Reexamining the Rule 10b5-1 Trading Plan Defense to Insider Trading

Reexamining the Rule 10b5-1 Trading Plan Defense to Insider Trading

Legal Sidebari

Reexamining the Rule 10b5-1 Trading Plan
Defense to Insider Trading
January 31, 2019
Earlier this week, the House of Representatives passed the Promoting Transparent Standards for
Corporate Insiders Act (H.R. 624) by a vote of 413-3. Previously included as part of the JOBS and
Investor Confidence Act of 2018 (S. 488), which passed the House of Representatives of the 115th
Congress but was not enacted, the bill would direct the Securities and Exchange Commission (SEC) to
carry out a study regarding the potential need to reform SEC Rule 10b5-1 and to conduct further
rulemaking. The SEC enacted Rule 10b5-1 in 2000, providing a way for insiders to transact in their
company’s securities without running afoul of federal insider trading laws by setting up prearranged
trading plans. For example, corporate executives, whose compensation may be significantly made up of
company stock, could engage in legitimate prearranged trading in company securities under the rule, even
though they are often privy to inside information. Rule 10b5-1 has since come under periodic scrutiny for
its potential susceptibility to abuses that could facilitate insider trading by corporate insiders.
This Sidebar reviews the purpose of Rule 10b5-1 trading plans, the debate regarding whether amendments
to the rule are necessary to prevent insider trading by corporate executives, and the Promoting
Transparent Standards for Corporate Insiders Act as passed by the House that is now pending in the
Senate.
10b5-1 Trading Plans as a Defense to Insider Trading
Insider trading is a violation of Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5, which
prohibit, respectively, the “use [of] . . . any manipulative or deceptive device or contrivance” and “any
act, practice, or course of business which . . . operates as a fraud or deceit” in connection with the
purchase or sale of a security. The scope of insider trading liability has developed over the years through
the courts, and the law generally prohibits “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 . . .”
In 2000, the SEC adopted Rule 10b5-1 largely to clarify that the language “on the basis of” contained in
the standard means that a person was “aware of” material nonpublic information at the time of the trade.
In so doing, the SEC rejected a more stringent standard some courts had embraced that required a
showing that the person actually used their knowledge of material nonpublic information as a basis for
their decision to trade. The SEC explained that it would be “highly doubtful” that a person with inside
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information could completely disregard that knowledge in making the decision to purchase or sell a
security.
In adopting the broader knowledge standard, however, the SEC also included affirmative defenses (or safe
harbors) in the rule that could under certain circumstances shield those with knowledge of material
nonpublic information from liability for conducting certain trades. Under the rule, “a person’s purchase or
sale is not ‘on the basis of’ material nonpublic information if the person making the purchase or sale
demonstrates that [b]efore becoming aware of the information, the person had . . . adopted a written plan
for trading securities.” In other words, the rule establishes a defense to insider trading for transactions
executed pursuant to a prearranged plan adopted in good faith and, importantly, at a time when the person
was not aware of material nonpublic information. Specifically, to avail themselves of the defense, a
person must specify the date, volume and prices of trades in advance; designate a pre-set formula for
trading; or hand control of the trades over to another person who is not aware of material nonpublic
information (so long as the insider does not have any subsequent influence over the trading).
The 10b5-1 plan defense addresses the trading needs of corporate insiders, like executives and directors,
who may from time to time have a legitimate need or desire to transact in their company’s stock, but are
also frequently privy to inside information. Corporate insiders now commonly adopt 10b5-1 plans, which
may be particularly useful because a significant component of executive compensation often comes in the
form of company stock.
The Debate over 10b5-1 Plans
The SEC and others have questioned the plans’ potential for abuse and possible weaknesses over at least
the past decade, citing certain well-publicized reports and studies indicating that many executives achieve
above-average returns when trading in their company’s stock, even when trading pursuant to Rule 10b5-1
trading plans. In response, some, including the Council of Institutional Investors (CII), have pointed to
various characteristics of the plans that might make them susceptible to exploitation. These include an
insider’s ability to adopt a plan shortly before the trading is to begin (e.g., within days), the ability to
cancel or amend the plan at any time, and the lack of disclosure rules surrounding plan adoption and
alterations. These potential weaknesses have raised suspicions among critics that insiders may in fact be
strategically entering into or modifying the plans based on material nonpublic information (e.g., entering
into a plan days before the announcement of a major corporate event), but still utilizing the plan as a mask
for inappropriate trading activity. CII has therefore called for reforms such as requiring a delay period
between adoption of a plan and trading (e.g., 90 days), allowing insiders to enter into plans only during
certain specified trading windows (e.g., after earnings releases, when insiders are unlikely to possess
further inside information), and discouraging plan alterations and cancellations through mandatory
disclosure requirements. In 2002, the SEC itself also proposed, but did not ultimately promulgate,
disclosure rules for 10b5-1 plan adoptions, modifications, and terminations.
Supporters of the current rule, though, have challenged whether executives’ beating the market is truly
indicative of insider trading. They point out that such performance data should be unsurprising because
company executives are often industry experts. Further, they note that because Rule 10b5-1 allows
insiders to specify that sales should occur on a certain date only if a certain price is met, their trades could
simply reflect a pre-determined instruction to “sell high” (this aspect of the rule, too, has been criticized
by some commentators). Moreover, legal advisors have noted that, particularly in light of the scrutiny
10b5-1 plans have received from time to time, many companies have already voluntarily adopted best
practices incorporating many of the same reforms that have been proposed. Further restrictions, they
argue, could render the plans so inflexible as to prohibit legitimate activity and to chill their use overall.
It should be noted that the current rule does not permit the abuses highlighted by CII and others, given the
rule’s good faith requirement and its condition that the person not be in possession of material nonpublic

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information when entering into a plan. The SEC has further clarified that plan terminations and alterations
may preclude the availability of the defense depending upon the circumstances (see the SEC guidance
linked here, particularly Questions 120.18-120.20). Courts have at times rejected attempts by defendants
to rely on the existence of their 10b5-1 plans to dispute securities fraud claims brought against them. For
instance, in 2008 a federal district court in Los Angeles, in refusing to dismiss securities fraud claims
against a Countrywide Financial executive, remarked that his frequent adoption and amendments to 10b5-
1 plans “appear[ed] to defeat the very purpose of 10b5-1 plans, which were created to allow corporate
insiders to ‘passively’ sell their stock . . . without direct involvement.” In other cases, however, the
existence of a defendant’s Rule 10b5-1 plan can pose a significant hurdle for plaintiffs attempting to
establish the strong inference of scienter required to survive a motion to dismiss in private securities fraud
cases. A New York federal district court in 2014, for example, dismissed securities fraud claims against a
Lululemon executive and director trading pursuant to Rule 10b5-1 plans. Even though plaintiffs alleged,
for example, that the company’s founder and director had made significant stock sales of over $100
million shortly after certain product quality issues (which led to a product recall) had emerged at the
company, the complaint was dismissed as it did not contain facts indicating that he knew of the quality
issues when entering into his Rule 10b5-1 trading plan.
Promoting Transparent Standards for Corporate Insiders Act
In light of the concerns raised above, the Promoting Transparent Standards for Corporate Insiders Act
would direct the SEC to undertake a study analyzing whether Rule 10b5-1 needs to be amended. The Act
would then require the SEC to commence further rulemaking addressing the study’s results. Specific
potential amendments set forth in the bill for the SEC to examine include:
1. allowing insiders to adopt 10b5-1 plans only during specified trading windows;
2. imposing mandatory trading delays after adoption of a 10b5-1 plan;
3. limiting the ability of insiders to adopt multiple 10b5-1 plans;
4. limiting the frequency of plan modifications;
5. requiring disclosure of plan adoptions and modifications; and
6. requiring corporate boards to police and monitor certain 10b5-1 plans.
The intended study by the SEC may serve to further inform the longstanding debate regarding Rule 10b5-
1, potentially through, for example, gathering updated trading data and examining whether voluntary
corporate best practices appear to sufficiently mitigate potential problems.

Author Information

Nicole Vanatko

Legislative Attorney

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