DOJ and SEC Scrutinize Potential Misuse of Rule 10b5-1 Trading Plans by Corporate Directors Affiliated with Investment Advisers

by Dechert LLP

Over the past four years, the U.S. Department of Justice (“DOJ”) and U.S. Securities and Exchange Commission (“SEC”) have focused on insider trading involving private funds as one of their key targets in the fight against white collar crime. In 2009 and 2010, the government’s focus was on allegations of insider trading by persons affiliated with Raj Rajaratnam and his Galleon Group. In 2011 and 2012, the government’s investigations expanded to the use of expert networks to gain access to corporate insiders and consultants with knowledge of inside information. Moving into 2013, insider trading remains a government enforcement priority – particularly in connection with trading by hedge funds and private equity funds.1 The latest salvo in the government’s ongoing war against insider trading, as reported by the Wall Street Journal in a recently series of published articles, involves the potential misuse of Rule 10b5-1 trading plans by corporate directors affiliated with investment advisers.2 This OnPoint discusses: (1) how Rule 10b5-1 plans work generally; (2) the government’s current investigation into the potential alleged misuse of these plans; and (3) steps for investment advisers and corporations to consider in light of these new insider trading investigations.

Rule 10b5-1 Plans – In General

The purpose of a Rule 10b5-1 plan is to facilitate stock purchases or sales by insiders or, through a stock buyback program, issuers, without running afoul of the laws prohibiting trading by insiders based on material nonpublic information (“MNPI”). Under the provisions in SEC Rule 10b5-1, an executive or other insider may have an affirmative defense to allegations that his or her trading was on the basis of MNPI, if the trades were conducted under a trading plan that satisfies the requirements specified in Rule 10b5-1(c).

In general, a Rule 10b5-1 trading plan is a written plan under which an insider will buy or sell securities, adopted at a time when the insider was not in possession of MNPI.3 The plan must: (1) specify the amount, price and dates of purchases or sales; (2) include a formula, algorithm or computer program for determining amount, price and date; or (3) prohibit the insider from exercising subsequent influence over the trading (and also prohibit those who exercise influence over the trading from having MNPI).4 The plan must be entered into in good faith, and not as part of a scheme to engage in unlawful trading.5 Any trading needs to occur under the pre-existing terms of the Rule 10b5-1 plan unless the terms are revised when the insider does not have MNPI, and there are restrictions on the ability of insiders to engage in various related hedging activities. In addition, even if trading under a Rule 10b5-1 plan is set to begin after a specified point in the future (e.g., 30 days from adoption), the plan will not protect against potential liability if the insider is in possession of MNPI at the time the plan is adopted – even if the MNPI will have become public before the insider trades under the plan.6 There is no requirement that trading plans be filed with the SEC, and the specifics of trading plans are not frequently disclosed to investors (although the issuer and/or its directors or officers may make public statements regarding some aspects of the plans).7

The Government’s Recent Investigation into Rule 10b5-1 Trading Plans

The government’s scrutiny of Rule 10b5-1 trading plans was recently reported in an April 24, 2013 Wall Street Journal (“WSJ”) article.8 In the article, the WSJ highlighted the alleged use of trading plans by corporate directors at three companies: Cardiovascular Systems, Inc., Tesla Motors, and Double-Take Software. Specifically, the article reported that supposedly:

  • Cardiovascular Systems outside director John Friedman, who was also a principal in Easton Capital Group, sold 83% of the stock owned by one of his investment funds pursuant to a recently-adopted trading plan, ending his selling just six days before a disappointing earnings announcement.
  • Tesla Motors director Antonio J. Garcias, CEO of Valor Equity Partners LP, sold more than half of Valor’s stake in Tesla pursuant to a newly-enacted trading plan right before a significant investor announced that it was selling a large block of Tesla stock.
  • Double-Take Software director Ashoke Goswami, a general partner of ABS Capital Partners, established a trading plan shortly after being briefed by management on the company’s business outlook, then sold $3.8 million worth of Double-Take stock in the month and a half before the company announced earnings guidance below expectations.

The April 24th article further reported that the government would investigate the use of trading plans by directors affiliated with investment advisers. Indeed, according to the WSJ, Assistant U.S. Attorney Patrick Sinclair of the U.S. Attorney’s Office for the Eastern District of New York, at a hedge fund conference in the Cayman Islands, warned that the DOJ would be “reviewing these practices further,” and that directors could expect to see enforcement actions relating to Rule 10b5-1 plans “coming down the pipe.”9

Mr. Sinclair’s warnings were prescient. On April 30, 2013, just a week after his speech, the WSJ reported that the U.S. Attorney’s Office for the Eastern District of New York had launched a criminal investigation to determine whether certain corporate directors had been misusing trading plans to cover up illegal insider trading on behalf of investment advisers.10 According to the article, the U.S. Attorney’s Office had issued subpoenas to Cardiovascular Systems and Tesla Motors, as well as to Easton Capital Group, ABS Capital Partners, and Valor Equity Partners. The article also reported that the SEC had begun an investigation into whistleblower allegations that Mitchell Gold, the former CEO of pharmaceutical company Dendreon, used a Rule 10b5-1 plan to trade ahead of news that the company would be discontinuing development of a prostate cancer drug.

The aforementioned investigations are not the first time the government has looked into Rule 10b5-1 trading plans. In October 2010, the SEC settled a case against Countrywide Financial CEO Angelo Mozilo, in which Mozilo paid $67.5 million to settle charges that included trading under Rule 10b5-1 sales plans that he established while aware of MNPI about Countrywide’s increasing credit risk.11 Previously, in 2004, the SEC brought an action against former Enron CEO Kenneth Lay, who was charged (among other things) with fraudulently amending his trading plans to sell more than $20 million worth of Enron shares when he was in possession of MNPI concerning Enron’s deteriorating financial condition.12 Whereas the Mozilo and Lay cases resulted from investigations into the activities of those particular CEOs, the current Rule 10b5-1 investigations appear to be the result of scrutiny by the government into the use of such plans by the private fund industry generally.

Steps to Consider in Light of the Rule 10b5-1 Investigations

With the government now focused on the potential misuse of trading plans, the fund industry, public companies and directors (especially those affiliated with funds) should expect closer scrutiny of Rule 10b5-1 plans. Hand-in-hand with this increased regulatory scrutiny is the potential for civil securities class actions relating to the misuse of such plans. Indeed, at least one plaintiffs’ law firm has begun searching for possible plaintiffs to bring suit against one of the companies identified by the WSJ articles.13

In light of these investigations, corporations and their directors, along with investment funds and their advisers, should consider reviewing their use of, and policies/procedures concerning, Rule 10b5-1 plans. Among other things, funds, their advisers and, where appropriate, companies should consider:

  • Re-examining the sufficiency of their policies and procedures relating to the use of Rule 10b5-1 plans;
  • Exploring whether there may be any potential questions raised by recent trades made pursuant to Rule 10b5-1 plans;
  • Focusing on any potential Rule 10b5-1 plan issues in advance of an SEC Office of Compliance Inspections and Examinations review;
  • Providing training to directors of public companies on the proper use of Rule 10b5-1 plans; and
  • Instituting “best practices” relating to Rule 10b5-1 plans, which might include:
  • Modifying trading plans only during open trading windows, and then only when the insider is not in possession of MNPI;
  • Avoiding a pattern of frequently adopting, amending, or cancelling plans;
  • Avoiding multiple or overlapping plans, at least with respect to the same security;
  • Requiring company approval of adoption of, or participation in, all trading plans and/or plan templates – or at least approval of the timing and adoption of a plan;
  • Generally imposing a mandatory waiting period between the establishment or modification of a plan and the first trade pursuant to the plan, with the waiting period being long enough to demonstrate the plan was not adopted to shield unlawful insider trading; and
  • Imposing mandatory minimum effective periods for trading plans during which such plans cannot ordinarily be modified.14

The use and potential misuse of Rule 10b5-1 plans presents a perfect convergence of insider trading issues involving funds, their advisers, corporations and directors. Enforcement actions in this space may be especially attractive to the DOJ and SEC insofar as such cases allow the government to target multiple participants in alleged insider trading schemes, from both Main Street and Wall Street, in the course of a single investigation. We expect that the government will continue pursuing more of these investigations going forward. Accordingly, funds, their advisers, corporations and directors should consider reexamining their Rule 10b5-1 plans and practices to make sure they are sufficient to withstand future scrutiny.


1 See Bruce Karpati, Chief, SEC Enforcement Division’s Asset Management Unit, Enforcement Priorities in the Alternative Space, Remarks Before the Regulatory Compliance Association (Dec. 18, 2012).

2 Susan Pulliam & Rob Barry, Directors Take Shelter in Trading Plans, Wall St. J., Apr. 24, 2013, at A1; Susan Pulliam, Rob Barry & Scott Patterson, Insider-Trading Probe Trains Lens on Boards, Wall St. J., Apr. 30, 2013, at A1.

3 Rule 10b5-1(c)(1)(i)(A).

4 Rule 10b5-1(c)(1)(i)(B).

5 Rule 10b5-1(c)(1)(ii).

6 See SEC, Compliance and Disclosure Interpretations, Feb. 13, 2012.

7 Indeed, often the Forms 4 filed by directors and officers will include a footnote stating that the purchases or sales described therein were made pursuant to a valid Rule 10b5-1 plan. This may be designed to deter plaintiffs’ lawyers from attempting to bring suit on the basis that such trades may have been made in violation of the insider trading laws.

8 Susan Pulliam & Rob Barry, Directors Take Shelter in Trading Plans, Wall St. J., Apr. 24, 2013, at A1.

9 See id.; Kris Devasabai, Tough Stance on Insider Trading at Hedge Funds Getting Results, Hedge Funds Review, Apr. 23, 2013.

10 Susan Pulliam, Rob Barry & Scott Patterson, Insider-Trading Probe Trains Lens on Boards, Wall St. J., Apr. 30, 2013, at A1.

11 See SEC News Digest, Former Countrywide CEO Angelo Mozilo to Pay SEC’s Largest-Ever Financial Penalty Against a Public Company’s Senior Executive, Issue 2010-196, Oct. 18, 2010.

12 See Litigation Release No. 18776, SEC, SEC Charges Kenneth L. Lay, Enron’s Former Chairman and Chief Executive Officer, with Fraud and Insider Trading (July 8, 2004).

13 See Press Release, Pomerantz Grossman Hufford Dahlstrom & Gross LLP, Pomerantz Law Firm Investigates Claims on Behalf of Investors of Cardiovascular Systems, Inc. (May 2, 2013).

14 See, e.g., Craig M. Scheer, Rule 10b5-1 Trading Plans in the Current Environment: the Importance of Doing it Right, Bus. L. Today (Feb. 2013), at 1-2.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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