ABA Section of Business Law

The SEC has recently made very plain its intention to more closely scrutinize plans contemplated by Rule 10b5-1. That rule was enacted in October 2000, and since then corporate insiders have extensively used plans authorized by the rule to establish trading programs that might not have previously been entered into for fear of insider trading liability. While often termed a "safe harbor," section (c) of the rule actually provides an affirmative defense to an allegation of insider trading. Rule 10b5-1 prohibits the purchase or sale of a security on the basis of material, nonpublic information. However, the purchase or sale will not be deemed to be made on the basis of material, nonpublic information if the person making the transaction demonstrates that before becoming aware of the information, he or she had (1) entered into a binding contract to purchase or sell the security, (2) instructed another person to purchase or sell the security for the instructing person's account, or (3) adopted a written plan for trading securities. The rule then describes the essential characteristics of such a plan, including the requirement of a written formula to be used to determine the amount of securities to be purchased or sold.

However, comments made in late 2007 by Linda C. Thomsen, the director of the SEC's Division of Enforcement, indicate that the commission will be reviewing these plans with a much more critical eye than it has in the past. The commission has previously charged individuals with abusing the protection afforded by 10b5-1 plans (witness the prosecutions of Ken Lay and Joe Nacchio), but those were relatively small issues in much larger prosecutions. Ms. Thomsen's comments now raise the much greater possibility of informal or formal commission investigations into several aspects of these plans, coupled with subsequent enforcement actions.

This reported commission action comes on the heels of Ms. Thomsen's comments in March 2007 that the SEC was, in fact, taking a hard look at several issues surrounding these plans, a sentiment she repeated in a speech on October 10 to the National Association of Stock Plan Professionals.

The SEC's enforcement interest in these plans accelerated following the publication of a study by Alan Jagolinzer, an assistant professor at the Stanford University Graduate School of Business. His paper analyzed a significant number of transactions carried out pursuant to 10b5-1 plans (information mostly taken from SEC Form 4 and 8-K filings). The study found that, on average, sales by participants generated "abnormal trade returns," and that "a substantive proportion of selected 10b5-1 plan initiations are associated with pending adverse news disclosure, and that participants terminate sales plans before positive shifts in firm returns." While the study stresses that the evidence it presents is not necessarily indicative of illegal behavior, there seems little doubt that his findings have generated a significant amount of interest in possible abuses of 10b5-1 plans.

Using 10b5-1 plans to reduce the risk of potential liability makes sense, but given its public pronouncements, it would be naive to think that the commission will ignore actions that fly in the face of plan requirements. Constant modifications and terminations, trading very shortly after the establishment of a plan, significant trading outside of the plan, and other activities could well, in the current atmosphere, trigger an SEC inquiry or result in a loss of the protection provided by the rule. Indeed, a focus on these plans might be a natural progression from the commission's well-publicized campaign with regard to option backdating. If an inquiry is triggered, of course, it is imperative to have counsel versed in dealing with the commission to assist. Even absent such oversight, it is crucial for a participant to be well versed in the requirements set out by the rule.