Overview

Executive suites in public companies across America took notice in recent weeks when federal prosecutors filed the first ever case based exclusively on an executive’s sale of company shares pursuant to what is commonly referred to as a “10b5-1 plan” – corporate stock trading programs created in the wake of the Securities and Exchange Commission (SEC)’s issuance of Rule 10b5-1(c) in 2000 that, if followed, provide an affirmative defense to insider trading claims. This action, coupled with newly effective amendments to Rule 105-1, raises a question as to whether these widely used plans will continue to make sense after 20 years on the books.

Background

The Exchange Act prohibits the use of “any manipulative or deceptive device or contrivance” in connection with the purchase or sale of securities. The relevant statute, found at 15 U. S. C. § 78j(b), is commonly referred to as “Section 10b. ” The SEC implemented the directives of Section 10(b) by issuing 17 CFR § 240. 10b-5, commonly referred to as “Rule 10b-5. ” The SEC specifically applied the prohibitions of Section 10b and Rule 10b-5 to insider trading by issuing 17 CFR § 240. 10b5-1, commonly referred to as “Rule 10b5-1. ” Subsections (a) and (b) of Rule 10b5-1 specify that the “manipulative or deceptive device[s] or contrivance[s]” prohibited by Section 10(b) and Rule 10b-5 include instances where a person owing a duty of trust or confidence to a company or its shareholders purchases or sells the company’s securities based on material nonpublic information about the company or its securities.

Insider trading carries significant and, in some cases, severe consequences. The SEC may bring a civil enforcement action which could result in monetary penalties up to three times the profit gained, or the loss avoided by wrongful trades. The SEC may also seek an order barring an alleged wrongdoer from serving as an officer or director of a publicly traded company in the future. Further, the U. S. Department of Justice (DOJ) may bring a criminal felony action seeking disgorgement, monetary penalties, and even incarceration. Finally, a stockholder may bring a private civil suit against the alleged wrongdoer to recover losses caused by the allegedly wrongful trades or, in the alternative, a derivative action – i. e. , a suit in the name of the company – to recover losses to the company.

Rule 10b5-1(c) provides an affirmative defense to a claim or charge of insider trading under subsections (a) and (b) if the subject transactions were made pursuant to a “written plan for trading securities,” commonly referred to as a “Rule 10b5-1 plan. “ Prior to February 27, 2023, an insider seeking to interpose this defense was required to show that:

• The plan specified the amount, price, and date of the transactions, or in the alternative, left these items to (a) the complete discretion of a third party not aware of inside information, or (b) a written formula, algorithm, or computer program;
• The insider did not deviate from the plan or enter into any related hedging positions; and
• The insider entered into the plan in good faith and not as part of a scheme to evade the Rules.

Many companies also implement internal policies governing insider trading generally and, more specifically, trading pursuant to 10b5-1 plans by officers, directors, and others with access to material nonpublic information. Company policies often provide for a “cooling off” period – typically 30 to 90 days following an insider’s adopting a 10b5-1 plan – during which the company prohibits the insider from transacting in the company’s securities. The rationale is that any material nonpublic information an insider might have at the time of adoption will be either public or irrelevant by the end of the period.

Amendments to Rule 10b5-1(c)

In December 2022, the SEC adopted amendments to Rule 10b5-1 with the goal of making it more difficult for insiders to use 10b5-1 plans to obfuscate trades based on material nonpublic information. On Monday, February 27, 2023, these amendments became effective. The amendments include:

• A mandatory cooling-off period during which directors and officers may not trade following the adoption or modification of a plan that is either: (i) 90 days following adoption or modification; or (ii) 2 business days following disclosure in certain periodic reports of the issuer’s financial results for the fiscal quarter in which the plan was adopted or modified, not to exceed 120 days following adoption or modification;
• A mandatory 30-day cooling-off period during which persons other than issuers or directors and officers may not trade following the adoption or modification of a 10b5-1 plan;
• A requirement that directors and officers certify in their 10b5-1 plans that, at the time of adoption or modification: (i) they are not aware of material nonpublic information; and (ii) they are adopting the plan in good faith and not as part of a plan or scheme to evade Rule 10b-5;
• A limitation restricting anyone other than the company to only one 10b5-1 plan at a time;
• A limitation restricting anyone other than the company to reliance on the affirmative defense afforded by a 10b5-1 plan to a single plan during any consecutive 12-month period; and
• A requirement that all persons adopting a 10b5-1 plan act in good faith with respect to that plan.

In addition to the foregoing requirements and prohibitions, the amendments also establish new disclosure obligations, including:

• Quarterly disclosure regarding the use of 10b5-1 plans by company directors and officers for the trading of the company’s securities;
• Annual disclosure of a company’s insider trading policies and procedures;
• Disclosures regarding a company’s awards of options close in time to the release of material nonpublic information; and
• Disclosures by filers of Forms 4 (trades by an insider) and 5 (changes in beneficial ownership) indicating by checkbox that a reported transaction was intended to satisfy the affirmative defense conditions of Rule 10b5-1(c).

Those required to report their ownership of and transactions in a company’s equity securities pursuant to Section 16 of the Exchange Act (e. g. , president, vice president, secretary, treasurer or principal financial officer, comptroller or principal accounting officer, and owners of more than 10% of the company’s equity securities) are required to comply with the amendments to Forms 4 and 5 for beneficial ownership reports filed on or after April 1, 2023. Issuing companies will be required to comply with the new disclosure requirements in Exchange Act periodic reports on Forms 10-Q, 10-K, and 20-F and in any proxy or information statements in the first filing that covers the first full fiscal period that begins on or after April 1, 2023.

The DOJ’s and SEC’s 10b5-1(c) Peizer Actions

On Monday, February 27, 2023, the SEC’s amendments to Rule 10b5-1(c) became effective. Two days lateron Wednesday, March 1, the DOJ announced its first ever criminal insider trading charges based solely on trades executed on behalf of a company insider pursuant to a 10b5-1 trading plan. The SEC commenced a parallel civil action the same day. The DOJ’s indictment and SEC’s civil complaint (the Peizer Filings) are excellent companion reading to the newly-amended Rule 10b5-1(c). The allegations in the filings provide a detailed illustration of (i) the type of events and communications the government may view as indicative of misusing a 10b5-1 plan to obfuscate insider trading, (ii) the timing of such events and communications in relation to the adoption of a 10b5-1 plan, and (iii) other circumstances considered.

Peizer Background[1]

Defendant Terren Scott Peizer founded Ontrak, Inc. in 2003 to provide purportedly cost-saving behavioral health services to members of large health insurance plans in return for fees paid by the plans to Ontrak. Ontrak’s common stock was publicly traded on NASDAQ. During the period covered by the Peizer Filings, Peizer served as Executive Chairman of Ontrak, having recently relinquished the office of CEO.

As of February 2021, Ontrak’s business depended on four large customers, with fees paid by customers Aetna and Cigna comprising more than half of Ontrak’s revenues. On Friday, February 26, 2021, Peizer, through his personal investment vehicle, defendant Acuitas Group Holdings, LLC, owned nearly 10 million shares of Ontrak common stock worth more than $572 million at the closing price that day of $58. 92 per share.

On Monday, March 1, 2021, Ontrak announced publicly that Aetna had terminated its contract with Ontrak effective June 26, 2021. Ontrak shares closed that day at $31. 62 per share, having lost a little more than 46% of their value. Peizer personally lost more than $265 million.

Peizer Adopts Rule 10b5 Plans While Ontrak’s Business Deteriorates

Aetna’s termination left Cigna as the largest of Ontrak’s three remaining customers, generating more than 50% of Ontrak’s business. The Peizer Filings allege events and communications aimed at demonstrating that Peizer (i) knew Ontrak’s deteriorating relationship and potential loss of Cigna’s business was material nonpublic information, (ii) understood that disclosure of that information could cause a drop in Ontrak’s share price and, (iii) created two separate 10b5-1 plans to exercise warrants and sell Ontrak shares to avoid losses like those he incurred when Ontrak announced Aetna’s termination. Below is a summary of these alleged events and communications.

Based on the events and communications alleged, the government asserts in both the civil and criminal actions that Peizer acted with scienter for a number of reasons:

1. Peizer knew information concerning Cigna was material and nonpublic when he adopted each 10b5-1 plan;
2. Nevertheless certified in writing that he had no material nonpublic information when he adopted each plan;

• Declined to transact through Broker 1 because Broker 1 required a cooling off period of at least a 14 days;

1. Rejected Broker 2’s advice to include a 30-day cooling off period in his 10b5-1 plans;
2. Exercised warrants well in advance of expiry and insisted that the shares be sold immediately;
3. Never adopted a 10b5-1 plan before adopting the May 2021 plan;

• Bought, but never sold, Ontrak shares at any time in the preceding 10 years; and
• Never sold Ontrak shares obtained by exercising warrants.

It seems clear that the government has sought to prepare itself with the allegations needed to persuade the finder of fact that Peizer is not entitled to the affirmative defense offered by Rule 10b5-1(c) because he did not adopt his 10b5-1 plans in good faith but rather as part of a plan or scheme to evade the rule’s prohibitions.

Conclusion

Whether the government’s Peizer actions portend a new offensive aimed at punishing those who have misused 10b5-1 plans in the past and to discourage potential wrongdoing in the future remains to be seen. Nevertheless, the Peizer actions do provide timely, concrete examples of the type of conduct the SEC intends the amendments to address. Time will tell whether they are effective.

As a practical matter, an insider intent on misusing a 10b5-1 plan can still misrepresent knowledge of material nonpublic information and good faith and can ignore the new disclosure requirements, albeit at greater risk. The mandatory 90-day cooling off period may prove a more potent safeguard because it seems unlikely that many registered broker-dealers would subject themselves to the potential liability of executing trades pursuant to a plan in violation of that requirement.

The bigger question may be whether the SEC’s amendments have just made 10b5-1 trading plans more hassle than they are worth.

For example, prior to the amendments the SEC did not require a cooling off period between adopting and trading pursuant to a 10b5-1 plan. Instead, companies and brokerages developed their own policies, typically requiring 30-60 to days. By allowing flexibility, those with a legitimate motive for trading in the near term could still avail themselves of the affirmative defense provided by Rule 10b5-1(c). The SEC’s mandatory 90-day rule eliminates that flexibility, requiring insiders to wait a full three months before trading. An insider with a legitimate motive for trading sooner must now weigh the potential benefit of the affirmative defense against the cost of waiting out the mandatory cooling off period. Likewise, the insider must consider the new limitation that trades made under a 10b5-1 plan adopted at any given time will be the only trades eligible for the affirmative defense for the following year. Finally, the insider must consider whether the value of the affirmative defense outweighs the potential costs of public disclosure.

Another consideration is the cost both monetarily and administratively of complying with the amendments. Up until now, both companies and insiders could reasonably view 10b5-1 plans as relatively low-cost, albeit contingent, protection against potential insider trading liability. Other than plan documentation – which is well-developed – the costs could fairly be viewed as limited. However, whereas 10b5-1 plans have, up until now, been largely a contractual matter between an insider and a broker-dealer, the amendments bring the company into the mix by requiring quarterly disclosures concerning the use of 10b5-1 plans by directors and officers, annual disclosures of the company’s insider trading policies and procedures, and disclosures concerning awards of options close in time to the release of material nonpublic information. In addition to the costs of complying with disclosure requirements, companies will need to review and likely revise their internal policies and procedures to ensure consistency with the new amendments.

Given these new considerations, it seems likely that companies will rethink their views on their directors’ and officers’ use of 10b5-1 trading plans in the future.

[1] The facts set forth herein are taken from the Peizer Filings.

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