The ghost of insider trading investigations may be haunting the corporate landscape again these days, but judicious use of a “Rule 10b5-1 plan” to sell stock can still provide solid protection for executives who want to avoid the specter of a visit from the Securities and Exchange Commission.
The chief of the SEC’s Enforcement Division, Linda Chatman Thomsen, caused a stir last month when she warned that the Commission would be looking “hard” at trading conducted pursuant to Rule 10b5-1. “We want to make sure that people are not doing here what they were doing with stock options,” Thomsen said in a March 8 speech. “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.”
Thomsen’s remarks came on the heels of a December 2006 study released by Stanford University professor Alan Jagolinzer, which examined more than 100,000 trades conducted by 3,000-plus executives participating in Rule 10b5-1 plans. He concluded that the trades by those executives outperformed trades by executives who did not participate in such a plan by almost 6 percent.
This study and others suggest that Rule 10b5-1 “is being abused,” Thomsen said in her speech.
In theory, Rule 10b5-1 plans protect executives from allegations of insider trading because they force the executives to buy or sell a fixed amount of stock at fixed times—say, the 15th of every month—regardless of where the stock price may be moving at that particular time.
Thomsen
Thomsen’s comments and recent SEC enforcement actions, however, have given believers in that idea pause. On March 13, New Century Finance Corp. disclosed in filings that its stock sales are being investigated by federal prosecutors, as well as by the SEC and New York Stock Exchange. Exactly what is being investigated remains unclear right now, but news reports suggest that 650,000 shares sold by New Century’s founders in 2006 pursuant to Rule 10b5-1 plans could be implicated. Abuse of such plans also figured in the case against former Qwest Communications chief executive Joseph Nacchio, currently on trial for insider trading.
‘Take A Careful Look’
SPEECH
Below is the text of a March 8 speech delivered by Linda Chatman Thomsen, the SEC's head of enforcement, on insider trading.
On another front, a week ago today we filed the largest insider trading case against Wall Street professionals since the days of Ivan Boesky and Dennis Levine. Our complaint alleged two overlapping insider trading schemes: One involved trading ahead of upcoming UBS analyst upgrades and downgrades, where the center of the scheme was a senior professional who served on a powerful internal committee dedicated to reviewing and approving UBS's proposed analyst recommendations. The other scheme involved trading ahead of corporate acquisition announcements using information stolen from Morgan Stanley. At the center of that scheme was a lawyer in Morgan Stanley's global compliance department, whose duties included safeguarding confidential information. All told, the case alleged unlawful conduct by 14 defendants, including eight Wall Street professionals, three hedge funds, two broker-dealers and a day-trading firm. We allege conduct that occurred over five years and involved hundreds of tips, thousands of trades and millions of dollars in illegal profits.
From my vantage point, it seems to me greed and money continue to be powerful, powerful motivators that aren't going away. It should come as no surprise that we are not going away either. We've got plenty to do and we're doing it.
Let's turn for a moment to sanctions. To be sure, they are costly in the short term, which to a certain extent, is the point. All law enforcement theory supports the concept that sanctions have to be high enough that people want to avoid them. As we just discussed, Professor Grundfest's analysis suggests our sanctions have done exactly what sanctions are supposed to do—deter and reduce incidents of illegal behavior. In recent years our efforts have been increasingly focused on the future. We look at the steps taken, and in some instances we insist that steps be taken, to avoid similar misconduct in the future. Some argue this amounts to regulation by enforcement—changing the rules. I submit we aren't changing rules, we're changing conduct to comply with existing rules. That's what deterrence is all about. Today, at least in part due to our efforts, companies and individuals are increasingly coming forward to report wrongdoing instead of waiting for us to find it. They are cooperating with law enforcement and are taking proactive remedial steps. More importantly, they are adopting systematic prophylactic measures to detect and deter violations. The stock option backdating area provides clear evidence of this trend, as companies across the country have commenced internal investigations and self-reported to the SEC, fired wrongdoers and revised their options-granting practices. In many cases, all this has happened without so much as a phone call from the SEC. And this is as it should be: no legitimate business should tolerate illegitimacy within its walls, and neither should any legitimate market ...
One significant consequence of high-profile corporate scandals is, as we all know, a call for increased regulation. Investors feel cheated, Congress and regulators feel obligated to take action to seek to prevent a recurrence of the factors that led to the scandals, and often the result is additional law and regulations. Sarbanes-Oxley is a case in point. While these additional laws and regulations often have beneficial effects, as Sarbanes-Oxley is widely acknowledged to have had, there is no doubt they also impose costs on companies. A critical point that often gets lost in the debate, though, is that financial scandals are preventable—if companies don't engage in illegal conduct, no one is going to be clamoring for more laws or more regulations. Pause for a moment and think about the airline industry—I doubt anyone would be talking about a passengers' bill of rights, if airlines hadn't left passengers sitting on tarmacs for hours on end ...
And that includes buying into the big picture—no line-drawing, edge-skating, pretzel-twisting or distinction-making among shades of grey. On that topic, let me share a current example. In 2000, the SEC enacted Rule 10b5-1 in order to clarify the law about when executives who may come into possession of inside information can legally trade. Rule 10b5-1 allows corporate executives to make a plan, at a time when they are not in possession of inside information, to make prearranged trades at specified prices or dates in the future. The idea was to give executives "a safe harbor" to proceed with these prearranged trades without facing charges of insider trading. The Rule was intended to give executives regular opportunities to liquidate their stock holdings—to pay their kids' college tuition, for example—without risk of inadvertently facing an insider trading inquiry. However, recent academic studies suggest that the Rule is being abused.19 The academic data shows that executives who trade within a 10b5-1 plan outperform their peers who trade outside of such a plan by nearly 6%; it ought to be the case that plan participants should be no more successful on average than those who trade outside a plan. The difference seems to be that executives with plans sell more frequently and more strategically ahead of announcements of bad news. This raises the possibility that plans are being abused in various ways to facilitate trading based on inside information. 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.
Source
Securities and Exchange Commission (March 8, 2007)
Deese
Nicole Deese, a lawyer with the Fowler White Boggs Banker law firm, says Rule 10b5-1 plans are “not necessarily working the way people had originally intended.” When originally enacted, the plans were supposed to be a safe harbor from insider trading accusations, she says. “But they may be being used now possibly to engage in insider trading or market manipulation—though I’m not sure we know what that something is that is going on.”
And Rick Burdick, a partner with the law firm Akin Gump Strauss Hauer & Feld, says companies and executives “have taken these things for granted. They’ve felt as long as there’s a 10b5-1 plan it’s OK. But they have to take a careful look at what information they have at the time they enter into the 10b5-1 plan.”
According to Gary Brown, a partner with Baker Donelson Bearman Caldwell & Berkowitz, several steps can be taken to avoid worries about Rule 10b5-1 plans. Among them:
Publicly disclose the fact that executives have such plans;
Don’t adopt the plans when an executive is in possession of material nonpublic information;
Put some time between the adoption of the plan and when the first trade is made;
Promptly report sales on a Form 4, the filing that discloses insider sales to the SEC and the public;
Exercise cautioning in amending the plan, and especially in terminating it; and
Make sure that the relationship with the broker doesn’t suggest that the executive is still making the decisions.
Still, Brown says the Stanford study might exaggerate the scope of the insider trading problem today. He says the ultimate conclusion of the study—that trades conducted pursuant to Rule 10b5-1 plans outperform other trading activity—isn’t necessarily a sign of anything nefarious.
He also notes that Rule 10b5-1 plans allow trades to be made when they might otherwise be precluded by blackout periods, and that people who don’t have 10b5-1 plans may “err on the side of not trading” at times, even when they have no material nonpublic information, to avoid any appearance of insider dealing.
Brown
“Are there ways to manipulate these plans? You bet,” Brown says. For example, an executive could create a plan that sells stock on a certain date, and then control the timing of the company’s release of news that might affect the share price. “That would be a violation of the rule,” he says. “You haven’t entered into the plan in good faith. If somebody was doing that, yeah that’s a problem.”
Avoiding Problems
Deese notes that the Stanford study pointed to particular suspicion over the termination and adoption of plans in possible anticipation of news. So “first and foremost, companies need to look at the plans that have been implemented … and make sure they’re not being canceled or modified so that they precipitate or follow a positive or negative news announcement,” she says. “And trading immediately following implementation of the plan might suggest that they had information when they designed the plan.”
Burdick says executives could “feel comfortable” if the plan didn’t even allow for termination. “As long as the person didn’t have any material information at the time they put the plan in place, everything should be OK.”
He says that people “don’t have enough information right now” to determine the extent of the problem, if any, with Rule 10b5-1 plans, but says he wouldn’t be surprised to see the SEC carefully scrutinize how plans are working and contemplate whether rules changes might be necessary.
Van Dorn
Walter Van Dorn, a partner with the law firm Thacher Proffitt & Wood, says the recent wave of concern over Rule 10b5-1 plans may be “a knee-jerk reaction” to “the many scandals and problems in the securities industry.”
Van Dorn notes that there’s nothing wrong with executives being “bullish” about their company’s prospects. “If you’re hopeful that your company is going to do better, it’s not a bad thing to set up a plan to buy more stock.”
The “bottom line,” says Van Dorn, is that “if you enter into these plans when you don’t have any inside information, you should be safe. That’s the best way to do it.”
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