Rule 10b5–1 Trading Plans Offer Affirmative Defense to Insider Trading

Prepare your plan before you receive the dreaded “Wells” notice!

Insider trading has increasingly drawn negative media attention and enforcement crackdowns from the U.S. Securities and Exchange Commission (SEC) in recent years. The concern is that officers, directors, and other company insiders leverage their exposure to material non-public information (MNPI) to enrich themselves. These corporate insiders have access to unique MNPI. They can use that access to inform decisions about whether to buy or sell corporate stock prior to the occurrence of a material event. However, there are many circumstances in which corporate insiders would simply like to liquidate their shares in the company. They do not want to inadvertently become entangled in an insider trading controversy. These persons may draw upon SEC Rule 10b5–1 to protect themselves.

The SEC promulgated Rule 10b5–1 in 2000, pursuant to Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Rule 10b-5 targets securities fraud by making it unlawful to trade a company’s shares on the basis of material insider information. More than 50% of S&P 500 companies have executives that use 10b5–1 plans.

Pre-authorized Rule 10b5–1 Plans

This is where pre-authorized 10b5–1 plans come into play to assist insiders with legitimately managing their equity. In response to heightened regulatory scrutiny, many companies have opted to implement Rule 10b5–1 plans. The plans help corporate insiders access liquidity while offering them protection from threats of liability. Rule 10b5–1 plans provide an affirmative defense to insider trading actions brought by the SEC. These plans help shield company insiders avoid accusations of intentional misconduct in claims of insider trading violations.

Plan Requirements

Preparing the plan requires detailed attention to make sure the 10b5–1 plan will be in compliance with Rule 10b5–1. It must also comply with any company-specific rules and other applicable laws. Both company insiders and non-insiders have the ability to establish a Rule 10b5–1 plan. But they must not have access to MNPI at the time of establishing the plan. Under Rule 10b5–1, the parties must enter into the plan in good faith. It cannot operate as part of a scheme to evade the insider trading prohibitions of the rule.

Although Rule 10b5–1 does not set a limit on the duration of a 10b5–1 plan. Most plans have a termination date scheduled around one year later. This allows for the routine reevaluation of circumstances and modifications before adoption of a new 10b5–1 plan. Plans with a shorter duration also help prevent situations whereby a 10b5–1 plan is terminated earlier than the scheduled termination date. Early termination of a 10b5–1 plan can raise suspicions that previous trades were not in compliance with SEC rules.

In order to reduce their own legal risks, most companies also have adopted their own insider trading policies. These policies often impose additional restrictions beyond what securities laws require. For example, company insider trading policies often include trading blackout periods that ban trading for a certain period of time before and after the release of a company’s quarterly earnings reports.

Pay Attention to Other Laws and Regulations, Too

Rule 10b5–1 plans must also adhere to other applicable laws and regulatory reporting requirements. A Rule 10b5–1 trading plan must comply with the volume limitations of Rule 144 of the Securities Act of 1933. Shares held by officers and directors are regarded as “control securities” and are subject to the requirements of Rule 144. Under Rule 144, an insider must file a Form 144 with the SEC prior to the sale of shares. There are volume restrictions under Rule 144 that limit the number of shares that an officer or director may liquidate during any given three-month period.

Additionally, officers, directors, and shareholders holding at least 10% of the total company’s issued stock must be careful of potential short-swing liability under Section 16(b) of the Securities Exchange Act of 1934. In the event that a company insider both purchases and sells company shares within six-month period, the insider may have to forfeit the profits unless the insider had properly filed a Form 4. Form 4 is known as the “Statement of Changes in Beneficial Ownership” and must be filed whenever material changes in stock ownership occur. To avoid Section 16(b) liability, a Form 4 would have to have been submitted specifying that the trade was made pursuant to a Rule 10b5–1 plan.

Despite their potential benefits, critics have noted that some corporate executives may have used 10b5–1 plans to achieve above-market returns. A 2006 empirical study illustrated that trades under 10b5–1 plans produced returns averaging about 6% above the market. In 2009, 10b5–1 plans came under SEC scrutiny after former Countrywide CEO Angelo Mozilo was accused of selling shares based on material insider information pursuant to his company’s 10b5–1 trading plan.

John A. Wells

“Wells” Notice Under Rule 10b5–1

In response to alleged illegal trades under a 10b5–1 plan, a “Wells” notice may be issued. A Wells notice is a letter that the SEC sends to notify an individual or firm that the SEC plans to bring an enforcement action and outlines the substance of the charges. It is called a Wells notice after the Wells Committee, a committee formed in 1972 to review the SEC’s enforcement practices and policies, and chaired by John Wells. The SEC sends a Wells noticeat the conclusion of an investigation into potential securities law violations. The individual or firm then has an opportunity to respond to the allegations within 30 days with a written statement.

The affirmative defense provided by Rule 10b5–1 plans remain an essential tool to enable executives and other corporate insiders to trade their company’s stock without liability. Although they provide a significant degree of flexibility, it is also important to understand the specific details of Rule 10b5–1 to develop a trading plan that complies with the securities laws and company-specific policies.

Originally published at https://carpenterwellington.com on December 1, 2020.

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Carpenter Wellington PLLC

Carpenter Wellington PLLC

Ryan Carpenter serves as Attorney and Managing Director of Carpenter Wellington. Ryan advises clients across a broad set of corporate and commercial matters.