Many corporate executives rely on Rule 10b5-1 plans to buy or sell shares of their company’s stock without having to worry about violating insider trading laws, even when the trades take place when the executive possesses material nonpublic information about his or her company. However, recent Wall Street Journal articles have described civil and criminal investigations into possible misuse of Rule 10b5-1 plans by executives at a number of companies.

Background

For many years, no rules provided any guidance about what was insider trading, which was prosecuted as a manipulative and deceptive device pursuant to Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. The Securities and Exchange Commission (SEC) finally adopted rules to provide such guidance. As a result, pursuant to Rule 10b5-1(a), “manipulative and deceptive devices”

include, among other things, the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information.

Rule 10b5-1(b) defines “on the basis of” as a purchase or sale of a security of an issuer when the person trading was aware of the material nonpublic information when the person made the trade.

The SEC rules further provide in Rule 10b5-1(c) that a securities trade is not “on the basis of” material nonpublic information if the person making the trade demonstrates that prior to becoming aware of the information the person had entered into a binding contract to purchase or sell the security, instructed another person to purchase or sell the security for the instructing person’s account, or adopted a written plan for trading securities (a Rule 10b5-1 plan) subject to specifications set forth in the rule.

Many public company executives have significant holdings of their companies’ securities and desire an opportunity to sell those securities. Such executives often become aware of material nonpublic information at inopportune times but Rule 10b5-1 plans allow for an executive to enter into a specific selling plan at a time when the executive does not possess material nonpublic information about his or her company and the transactions pursuant to the plan occur in the future, even if the executive subsequently learns material nonpublic information that would have prevented him or her from trading in the future.

Recent Enforcement Activity

The recent Wall Street Journal articles describe stock trading by executives that was done pursuant to Rule 10b5-1 plans but the trades in question may be challenged by the government. These recent articles follow an earlier article in which the Wall Street Journal analyzed stock trading by corporate insiders and found that profitable and well-timed trades were executed by more than 1,400 executives. There are at least three areas into which the government may be scrutinizing trading pursuant to Rule 10b5-1 plans.

First, according to the Wall Street Journal, the SEC and U.S. Attorney are looking into whether or not the executives were aware of material nonpublic information when they entered into their 10b5-1 plans.

Second, Rule 10b5-1(c) states that a trade is not pursuant to a Rule 10b5-1 plan if the person who entered into the plan altered or deviated from the plan by changing the amount, price, or timing of the trades to be made or entered into or altered a corresponding or hedging transaction or position with respect to the security.  This will be another avenue for investigation.

Third, Rule 10b5-1 states that the affirmative defense afforded by the rule is only applicable when the Rule 10b5-1 plan was entered into in good faith and not as part of a plan or scheme to evade the prohibition of Rule 10b5-1. The government will be looking closely at this as well.

Pepper Points

Before entering into a Rule 10b5-1 plan, make sure that you are in compliance with all aspects of Rule 10b5-1 and not aware of any material nonpublic information.

If you already have a Rule 10b5-1 plan, confirm that it was entered into in compliance with all aspects of Rule 10b5-1.

Before engaging in any securities transactions outside of an existing Rule 10b5-1 plan, discuss with counsel the potential impact of such transactions on the Rule 10b5-1 plan.

If you have traded in securities pursuant to a Rule 10b5-1 plan and such trades are being questioned by the government, you should consult with an attorney who is knowledgeable about SEC and/or U.S. Attorney investigations as soon as possible and, in any event, before communicating with the government.

Keep in mind that corporate executives need to be careful about communications with in-house attorneys about their Rule 10b5-1 plans, as those attorneys represent the company and not the executives so such communications may not be protected by the attorney-client privilege.