The Securities and Exchange Commission (SEC) promulgated Rule 10b5-1 in October 2000 to resolve an unsettled issue over the definition of insider trading, which is prohibited by SEC Rule 10b-5. By way of background, the SEC adopted Rule 10b5-1 to permit corporate insiders, who regularly possess material nonpublic information, to sell their company shares without the risk of claims of insider trading. Pursuant to the Rule 10b5-1 safe harbor, a corporate insider can establish a trading plan specifying preestablished dates for determining when the insider can sell shares without the risk of insider trading. To be valid, the plan must, among other things, be executed while the insider is not in possession of material nonpublic information and must be implemented in good faith. If such a plan is validly established, an insider who subsequently transacts pursuant to that plan is permitted an affirmative defense to insider trading allegations.
A trio of recent events this year has shone a new spotlight on SEC Rule 10b5-1 plans:
- A Stanford study, Gaming the System: Three “Red Flags” of Potential 10b5-1 Abuse, published on January 19, 2021, presented “new evidence” on the trading behavior of corporate executives using a unique data set of over 20,000 Rule 10b5-1 plans. The study showed “that a subset of executives use 10b5-1 plans to engage in opportunistic, large-scale selling of company shares.”
- On June 7, 2021, in remarks before the Wall Street Journal’s CFO Network Summit, SEC Chair Gary Gensler identified plans to “freshen up” Rule 10b5-1 in response to “cracks in our insider trading regime”—citing the Stanford study—and outlined several areas of focus for the SEC regarding executive stock ownership and the means by which insiders sell shares in the companies with which they’re affiliated while in possession of material information that the public doesn’t have.
- On June 24, 2021, U.S. Senators Chris Van Hollen and Deb Fischer reintroduced their bipartisan Promoting Transparent Standards for Corporate Insiders Act to bring greater transparency to corporate stock trading. If enacted, the bipartisan bill would require the SEC to study the issue of insider trading, report its findings to Congress, and write additional rules restricting an insider’s ability to take advantage of the system.
In particular, the Stanford study’s authors focused on three “red flags” associated with the opportunistic use of 10b5-1 plans: (1) short cooling-off periods, (2) plans that cover a single block trade, and (3) plans that are adopted and commence trading immediately prior to earnings announcements. Chairman Gensler identified these same aspects, as well as enhanced disclosure requirements, as areas of potential reform for Rule 10b5-1.
None of this is news to plaintiffs’ lawyers and private litigants prosecuting securities fraud violations: Nearly 100 reported decisions discuss Rule 10b5-1 plans in the context of supporting a strong inference of a defendant’s scienter. See, e.g., In re Under Armour Sec. Litig., No. CV RDB-17-388, 2021 WL 1985015, at *6 (D. Md. May 18, 2021) (“This Court’s holding on scienter with respect to Defendant Plank may be supported not only by allegations regarding senior management and executives included in the SEC Order, but also specific allegations in the TAC considered in light of the Order, including Plank’s . . . entry into a Rule 10b5-1 trading plan in November 2016 and April 2016 through which he sold $138.2 million in Under Armour stock.”).
Our firm’s experience prosecuting and preparing securities fraud cases for trial supports the conclusion that the “red flag” behaviors are strongly indicative of a 10b5-1 plan that does not deserve the benefit of the safe harbor. Moreover, we suggest there are actually seven “hallmarks” (subscription required) of a valid 10b5-1 plan (as articulated by Professor M. Todd Henderson of the University of Chicago Law School): (1) a significant time lag between the plan’s adoption and the first trade; (2) regularly scheduled trades; (3) sales over long periods of time; (4) sales of relatively consistent size and relatively small amounts compared with overall shareholdings; (5) sales at a range of stock prices; (6) no changes or cancellations of the plan; and (7) a high level of board and general counsel involvement in plan adoption, alteration, and termination decisions. Congress and the SEC should assess whether the presence of these additional factors similarly reduces opportunistic abuse of 10b5-1 plans that harms investors and diminishes confidence in our capital markets.
Take the Under Armour example above. The complaint (subscription required) in that case alleged that
[a]lthough Plank’s $138.2 million in sales were purportedly made pursuant to a Rule 10b-5-1 trading plan (“Plan”) providing for his sale of Class B Common Stock and, when issued, Class C Common Stock, this supposed Plan was suspiciously entered into on October 28, 2015, while Plank was already in possession of material, non-public information about the Company—this nullifies the purpose of the Plan. Moreover, to the extent such a Plan exists, there is no indication that the dates, timing, and price of Class Period sales were pursuant to a written formula in the Plan that were not susceptible to change or influence, or that trades were in accordance with the unamended Plan. See 17 C.F.R. 240.10b5-1(c). Thus, any asserted Plan is suspect because it was entered into as a cover for Plank’s insider trading at a time he was actively engaged in deceiving investors.
The court agreed and found the 10b5-1 plan—and subsequent massive insider trading, which deviated from historical practices—bolstered the strong inference of scienter as to this defendant at the Rule 12(b)(6) stage.
As Chairman Gensler noted in June at the CFO Network Summit, these issues “speak to the confidence that investors have in the market,” and “[a]nytime we can increase investor confidence in the markets, that’s a good thing.” We urge companies, the SEC, and Congress to enhance investor protections and bolster our capital markets by ensuring that Rule 10b5-1 plans adhere to the seven “hallmarks” Professor Henderson identified.
Copyright © 2021, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Litigation Section, this committee, or the employer(s) of the author(s).