Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 prohibit the employment of manipulative and deceptive devices in connection with the purchase or sale of securities, including transacting in securities “on the basis of” material nonpublic information, or, as it is more colloquially known, insider trading. The SEC bolstered its enforcement of insider trading by promulgating Rule 10b5-1, which simultaneously interprets “on the basis of” to apply broadly, while also providing individuals, issuers and brokers with an affirmative defense to insider trading allegations where the purchase or sale of the securities occurs pursuant to a plan entered into prior to the acquisition of material nonpublic information (a 10b5-1 Plan).

10b5-1 Plans, however, do not provide unqualified certainty. The protections provided by 10b5-1 Plans have been increasingly scrutinized, beginning largely with the SEC’s high profile 2009 case against Countrywide’s former CEO Angelo Mozilo and renewed recently with publicity regarding 10b5-1 Plan abuse.*

Companies are reacting to the increased scrutiny by revisiting their insider trading policies and the terms of the 10b5-1 Plans approved thereunder. What follows is a brief discussion of how 10b5-1 Plans operate and how they can be strengthened.

Rule 10b5-1 Plans insulate individuals who are trading in securities while privy to material nonpublic information from accusations of insider trading where:  

1. Prior to becoming aware of the material nonpublic information, the person entered into a 10b5-1 Plan with a third party to purchase or sell his/her/its securities; 
2. Such agreement or plan instructed the third party as to the amount of securities to purchase or sell, the price at which to purchase or sell them and the timing of such purchase or sale, either by establishing express quantities, prices and dates, or by establishing algorithmic parameters by which the third party, without exercising its discretion or influence, could initiate securities transactions; and
3. The purchase or sale occurred pursuant to such agreement or plan. 

  
10b5-1 Plans are intended to allow executives liquidity in their own company’s securities, flexibility that is otherwise constrained by the Section 10(b) and Rule 10b-5 insider trading regime. Liquidity allows insiders to:
 

• Diversify holdings where a significant portion of their compensation is in the stock and options of their employer;
• Satisfy other SEC stock ownership rules and thresholds; and
• Provide the cash needed for large, predictable expenses such as college tuition or other scheduled payments.

In order to ensure that executives are not in violation of Rule 10b-5, traditional best practices in the establishment of 10b5-1 Plans include:
 

• Only permitting insiders to establish 10b5-1 Plans during open trading windows;
• Requiring that insiders certify in writing that they do not possess material nonpublic information upon entering into a plan;
• Requiring that the trading instructions included in the plan provide specific, non-discretionary guidance to their trader;
• Reducing the intermittent influence of the executive on the purchase and sale of securities by allowing limited permissible amendments and establishing a mandatory term; and
• Ensuring that the plan is not intended to otherwise circumvent the prohibitions of Rules 10b-5 and 10b5-1.

Recent publicity surrounding insiders’ abusive use of 10b5-1 Plans, however, has lead companies and their counselors to reevaluate and strengthen the terms of such plans, including:
 

• Increasing the length of the waiting period between execution or amendment of the plan and the initiation of trades thereunder;
• Increasing the term of a plan so as to decrease the potential for trading on insider knowledge;
• Reducing the number and frequency of allowable amendments to plans; and
• Simplifying the parameters upon which the third party is authorized to sell or purchase company securities.

Although such steps will not ensure protection under the affirmative defense established by Rule 10b5-1, it is advisable in an environment of increased regulatory scrutiny to address the most prevalent areas of abuse and endeavor to minimize their occurrence. If you believe that your current corporate insider trading policy may insufficiently address these issues, you should review and strengthen such terms with an attorney.

 
* See Susan Pulliam & Rob Barry, Executives’ Good Luck in Trading Own Stock, THE WALL STREET JOURNAL, November 27, 2012 at A1; Jean Eaglesham & Rob Barry, Trading Plans Under Fire, THE WALL STREET JOURNAL, December 13, 2012, at C1; Firms Set Curbs on Trading, THE WALL STREET JOURNAL, July 29, 2013 at C1.