Seventeen years ago this month, the SEC instituted Rule 10b5-1 to permit company insiders – who often hold a significant portion of their wealth in company stock – to sell their shares without incurring liability under the federal securities laws. The Rule permits insiders who have traded in company shares to rebut the inference of scienter by showing that the trades were pre-scheduled and not suspicious. Over time, questions have been raised about the ways that some company executives have tried to use the plans. As discussed in an August 10, 2017 memo by the Simpson Thacher law firm on the CLS Blue Sky Blog entitled “Combatting Securities Fraud with 10b5-1 Trading Plans” (here), “sales made under 10b5-1 plans can substantially assist a company in getting such a claim dismissed by helping to rebut the inference of scienter that normally results when plaintiffs present evidence of insider stock sales during the class period.”
However, as discussed further below, while the plans can provide a substantial defensive boost, there are a number of steps companies should take in order to improve the likelihood that the existence of the plan will provide the intended protection.
Using Rule 10b5-1 to Rebut the Inference of Scienter
To illustrate how the existence of a trading plan can aid the defense in a securities fraud class action lawsuit, the law firm memo refers to a recent decision in the District of Massachusetts in the Tetraphase pharmaceuticals case, where the court dismissed a securities suit after determining that all of the insider trades on which the plaintiffs sought to rely had been made pursuant to Rule 10b5-1 plans established before the supposed material nonpublic information on which the plaintiffs sought to rely had become known.
Tetraphase Pharmaceuticals has been seeking to develop an antibiotic. The Phase I clinical trials for the new antibiotic were promising and the company’s share price rose. However, in September 2015, the company announced that its Phase II clinical trials had failed to meet its primary endpoint. Following the announcement, the company’s share price dropped 80%, representing a $1.3 billion market capitalization decline. Throughout the class period, the three individual defendants had made large trades in the company’s stock. As discussed here, in January 2016, plaintiffs filed a securities class action lawsuit in the District of Massachusetts against the company and the three defendants. The defendants filed a motion to dismiss.
In his May 9, 2017 order (here), Judge Leo Sorokin granted the defendants’ motion to dismiss. In their complaint, the plaintiffs alleged that the defendants knew the antibiotic would fail long before the information was released to the public. In ruling on the defendants’ dismissal motion, Judge Sorokin first determined that the plaintiffs’ allegations were insufficient to support the allegation that the defendants were aware of the disappointing clinical trial results as early as the plaintiffs had tried to suggest.
Judge Sorokin then turned to the plaintiffs’ allegations that the individual defendants’ sales of company stock supported an interference of scienter. Judge Sorokin determined that all of the trades on which the plaintiff sought to rely had been made pursuant to Rule 10b5-1 trading plans. Judge Sorokin found it particularly significant that all three plans had been established before the date on which even the plaintiffs tried to argue that the defendants possessed the results of the pivotal portion of the Phase II trial. In ruling that the existence of the Rule 10b5-1 plans rebuts the inference of scienter, Judge Sorokin noted that the mere existence of a plan is not enough to rebut the inference. He then examined the circumstances under which the individuals had created their plans. He noted that one of the defendant’s plans predated the class period, and the other defendants’ plans were created at a date prior to which it was reasonable to infer that the defendants had information about the clinical trial outcomes.
Questions Surrounding Rule 10b5-1 Trading Plans
As Judge Sorokin’s ruling in the Tetraphase Pharmaceuticals case shows, Rule 10b5-1 trading plans can provide a substantial defense to securities fraud allegations. However, the mere existence of a trading plan is not alone sufficient; courts have made it clear that they will carefully scrutinize the plans and the circumstances under which they were created and the ways in which they were implemented to ensure that the plan’s existence does actually rebut the inference of scienter.
Arguably the highest profile example of a case in which the existence of a Rule 10b5-1 trading plan faced substantial scrutiny is the 2009 enforcement action that the SEC brought against former Countrywide Financial Angelo Mozilo. A critical part of the agency’s allegations in that action was that Mozilo had manipulated multiple, overlapping Rule 10b5-1 trading plans to permit him to reap vast profits in trading his shares in company stock while he was aware of increasingly serious problem in the company’s mortgage portfolio. In October 2010, Mozilo agreed to settle the SEC’s enforcement action for a payment of $67.5 million dollars, including a $22.5 million penalty and a disgorgement of $45 million.
Periodically since that time, questions have been raised about executives’ use of Rule 10b5-1 trading plans. For example, A front page November 28, 2012 Wall Street Journal article entitled “Executives’ Good Luck in Trading Own Stock” (here), reports on the newspaper’s analysis of thousands of trades by corporate executives in their company’s stock. Among other things, the newspaper reports on 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.
The article catalogues a number of deficiencies of at least some plans that undermine the Rule’s goal of allowing insiders to trade in their company shares without creating the impression that the executives were trading because they knew something about the company that other investors did not.
Among other plan features that can cause problems, the article shows, is the ability of executives to alter or cancel plans at their own discretion. The article notes that “there is very little in the system to prevent an executive who foresees good news about the company from canceling a scheduled share sale, or an executive who foresees bad news from canceling a scheduled share purchase.”
In light of these kinds of concerns, there have been periodic calls for reforms to or revisions of the Rule, in order to reduce the possibility that insiders might manipulate these kinds of plans in order to try to mask or cover trades that otherwise might appear to be improper. For example, as discussed in in a June 2, 2016 post on the CLS Blue Sky Blog (here), Gothenburg University Professor Taylan Mavruk and University of Michigan Business School Professor H. Nejat Seyhun conclude that “safe harbor plans are being abused to hide profitable trades made while in possession of material non-public information” and suggest a number of revisions to the Rule in order to “prevent further abuse.”
Building an Effective Rule 10b5-1 Trading Plan
Because of the kinds of concerns with Rule 10b5-1 trading plans over time, courts have, the law firm memo’s authors note, “shown an increased willingness to thoroughly examine the legitimacy of Rule 10b5-1 trading plans.” The memo cites a number of examples of cases in which courts have rejected defendants arguments that the existence of the trading plans rebuts the inference of fraud.
Just the same, the authors note, while courts have “been demonstrating a greater proclivity to scrutinize 10b5-1 trading plans, these plans remain an effective method of protecting executives and preventing and defending securities fraud claims.” The authors note that there are a number of “best practices” to consider to “help ensure the maximum effectiveness of Rule 10b5-1 trading plans.” Many of the specific steps the authors suggest are specifically intended to address the concerns noted above in the preceding section of this post, including measures designed to reduce questions surrounding the timing of the creation, modification, or termination of the plan.
A critical element in the successful use of a Rule 10b5-1 trading plan is being able to show that the plan’s beneficiary created a plan at a time when they were not in possession of material non-public information. The ability to make this showing obviously was key in the outcome of the Tetraphase Pharmaceuticals case. In order to assist this showing, the memo’s authors suggest that “insiders should adopt (and amend or terminate) a 10b5-1 trading plan during an open trading window and when they are not otherwise aware of any material nonpublic information.”
The authors also suggest that the best approach is for the plan to require a waiting period before the first execution of trades under the plan. The Rule itself does not require a waiting period, but the provision for a pause removes any suggestion that the plan was created by a desire to time the market or to trade based on awareness of impending developments at the company.
Consistent with the problems that arose with Angelo Mozillo’s competing and conflicting trading plans, the authors also suggest that the existence of multiple plans “may undermine the notion that the insider entered into the 10b5-1 trading plan in good faith and while not in possession of material nonpublic information.” The authors suggest that as a general rule, executives should avoid adopting multiple, overlapping 10b5-1 trading plans.
It ought to go without saying, but just the same it probably bears emphasizing that the use of the plan to try to rebut the inference of scienter will be substantially undermined by the existence of trades outside the plan. By the same token, by the Rule’s own terms, the Rule’s protections are not available when the insider has entered into a “corresponding or hedging transaction or position” with respect to the stock in the plan.
There are other specific details of the trades permitted under the plan that can help support its defensive usefulness. For example, plans of a longer duration help mitigate the concern that the plans are merely covers for short-term trading objectives. The size of the sales permitted under the plan also can affect the way that trades under the plan are perceived. Sales of larger amounts of an insider’s stock, particularly early in the plan’s existence, may undermine its defensive usefulness.
The authors also note that while the Rule itself does not require disclosure that executives’ trades in company shares were made pursuant to Rule 10b5-1 trading plans, “it is generally best … to disclose executives’ sales made pursuant to 10b5-1 trading plans.”
In addition to the law firm memo’s authors’ suggestions, I add here a couple of suggestions of my own based on my review of the literature critical of Rule 10b5-1 trading as well as of the cases where courts have declined to find that the existence of a trading plan rebuts the inference of scienter.
First, a plan is likelier to survive scrutiny if it simply specifies the number of shares to be purchased or sold and the dates or timing of the proposed transactions. Plans based on prices, formulas, or computer programs, and or that are conditioned on future stock price or future market conditions are much more likely to be scrutinized and much less likely to help rebut the inference of scienter.
Second, in addition to publicizing that executives’ trades were made pursuant to trading plans, companies may want to go one step further and publicly disclose details of the so that both the SEC and investors can verify that the executives are actually complying with their own proposed rules. Trades subject to this kind of scrutiny seem much less likely to be questioned later.
Despite the concerns that occasionally have been raised about Rule 10b5-1 plans, and despite the evidence that the plans sometimes have been abused, the use of trading plans remains an important part of the toolkit to try to help corporate executives to trade in their company shares without incurring securities law liability. Indeed, as the recent Tetraphase Pharmaceutical ruling illustrates, a well-designed and well-executed plan can still provide substantial liability protection by allowing insiders to trade in their holdings of company stock.
For D&O insurance underwriters, a company’s use of trading plans can be an important underwriting consideration. The fact that a company has trading plans in place can be interpreted to suggest that the company and its senior officials are being proactive in trying to mitigate their securities litigation exposure. However, the extent to which the existence of the plan can be interpreted as a positive underwriting factor could depend on the specific details of the plan.
A straightforward plan created during a trading window, with a waiting period before trades can be executed, and a simple formula for the timing and size of the permitted trades, could be viewed as a substantial securities litigation loss prevention measure, and therefore as a positive factor from an underwriting perspective. However, a complicated plan with plan or the existence of multiple plans, or the existence of trades made outside of the plan, could be viewed as creating a heightened risk of securities law exposures, and therefore as representing a negative factor from an underwriting perspective. Underwriters will want to carefully consider the plan’s details and also consider whether the plan is carefully calculated to help boost the defense in the event of a securities claim.