did the allegations regarding the defendants’ bonus and other compensation. In that regard, it is interesting to note that Judge Pregerson specifically observed with respect to the defendants’ trading plans that "the timing of the 10b5-1 plans, several years after they became available, at least raises the question precisely why there was a delay in creating these plans, and why they were formed during the Class Period."

Judge Pregerson also denied KPMG’s motion to dismiss. The firm had issued an audit opinion on the company’s 2005 financial statements. He found that the amended complaint adequately alleged that KPMG was aware of accounting and internal control deficiencies but nevertheless issued its audit opinion. He found that the allegations against KPMG adequately alleged scienter and loss causation.

Finally, Judge Pregerson concluded that the amended complaint adequately pled claims under Section 11 in connection with New Century’s securities offerings, including as to the Underwriter Defendants.

Discussion

Judge Pregerson’s opinion is another subprime-related securities lawsuit pleading-stage victory in favor of plaintiffs. The New Century opinion, together with the recent decision in the Countrywide case,  undermine the suggestion (refer here) that plaintiffs may not be faring well in the subprime related litigation. These cases establish that in at least some instances, plaintiffs can satisfy the pleading requirements, notwithstanding the fact that the current financial crisis has affected virtually every company and every segment of the economy.

Moreover, both the New Century and the Countrywide opinions are sweeping and strongly worded. The potential for these cases to take on a collective power may be seen in Judge Pregerson’s own reference, in connection with the loan quality and underwriting standards allegations, to the conclusions in prior rulings in other cases. A developing body of judicial decisions potentially could take on a collective and persuasive weight that could affect other cases.

Judge Pregerson’s ruling with respect to KPMG is also noteworthy. His decision may have been influenced by the strongly worded findings in the New Century bankruptcy examiner’s report. But in any event, his willingness to permit the allegations as to KPMG to go forward may suggest the possibility that auditors could be targeted in at least some other subprime and credit crisis related cases.

One interesting note in the opinion is Judge Pregerson’s reference to the defendants’ trading pursuant to Rule 10b5-1 plans. As in the Countrywide case, Judge Pregerson found that the defendants’ use of the trading plans raised suspicions. Rule 10b5-1 was intended to provide a way for insiders to trade without liability concerns, yet, ironically perhaps, the defendants’ implementation of trading plans was in and of itself found in these cases to be grounds for suspicion. As I have noted elsewhere (here), Rule 10b5-1 plans can still be a good idea if properly implemented, but they clearly can be dangerous is not used properly.

A final observation about Judge Pregerson’s comments on the trading plans. There is an odd note in his consideration of the defendants’ plans. He referred, with suspicion, to the timing of the defendants’ adoption of plans "several years after they became available." This is a curious statement, as if he is suggesting that the very fact that the defendants decided to adopt a plan later is itself suspicious. These seems to me to be the very kind of circumstances in which there a host of alternative innocent inferences, including even the possibility that the defendant just didn’t get around to doing it for awhile. The suggestion that a belated adoption is suspicious would potentially bar anyone who has not already adopted a plan from doing so now, which obviously would undermine the Rule’s purposes of attempting to allow corporate officials to trade in company shares without liability concerns.

In any event, I have added the New Century decision to my table of subprime and credit crisis-related lawsuit dismissals and denials, which can be accessed here.

D&O Indemnification and Insurance: As the credit crisis litigation wave gains momentum, issues surrounding indemnification and insurance for directors and officers are becoming increasingly important. A December 3, 2008 memo by the Gibson, Dunn & Crutcher law firm entitled "Director and Officer Indemnification and Insurance in Turbulent Times" (here) takes a look at recent case law developments regarding indemnification and review the key issues concerning D&O insurance.

The memo provides a good summary overview of these issues. I note parenthetically that readers who may be interested in more detail regarding the specific items in the memo can refer back to this blog, where I have discussed at greater length each of the items discussed in the memo.

One particularly noteworthy observation in the memo is the statement with respect to D&O insurance that:

Due to the complexity of policy language and the issues involved, expert advice from qualified insurance and legal professionals can be important in obtaining a thorough understanding of the coverage available under a company’s D&O insurance program. A growing number of boards of directors are seeking comprehensive analyses of their companies’ D&O insurance programs, undertaken with the assistance of experts, in connection with the purchase or renewal of D&O insurance coverage.

As suggested in the memo, I have also noted that more boards are now seeking outside reviews of their insurance, and that an increasing number of boards (and, in particular, independent directors) are interested in a review of their insurance independent from the company’s broker or regular outside counsel, whom boards apparently are concerned have their first loyalties to company management. I have in recent months taken on a number of assignments along these lines, and I am available to discuss these services for others who may be interested.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Most of the focus on Rule 10b5-1 plans lately has been on possible abuses (refer, for example here). Indeed, one of the reasons the court cited in the dismissal motion denial in the Countrywide derivative lawsuit pending in California was concern about Angelo Mozillo’s possible manipulation of his 10b5-1 plan (refer here). 

However, an October 16, 2008 Eighth Circuit opinion in Elam v. Neidorff (here) confirms that corporate officials’ proper use of Rule 10b5-1 plans can still afford a substantial securities lawsuit defense.

As discussed more fully here, on July 28, 2006, plaintiffs had initiated a securities class action lawsuit against Centene Corporation and certain of its directors and officers. On June 29, 2007, Judge Catherine D. Perry of the Eastern District of Missouri granted the defendants’ motion to dismiss, on the grounds that "plaintiffs have not met the heavy pleading standard required" by the PSLRA. Judge Perry’s opinion can be found here. The plaintiffs appealed.

The Eighth Circuit, in an opinion written by Judge Bobby E. Shepherd, affirmed the district court’s ruling on two grounds. First, the Court held that "the district court properly found that plaintiffs have not adequately pled that defendants’ … statements were false when made." Second, the Eight Circuit held that "the district court properly found that plaintiffs have not met the PSLRA’s standard for pleading scienter."

In ruling that the plaintiffs had not adequately pled scienter, the Eighth Circuit considered among other things, the fact that the individual defendants’ stock sales on which the plaintiffs sought to rely had been made pursuant to a Rule 10b5-1 trading plan.

The Court’s opinion stated (citations and internal quotations omitted):

Neidorff and Witty each sold a portion of their personal holdings of Centene stock in April 2006 pursuant to Rule 10b5-1 trading plans, in place since December 2005. The sales constituted 5.3 percent of Neidorff’s unrestricted holdings and 2.4 percent of Witty’s unrestricted holdings. Stock sales pursuant to Rule 10b5-1 trading plans can raise an inference that the sales were prescheduled and not suspicious. This is particularly true where, as here, the stock sales at issue represent only a small portion of each seller’s overall holdings. Accordingly, no inference of scienter arises from Neidorff’s and Witty’s April 2006 stock sales.

The Eighth Circuit’s opinion is a reminder that, notwithstanding the concerns that recently have been raised about possible Rule 10b5-1 plan abuses, proper trading plans can afford substantial protection and can permit company officials to trade in their shares in company stock without fear that the trades might later serve as the basis of liability under the federal securities laws.

As examples of trading plans that successfully averted any scienter inference, the Centene officials’ plans merit a closer look.

The Eighth Circuit stated that the individual defendants’ trading plans "lay out in advance the dates at which the trade will be made in advance and give control of the trades to a broker." The District Court’s dismissal opinion stated further that the plaints "provided for automatic sales on certain dates if the stock price was above $25." The only sales made under the plans, which were instituted in December 2005, were two in February and April 2006. "There were no later sales, not because defendants halted the program, but because the stock price never reached the $25 mark."

The critical aspects of the plan appear to have been, first, that the officials entered the plan in advance; second, that the plan specified the trading dates, but subject further to a specified trading price: three, that the trading on those dates, if the price criterion was met, was automatic; and fourth, that a broker controlled the trades. It does not seem to have mattered that the officials did not trade regularly under their plans, because of the minimum share price requirement.

It is probably important to note that the plan lacked many of the attributes that recently have drawn negative attention to these kinds of plans. That is, the Centene officials’ plans were not changed, nor were the plans stopped and started; and the individuals were not running multiple plans.

Amidst the negative publicity that recently has surrounded Rule 10b5-1 plans, the Eighth Circuit’s opinion is a useful reminder that Rule 10b5-1 plans can and should be a part of a coordinated securities litigation loss prevention program. A comprehensive (although now slightly dated)overview of securities litigation loss prevention in general can be found here.

The 10b-5 Daily blog has a post relating to the Eighth Circuit’s opinion here, as does the Securities Docket, here.

Not Exactly Lou Gehrig’s Farewell Speech, But Still Entertaining: If you have not yet seen the October 17, 2008 farewell letter from Andrew Lahde of Lahde Capital Management, you will want to refer here. Lahde, one of whose funds returned 870 percent last year by betting against subprime mortgages, decided to close down his funds and return money to investors after concluding that the danger of losing money from a bank collapse was too high.

Lahde claims that he wrote his farewell letter "not to gloat" -- but darned if his letter nevertheless doesn’t sound an awful lot like gloating (except for the part where he is advocating the legalization of marijuana). The letter is worth reading in full for its entertainment value, but among the highlights is the following single-finger salute to his now-former competitors and counterparties:

The low hanging fruit, i.e., idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.

Lahde also suggests the institution of a forum (perhaps to be funded by George Soros) to "create a new system of government that truly represents the common man’s interest, while at the same time creating rewards great enough to attract the best and the brightest minds to serve in government roles without having to rely on corruption to further their interests or lifestyles. The forum could be similar to the one used to create the operating system, Linux."

Wikigovernment. Cool.

Special thanks to Peter Schwartz of the Wired Mosaic blog (here) for bringing Lahde’s letter to my attention.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

As a result of recent academic research (refer here and here) and other recent developments, Rule 10b5-1 trading plans have attracted critical attention, including SEC scrutiny (refer here). Allegations of alleged misuse of Rule 10b5-1 trading plans have even made their way into shareholder litigation. For example, allegations of Andrew Mozillo’s alleged misuse of his Rule 10b5-1 plans are a central part of the Countrywide shareholders’ derivative complaint (refer here).

An August 18, 2008 Latham & Watkins memorandum entitled "Rule 10b5-1 Plans: Recommended Guidelines for Managing Risks in the Current Environment" (here) takes a look at the heightened scrutiny currently surrounding Rule 10b-1 trading plans and presents a set of "better practices to consider" in developing and deploying the plans.

Among other things, the authors examine the Rule’s various requirements, and in particular the Rule’s provision specifying that an individual may "in good faith" modify a prior plan, so long as he or she is not aware of material nonpublic information at the time of the modification. The authors correctly note that "the good faith requirement is an important constraining, and problematic, factor because it is inherently subjective. Modifications that do not have a good faith justification will lose the benefit of the affirmative defense. Frequent modifications may be especially hard to justify."

The authors review other questions that have been raised in connection with Rule 10b5-1 plan structure and implementation. They suggest that to avoid these kinds of problems or questions companies can adopt certain guidelines to "limit opportunities for their insiders to engage in abusive practices, and more importantly, to avoid the appearance of practices that might be viewed as abusive based on later developments."

The authors make a number of good, practical suggestions that should go a long way toward avoiding some of the issues that have raised questions in connection with Rule 10b5-1 plans. The suggestions that appear particularly important in light of recent questions is the authors’ suggestions that "companies should prohibit insiders from entering multiple overlapping 10b5-1 plans," and that companies should promptly disclose insiders’ adoption of Rule 10b5-1 plans through a press release or 8-K filing. The authors also suggest tight restrictions on plan modifications and terminations, as well as on "fast sales," suggesting instead a requirement for a cooling off period.

The recent questions surrounding alleged Rule 10b5-1 plan misuse haveraised concerns about the protective value these plans may offer. But as the authors make clear, properly structured plans may continue to provide valuable protection. It is true that insiders who are starting or stopping plans, or running multiple plans, may find themselves unable to rely on the Rule’s safe harbor. But trading plans structured and implemented according to the original intent of the Rule should still afford the protection for which the Rule was designed.

Special thanks to Adam Savett of the Securities Litigation Watch blog for providing me with a copy of the Latham & Watkins memorandum.

Rating Agencies and Subprime Litigation: As I noted in a prior post (here), the SEC recently released a report critical of rating agencies’ "shortcomings" in connection with their provision of ratings on mortgage-backed securities and other instruments now at the cent of the subprime meltdown. As also discussed in a separate prior post (here), claimants in a recent securities lawsuit have also raised allegations against the rating agencies, alleging conflicts of interest and other alleged misconduct.

According to an August 12, 2008 article entitled "Rating Agencies: A New Front in Subprime Litigation" (here), by Larry Ellsworth and Ishan Bhabha of Jenner & Block, the recently filed lawsuit naming rating agency defendants "may just be the tip of the iceberg." The authors suggest that regulatory investigations and other developments may portend further claims against the rating agencies.

However, the authors also note that the "agencies are not without defenses." In particular the rating agencies may be able to rely on case authority developed in connection with the Orange County and Enron cases that their rating activities are protected by the First Amendment.

The authors question whether the rating agencies will actually be able to rely on these defenses in the circumstances surrounding their rating of the subprime mortgage-backed assets and other related instruments. The authors note that "the agencies only rated those securities for which they were paid, and furthermore had substantial and ongoing involvement with the banks in order to structure the offerings." (For further discussion of the availability of the rating agencies’ potential defenses, refer here.)

In addition, the authors also note that "to the extent the rating agencies were actively working with issuers to help them package products in order to get a higher rating the agencies may be especially vulnerable to charges of self-dealing and conflicts of interest, and, if the agencies did not reveal these relationships, these actions might be investigated as material omissions."

The authors conclude by noting that these issues are "sure to generate contentious and interesting litigation for years to come."

• Email This
• Print
• Comments
• Trackbacks
• Share Link

In October 2000, the SEC promulgated Rule 10b5-1 to provide company insiders with a way to trade their shares in company stock without incurring securities law liability, through the pre-trading adoption of a written trading plan. Despite the Rule’s protective purpose, concerns have arisen more recently about Rule 10b5-1 plan abuses, as I noted in prior posts (here and here).

Indeed, concerns about Angelo Mozilo’s possible Rule 10b5-1 plan misuse were an important part of the court’s recent refusal to dismiss the Countrywide subprime-related derivative lawsuit. (My prior post about the Countrywide dismissal denial can be found here. A more detailed analysis of the Countrywide court’s discussion of Rule 10b5-1 plan issues can be found on The Corporate Counsel.net blog, here.)

A May 27, 2008 paper by University of Chicago Law Professor Todd Henderson, Stanford Business School Professor Alan Jagolinzer, and Penn State Business Professor Karl Muller entitled “Scienter Disclosure” (here) looks at Rule 10b5-1 plans from a different perspective, asking what can be inferred from a company’s disclosure of its officials’ plans. The authors’ surprising conclusion is that the more detailed a company’s plan disclosure, the more likely are the subsequent trades to capture abnormal trading returns.

The starting point of the authors’ analysis is that, although Rule 10b5-1 itself does not require the plans to be disclosed, “disclosure can enhance the legal protection by increasing the likelihood of early dismissal of class action lawsuits.” This “litigation benefit” arises due to the fact a Rule 10b5-1 plan trading defense will only be available at to dismissal stage if the plan is identified and described in the company’s SEC filings (which a court may consider at the initial pleading stage). If the company fully discloses the plan details, “a court may better ascertain that the allegedly fraudulent trades fall within the Rule’s affirmative defense, thereby increasing the possibility of a low-cost dismissal.”

From this, the authors infer that companies perceiving a greater litigation risk are “more apt to disclose the existence and details of Rule 10b5-1 plans.” But there are costs associated with disclosing the plans, particularly “if investors infer a price relevant signal from disclosure or if disclosure enhances investors’ monitoring of insiders’ trade plan commitment.” The “signal” might encourage investor “front running” which could deprive the insider of anticipated trading profits. The monitoring “reduces the value of early termination options” the insider might have if a planned trade no longer appears desirable.

The authors hypothesized that insiders will nonetheless prefer Rule 10b5-1 plan disclosure if the “scienter disclosure” provides incremental litigation benefit – which is likely to be greatest precisely where the ability to trade provides the greatest opportunity to profit. That is, “pre-disclosure of trade may be strategic in the face of high legal risk if it mitigates legal risk and does not fully reveal privately held information.”

The authors examined company disclosures for hundreds of companies during the period between October 2000 and December 2006, and grouped the companies according to whether the companies had low, moderate or detailed Rule 10b5-1 plan disclosure. The authors then correlated the companies’ disclosure and “subsequent firm returns and earning performance.” The authors found that “more specific 10b5-1 plan disclosures are associated with more negative post-trade abnormal returns” and that “the association between sales transactions and subsequent negative performance is increasing in disclosure specificity, after controlling for other factors that are associated with firm returns.”

As a group, executives at those companies with the most detailed disclosure avoided an average of 12% loss in the companies’ trades relative to the broader market in the six months following their sales. The authors conclude that “voluntary Rule 10b5-1 plan disclosure is associated with the higher level firm legal risk and a proxy for insider’s potential strategic trade.”

In other words, the more detailed disclosure manifests insiders’ perception that subsequent trades are more likely to be advantageous – and therefore legal protection is more likely to be important, justifying the detailed disclosure.

These data suggest, and the authors hypothesize, that “investors should respond negatively to specific disclosures regarding 10b5-1 participation, if they infer that insiders have high strategic trade potential for which they seek high litigation protection.” However, the authors found that there is no observable negative investor response to Rule 10b5-1 disclosure.

The authors’ conclusions have a number of important implications. Obviously, investors may be missing an important signal related to 10b5-1 disclosure. Another important implication relates to the protection that the Rule affords; the authors’ conclusion that the companies with the most detailed disclosure are also the ones with the most fortunate timing suggests that, at least in some companies, transparency may be facilitating aggressive stock sales. The Rule was designed to provide company officials with a way to trade safely, but the authors’ study suggests that at least some company officials may be using the Rule as a shield to unload stock at an opportune time.

While I confess that initially I found the authors’ conclusions troubling, after further reflection I am less concerned. The problem here is not that insiders are using Rule 10b5-1 plans and plan disclosure strategically – after all, the whole idea of the Rule was to facilitate trading, and there is certainly no suggestion that trades made pursuant to the Rule cannot be advantageous. The problem is that at least so far, investors have missed the negative signal that Rule 10b5-1 plan disclosure implies.

The authors themselves speculate that the absence of negative investor reaction “may indicate that there are frictions to implementing strategies based on 10b5-1 disclosure signals or that investors do not understand 10b5-1 disclosure implications, which is possible if our same period reflects the transition period regarding 10b5-1 use.” To the extent, however, that the signal is better understood, the more the marketplace itself will discipline the process.

The greater likelihood that the mere announcement of a 10b5-1 plan could undermine a company’s share price could provide a missing disciplinary constraint on strategic trading and reduce company officials’ ability to capture abnormal returns. In other words, the whole mechanism will function better if investors appreciate the significance of 10b5-1 disclosure – an appreciation that the authors’ research clearly should facilitate.

A May 27, 2008 USA Today article discussing the authors’ study can be found here. An entry on the University of Chicago Law School Faculty Blog discussing the article can be found here.

Very special thanks to Professor Henderson for alerting me to the article and for providing me with a link.

Another Options Backdating-Related Class Action Settlement: In its May 8, 2008 filing (here), Kratos Defense & Security Solutions (formerly known as Wireless Facilities) announced that in March 2008, it had reached a tentative agreement to settle the options backdating-related securities class action lawsuit pending against the company and certain of its directors and officers. The amount of the settlement is $4.5 million, of which $1.7 million will come from the company and the balance of which will come from the company’s D&O insurer.

I have added this settlement to my table of options backdating-related lawsuit settlements and dismissals, which can be accessed here.

Hat tip to Adam Savett of the Securities Litigation Watch blog (here) for providing the heads’ up about the Wireless Facilities settlement

Not Just Immune, But Infallible: If you were immensely rich and powerful, you too might well, as did the Sultan of Brunei in 2004, amend the constitution to “declare himself infallible and immune from any obligation to appear in court …and to subject anyone who criticizes him to criminal punishment.”

Those curious to know how a court might actually apply a provision like this and related legal issues will want to refer to Francis Pileggi’s Delaware Corporate and Commercial Litigation Blog (here), in which Pileggi reviews a May 23, 2008 Delaware Chancery Court decisions involving the Sultan and his brother. Among other things, Pileggi notes that in the course of reaching its decision, the Court “recites the background facts of royal family battles that could be part of a movie script.”

• Email This
• Print
• Comments
• Trackbacks
• Share Link