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DOJ and SEC Used Data Analytics to Target Insider Trading Through 10b5-1 Plans

Charles D. Riely, Brandon D. Fox, and Sara Cervantes

Summary

  • The U.S. Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) have made no secret of their interest in combatting potential insider trading by high-level executives misusing Rule 10b5-1 plans.
  • Those plans provide a potential safe harbor for executives trading their company’s stock, but the SEC has expressed concerns about how those plans are used in practice and has issued new rules accordingly. The DOJ has also made no secret that it is using data analytics to root out misconduct.
  • The SEC’s and DOJ’s focus on 10b5-1 plans has important implications both for the companies that administer those plans and the executives who make use of them.
DOJ and SEC Used Data Analytics to Target Insider Trading Through 10b5-1 Plans
Lisa-Blue via Getty Images

The U.S. Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) have made no secret of their interest in combatting potential insider trading by high-level executives misusing Rule 10b5-1 plans. Those plans provide a potential safe harbor for executives trading their company’s stock, but the SEC has expressed concerns about how those plans are used in practice and has issued new rules accordingly. The DOJ has also made no secret that it is using data analytics to root out misconduct.

In recent cases filed, the DOJ and SEC both brought charges specifically targeting trading on material nonpublic information (MNPI) through a Rule 10b5-1 plan. There, Ontrak’s chairman, Terren Peizer, was selling millions of dollars of the company’s stocks while he allegedly knew that the company’s relationship with its key customer was in peril. After that customer relationship was publicly severed, Ontrak’s stock price went down by over 40 percent, and the government alleges that Peizer saved more than $12 million by selling company stock when he did.

This is the first criminal case involving 10b5-1 plans. The agencies highlighted that it was the result of an ongoing effort to specifically identify potential misconduct related to 10b5-1 plans. The SEC’s press release highlighted that “the investigation arose from a data-driven initiative into executive trading pursuant to 10b5-1 plans.” The DOJ similarly credited its “data-driven initiative . . . to identify executive abuses of 10b5-1 trading plans.” In a speech at the American Bar Association’s National Institute on White Collar Crime in Miami, on March 3, 2023, Assistant Attorney General Kenneth Polite, Jr., highlighted the case and indicated it may be a part of a coming wave, telling the audience to “take note. Because I expect others will follow.” This article describes what happened in this case and discusses key takeaways for companies and high-level executives at publicly traded companies.

Background on 10b5-1 Plans

Rule 10b5-1 is the codification of the SEC’s position that the purchase or sale of a security on the basis of MNPI and in breach of a duty of trust constitutes a manipulative or deceptive device prohibited by Section 10(b) of the Exchange Act. Rule 10b5-1 also provides a safe harbor in the form of an affirmative defense against allegations of insider trading when a Rule 10b5-1 plan is used. In December 2022, the SEC adopted several rule and form amendments, adding more conditions to the availability of 10b5-1 plans in an effort to “address critical gaps in the SEC’s insider trading regime.” Among other new requirements, 10b5-1 plans now require a mandatory cooling-off period between entering the plan and executing securities transactions, as well as additional disclosures certifying that the transactions are not based on MNPI and that the company has anti-insider trading policies in place.

Background on the Peizer Case

The enforcement actions against Peizer highlight that the government is focused on identifying potential misconduct arising from 10b51 plans. In the charging documents, the government alleged a relatively straightforward insider trading scheme in which Peizer, as chairman of Ontrak’s board of directors, knew that the company’s agreement with its key customer was in peril. Peizer allegedly participated in dialogue with Ontrak’s chief executive officer and consultants to try to salvage the customer relationship, which represented over half of Ontrak’s annual revenue. Because of these conversations, Peizer received updates on the attempts to repair the relationship, which were reportedly not going well. For example, the government alleges that in July 2021, an Ontrak consultant sent a text message to Peizer stating that the customer had drastically reduced its business with Ontrak and that business from the customer was “a trickle at this point.” A month later, Peizer allegedly called an Ontrak executive, who was tasked with leading the contract renegotiations with the key customer, to find out about the likelihood of Ontrak retaining the customer. That executive allegedly told Peizer it was likely that the customer would formally terminate its relationship with Ontrak.

At the same time Peizer was privy to this nonpublic information, he allegedly entered into 10b5-1 plans providing for the immediate sale of Ontrak securities. Pursuant to those plans, he sold $20 million worth of Ontrak stock. The government alleges that Peizer entered into one of these plans the same day that Peizer learned that Ontrak would likely lose its key customer. For each plan he entered into, Peizer began selling his shares immediately, allegedly ignoring warnings from multiple brokers that industry best practice was to implement a 30-day cooling-off period between entering into the 10b5-1 plan and selling his stocks. The SEC stated in the charging documents that the “longer the period of time between the date that a trading plan is adopted and the date of the first transaction to be executed under the plan—the ‘cooling off period’—the less likely that a corporate insider can benefit” from MNPI. According to the government’s allegations, Peizer ignored the brokers’ warnings that skipping such a cooling-off period, together with “rapid transaction executions subsequent to plan adoption,” might “create an appearance of impropriety and call into question whether a plan adopter had MNPI at the time of plan adoption.”

After Peizer had sold his shares, Ontrak announced that its largest customer had terminated their contract, resulting in the stock price falling more than 44 percent. The government alleges that Peizer avoided over $12.7 million in losses as a result of selling his stock early based on insider information.

Implications for Executives and Companies

The SEC’s and DOJ’s focus on 10b5-1 plans has important implications both for the companies that administer those plans and the executives who make use of them.

First, companies can use the DOJ’s and SEC’s focus on these issues to highlight the importance of following best practices relating to these plans. As referenced above, the DOJ and SEC are specifically looking for insider trading by high-level executives and are using data analytics to do so. Gurbir S. Grewal, director of the SEC’s Division of Enforcement, stated in the SEC’s announcement of the charges against Peizer, “Few things undermine trust in the markets more than insiders abusing their positions for personal advantage: the SEC remains committed to investigating such abuse and holding bad actors accountable.” The DOJ echoed this statement in its own press release about the case. Assistant Attorney General Polite said that the indictment of Peizer demonstrates that the DOJ “will not allow corrupt executives to misuse 10b5-1 plans as a shield for insider trading” and that the DOJ has “embraced the use of data to proactively identify and investigate fraud” to “ensure that ordinary investors are on an equal playing field with corporate insiders.”

Second, the SEC will closely scrutinize representations by corporate executives that they do not have insider information at the time of their stock sales. Public companies, of course, are not required to instantly announce all inside information. But when executives sell stock right before a market-moving announcement, the DOJ and SEC will closely look at both the companies’ approach to disclosure and the executives’ representations that they lacked MNPI when they sold their shares. Even if the government has no basis to second-guess the timing of disclosure material required by 10b5-1, it can make the case that stock sales done in advance of that announcement involved MNPI. As the SEC stated in its complaint against Peizer, the shorter the period of time between the date of a 10b5-1 plan adoption and the first transaction executed under that plan, “the more likely an insider could benefit from material nonpublic information.”

Third, the case highlights the importance of companies ensuring that they are complying with the recently adopted changes to Rule 10b5-1. As detailed above, the amended rule now requires a mandatory cooling-off period, disclosure of company insider trading policies, and certifications that executives are entering into the plan in good faith and not transacting based on MNPI. Although this case involved conduct well before the adoption of the new rules, it highlights how the amendments can help companies prevent insider trading. For example, in Peizer, following the 90-day cooling off period may have helped avoid or at least mitigate the misconduct.

This does not mark the end of the government’s focus on 10b5-1 plans. As companies prepare for this upcoming scrutiny, they should follow 10b5-1 best practices and learn the lessons from Peizer.