The SEC Rule 10b5-1(c) Trading Plan Defense
Originally published on this site September 2000
Updated November 7, 2003
On August 15, 2000, the Securities Exchange Commission adopted Rule 10b5-1 (the "Rule").[FN1] Subsections (a) and (b) of the Rule attempt to clarify when an individual may be liable in an SEC insider trading proceeding. Subsection (c) of the rule creates an "affirmative defense" to insider trading liability. The defense applies to trades that are made on the basis of a prexisting trading plan entered into in good faith at a time when the insider was not aware of material nonpublic information. The Rule took effect on October 23, 2000, and has since been interpreted by the SEC Staff in Telephone Interpretations issued in December 2000 and May 2001.
As noted in my comments on the proposed Rule[FN2], the SEC's defense offers relief for honest directors, officers, and employees who want to obey the law and diversify their portfolios without being accused of insider trading or securities fraud. The Enacting Release could not have been clearer in stating this point in an important discussion of the benefits of the defense:
We anticipate two significant benefits arising from Rule 10b5-1. First, the rule should increase investor confidence in the integrity and fairness of the market because it clarifies and strengthens existing insider trading law. Second, the rule will benefit corporate insiders by providing greater clarity and certainty on how they can plan and structure securities transactions. The rule provides specific guidance on how a person can plan future transactions at a time when he or she is not aware of material nonpublic information without fear of incurring liability. We believe that this guidance will make it easier for corporate insiders to conduct themselves in accordance with the laws against insider trading.[FN3]
As I see it, there are five key points to keep in mind in creating trading plans.
1. Resolve any differences in perspective between a company and its employees.
Many companies have existing insider trading policies providing for trading windows and/or pre-clearance of trades. A "trading window" restricts the dates in which insiders most likely to possess material nonpublic information may trade. Usually, the window opens shortly after the publication of the previous quarter's financial results, and closes at the start of the last month of the quarter -- the theory being that this is the time frame in which insiders are least likely to possess material nonpublic information. Windows also may be closed on an ad hoc basis for other material events such as a merger, acquisition, or pre-announcement of poor results. Policies that require pre-clearance of trades mandate that any insider (here, usually only those at the higher levels of the organization) must clear any proposed stock sales in advance of making them with a compliance officer. The compliance officer, who is usually either a CFO's designee or the General Counsel, discusses the proposed trade to ensure that the trader does not possess material nonpublic information.
Where a company has an existing insider trading policy, for trading plans to be allowed, either that policy must be amended so as to accommodate trading plans, or trading plans must comply with the existing company policy. There are very good reasons for a company to recognize trading plans. For one thing, they may save the company the adminstrative resources of monitoring each individual trade. More importantly, the trading plan mechanism make sits easier for company to compensate their officers, directors, and employees with stock-based compensation -- a form of compensation that helps companies attract employees, and aligns management's interests with those of the shareholders. There are three issues, however, that may emerge in deciding how far a company will accommodate plans.
First, may an insider follow a trading plan in lieu of complying with the trading window or pre-clearance requirements? In theory, trading plans provide an alternative mechanism to achieving the same goal as windows or pre-clearance; namely, insuring that trades are not made on the basis of material nonpublic information. Thus, if trades are made according to a preexisting plan then there is no need to check on each individual trade -- and a company should benefit as well because it need not incur the administrative costs of this function. Most companies have agreed with this logic. Nevertheless, companies with very high risk profiles to securities fraud lawsuits still may want to restrict trades to windows, as a prophylactic measure to insure that all executives' trades are made at the most benign times. Companies also need to reserve to themselves an ability to halt all trades, even under trading plans, if necessary to protect a corporate purpose; formerly, this was reserved in order to protect a pooling of interests merger, but the FASB has now eliminated pooling. However, if an insider has adopted a trading plan, that plan will continue to operate even when the company erects an ad hoc blackout period. Under the logic of the SEC's defense, the sales to be made pursuant to those plans should continue even if material nonpublic information comes to the surface in a company.
Second, if a company agrees to accommodate trading plans, must companies agree to allow all trading plans? It is one matter if an employee plans to sell, say, 25% of her stock in a year. It may be regarded as something else if a senior executive sells 100% of her stock in a year. From a business perspective, a company may conclude that such a divestiture would send the wrong signal to the market. (Preventing this, indeed, is a subtle purpose of pre-clearance requirements.) It should not be the case that selling a high percentage of one's stock holdings, by itself, gives rise to an inference of scienter -- yet, in some courts, it does. A company's sensitivity to the risk profile created by high-divestiture trading plans may lead it to reject such plans.
Third, a company needs to decide how involved it will become in its insiders' trading plans. A very few companies already take a hands-off approach, requiring only that the insiders acknowledge the rules but leaving it to the insider to comply with the law. Most companies, however, take a more active role in policing insider trading. Those companies, if they are to follow existing practices, will want to review any proposed plans to insure for their own satisfaction that they meet the requirements of Rule 10b5-1. Other companies may wish to write sample plans for their insiders to consider.
2. Write a trading plan that meets the SEC's -- and the insider's -- requirements.
Once it has been cleared with the company that trading plans will be allowed, insiders should put their plans in writing. Trading plans (as opposed to contracts or instructions to brokers) must be in writing, and in any event it is advisable to document a plan because the insider bears the burden of proof on the defense[FN4]. Judges and juries will reject obviously bogus trading plan defenses.
The most important requirement is that the trading plan be entered into at a time when the person was not aware of material nonpublic information about the security or issuer in question.[FN5] Equally important is that the trading plan be "entered into in good faith, and not part of a plan or scheme to evade the prohibitions" against insider trading.[FN6] Trading plans also must either specify the date, amount, and price of the trades to be executed; or "include a written formula or algorithm, or computer program, for determining the amount of securities to be purchased or sold and the price at which and the date on which the securities were to be purchased or sold," or completely divest the insider of influence over "how, when, or whether to effect purchases or sales."[FN7] The terms "amount", "price", and "date" are defined broadly; "price", for example, means either the market price on a particular date or a limit price or a particular dollar price.[FN8] Actual trades must be made according to the trading plan, which means that the insider cannot have entered into any corresponding hedging transaction or position, or altered or deviated from the plan.[FN9]
There is a simple method for insuring that these requirements are met: write them into the plan. Thus, a plan should include not only a description of the amounts, dates, and times of the trades to be made, but, for example, also a statement that the person entering into the plan is not aware of material nonpublic information, will not enter into any hedging transactions, and so forth. (Other important suggested provisions are presented in the balance of this article.) Likewise, there is an easy method for companies that intend to accommodate trading plans to insure that the plans comply with these requirements: amend the insider trading policy to state that only those plans that comply with the SEC's requirements will be approved.
As important as meeting the SEC's requirements is meeting the insider's requirements. All other things being equal, the simpler the trading plan, the less likely it is that an insider may be accused of having entered into a plan in less than good faith, or having drafted the plan to take advantage of material nonpublic information. Other persons may benefit from more sophisticated trading strategies. The Enacting Release recognizes flexibility in this matter:
Taken as a whole, the revised defense is designed to cover situations in which a person can demonstrate that the material nonpublic information was not a factor in the trading decision. We believe this provision will provide appropriate flexibility to those who would like to plan securities transactions in advance at a time when they are not aware of material nonpublic information, and then carry out those pre-planned transactions at a later time, even if they later become aware of material nonpublic information.[FN10]
The SEC gave as an example of this flexibility a trading plan that "could provide, for example, that the employee will exercise options and sell the shares one month before each date on which her son's college tuition is due, and link the amount of the trade to the cost of the tuition."[FN11] As further examples of the flexibility that is allowed, I have been involved in helping draft trading plans associated with loans, funds, and company stock repurchase plans. (The SEC's May 2001 Telephone Interpretations make clear that the trading plan defense is available for repurchase plans.)
In the past, I had advised that an important thresold decision that insiders face is whether specify trading for a range of days, rather than a specified date. It may lead to suboptimal outcomes if the only day within a month or quarter in which trading is allowed by a plan is one in which the stock price was depressed for reasons having nothing to do with the particular security or issuer in question. There is no indication that the SEC meant to require insiders to expose themselves to this type of market risk. Indeed, one reason why the SEC modified the defense from the originally proposed text was that commentators "noted that the requirement that a trader specify prices, amounts, and dates of purchases or sales pursuant to binding contracts, instructions, or written plans left some common, legitimate trading mechnisms outside of the protection of the proposed affirmative defenses."[FN12] Thus, to avoid this type of risk, a trading plan could state, for example, that a particular number of shares will be sold between the twelfth and the fifteen trading day of the month, or in the month as a whole. However, most brokerage firms have delcined to accept such discretion; they want to be told the specific days on which to trade, such as a particular day each week for trading plans that contemplate weekly sales.
If a trading plan does allow any discretion as to the timing, amount, or price of the sales, the plan should delegate that discretion to the broker and insure that the insider cannot be said to have any influence. The May 2001 Telephone Interpretations emphasize the significance of not allowing the insider to exert for any subsequent influence (discretion) on the timing, amount, or price of the trades, if discretion on any of these elements is to be left to another party (i.e., a stockbroker.) For example, if a plan contemplates that X number of shares will be sold during the term of the plan, but also provides that the broker is not responsible for selling any shares that are not in the insider's brokerage account, then the insider should agree to deposit into his or her account all of the shares needed to fulfill the trading plan. This removes the ability of a critic of the plan to contend that the insider was able to exert influence over the plan by refusing to deposit the shares that otherwise would have been sold. (An insider who is in a position to influence a company's disclosures also would want to delegate discretion over the timing of trades so as to minimize exposure to the allegation that she timed a company's decision to disclose material nonpublic information to accord with her trading plan.)
A corollary is that the written trading plan should contain a provision that the insider will not communicate about the security or issuer with the stockbroker who is executing the trades pursuant to the plan. This follows from the requirement that where the insider delegates discretion to trade, "that any other person who, pursuant to the contract, instruction, or plan, did exercise such influence must not have been aware of the material nonpublic information when doing so."[FN13] The SEC Staff reaffirmed the significance of this requirement in the May 2001 Telephone Interpretations. It also follows from the requirement that the trades actually be made pursuant to the plan, and not as a result of subsequent alterations or deviations from the plan directed by the insider.[FN14] It also makes sense to include this provision in light of the overarching good faith requirement.
Insiders also should recogize that to the extent that flexibility in a trading plan results in trades that do not appear to fall into a pattern -- particularly if the plan does not result in the same number of shares being sold in each quarter -- there is a risk that a court in a securities fraud class action lawsuit would not recognize that the trades were made pursuant to a plan. This brings into focus the tricky question of limit prices. The Rule explicitly allows limit prices, and there are good reasons for insiders to decide that they will not sell their stock too cheaply. On the other hand, if setting high limit prices results in no trades being made for a period of time, this erodes the goals of portfolio diversification and cash flow. Insiders should recognize these trade-offs.
3. Provide a mechanism to modify or terminate the trading plan.
The Rule itself does not set forth any adverse consequences of trading outside a trading plan, other than that the defense set forth in the Rule cannot be used.[FN15] If an insider is sufficiently motivated to enter into a trading plan, however, it makes sense to infer that she intends to stick to the plan and retain the availability of the defense. Recently, the May 2001 Telephone Intereprations answered an open question by opining that if an insider sells additional shares during the pendency of a trading plan, it does not affect the avilability of the trading plan defense for the shares sold under the plan. See Answer to Question 13(b). However, selling additional shares during a particular time period may encourage securities class action plaintiffs to allege that the additional shares reflected the insider's knowledge of adverse information.
In my opinion, these factors suggest that a well-written trading plan should include formal provisions for its modification or termination. In theory, an insider may intend to take fluctuations of the stock prices in stride. In practice, volatile stock markets render it difficult to predict prices too far into the future. Thus, an insider may have entered into a trading plan in extremely good faith, yet still want to change her trading strategy if there is a change in circumstances. But if the insider alters or deviates from the original plan, formally speaking, the defense is no longer available.[FN15] A logical solution is that to continue to use the defense when circumstances change, the underlying plan itself should be modified, such that subsequent trades are made pursuant to a new and improved plan. And a logical way to recognize and facilitate possible modifications is to include a termination provision in the original plan. The May 2001 Telephone Interpretations opine that, formally, changing the trading formula ends the previous plan and starts a new plan. See Answer to Question 14. However, the SEC Staff also cited footnote 111 of the Enacting Release, which provides that "a person acting in good faith may modify a prior contract, instruction, or plan before becoming aware of material nonpublic information. In that case, a purchase or sale that complies with the modified contract, instruction, or plan will be considered pursuant to a new contract, instruction, or plan."
In writing termination or modification provisons, the key point is to keep in mind the overarching requirement that a trading plan must be entered into in good faith. If plans are modified too frequently, a critic of those plans may question whether there was ever an underlying plan, as distinguished from ad hoc trading decisions.[FN16] To reduce the possibility of this challenge, at the outset, the trading plan should state that it may not be modified too frequently (for exmaple, for at least six months after it is adopted). The trading plan also should include a time lag (of at least one month, and perhaps longer) between the adoption date of a modified plan and any trades to be executed pursuant to that new plan. Inserting this requirement in writing reduces the posssibility that a critic could contend that the original plan was modified so as to allow trades based on an insider's awareness of material nonpublic information. Finally, a good way to write a termination provision is to use an automatic time limit (such as one year). A long time limit creates an additional benefit: it provides a greater possibility to use a trading plan in private securities fraud lawsuits. As noted in my comment to the proposed rule, typically, private plaintiffs contend that executives' stock sales prior to the disclosure of adverse information signifies knowledge of that information, and hence fraud. But if a trade that appears to be close in time to the disclosure of adverse information was in fact made pursuant to a plan entered into far in advance of the trade, then plaintiffs; argument is not plausible.
4. Insure that reporting requirements are met.
As written, the Rule does not create any reporting requirements, neither does it remove any requirements. The SEC had proposed mandatory disclosure of trading plans by issuers, but tabled that proposal for further consideration. Thus, absent further guidance from the SEC, insiders must still file Form 4s and, if applicable, Forms 144. This, too, is a good provision to include in a written trading plan. For trading plans that are to be implemented by a stockbroker, the stockbroker must agree to effect the paperwork needed to allow the company or individual to file the SEC forms.
One issue on this point has arisen from a conflict between Rule 144 and the Rule. A Form 144 contains a representation that at the date of signing, the trader is not aware of any material nonpublic information. But, of course, under a trading plan, a person may indeed sell stock pursuant to a trading plan when she is aware of material nonpublic information, so long as she was not aware of such information when the plan was adopted. It cannot be the case that a technical requirement of a Rule 144 form precludes persons from taking advantage of the SEC's defense. In earlier drafts of this comment, I had suggested that insiders annonate the Rule 144 form to indicate that the trades that are the subject of the form are being made pursuant to a trading plan adopted when the seller was not aware of material nonpublic information. In December 2000, the SEC Staff issued Telephone Interpretations approving this approach.
The topic of the individual's reporting requirements elides into a company's disclosure policies. The Rule does not require a company to disclose the existence or contents of its executives' trading plans. At the extreme -- but only at the extreme -- the adoption of a trading plan by a significant shareholder might itself constitute an event for which disclosure is required. Other than at that point, disclosure is discretionary. There are good reasons why a company may choose not to disclose the details of any trading plan. For one thing, insiders may have a justifiable disdain not to have their private financial information publicly disclosed, above and beyond existing SEC requirements. On the other hand, if a company discloses the existence of its executives' plans (or that insiders may from time to time enter into trading plans) in a routine SEC filing, it allows the company to anticipate any subsequent investor questions about the trades as they occur pursuant to plan, questions that may arise when the trades are disclosed though the Form 4 and Rule 144 process. Disclosure in an SEC filing also may increase the probability that in a private securities lawsuit, a court would take judicial notice of a trading plan. Companies have started to announce trading plans more frequently, as seen in a related survey.
5. Recognize that the defense has not been widely tested.
The final point that insiders (and their companies) should keep in mind is that the SEC's defense is new, at least formally. It make sense to reason that the SEC, having itself promulgated the Rule, will be faithful to its act and give credit to credit bona fide trading plans. Less is known about private securities class action plaintiffs. As noted in my comments on the proposed Rule, there is a danger that plaintiffs will contend that an insider's adoption of a trading plan provided the "motive" for the insider to inflate her company's stock price, which in some courts may go a long way to pleading scienter under the Private Securities Litigation Reform Act of 1995. While such an argument would be wrong -- dead wrong -- it is difficult to predict what courts will do, particularly where a trading plan did not result in trades which appear to fit in an obvious pattern, or where an executive sold a high percentage of her shares pursuant to a trading plan. The first decision looks promising: a federal court reasoned that alleged 10b5-1(c) trading plans could negate any inference of suspicious stock sales.
On a related topic, questions had been raised as to the effect of the defense on State law insider trading claims. On November 16, 2000, the California edition of the Wall Street Journal ran an article present an unduly alarmist view of this prospect. Fortunately, the California Department of Corporations adopted final regulations that recognize the defense. Should the issue arise in other States, I will venture some propositions on this topic, which should become the law in a perfect and just world.
Under Delaware corporate law -- which should apply to all Delaware corporations, even in lawsuits based in other States -- there should not be any difficulty with trades made pursuant to a trading plan. This is because the few reported Delaware decisions rely on the theory that an insider should not use information garnered in her position as a corporate insider for her own private profit by making a sale on the basis of that information. As one Delaware court explained, an insider trading plaintiff "must allege a 'causal link' between specific inside information and each stock sale by each defendant by presenting specific facts showing each sale was entered into and completed on the basis of and because of non-public information."[FN17] By definition, under a good faith trading plan, an insider's sales are not made on the basis of information garnered in her positon as a corporate insider. Rather, trades are made pursuant to a trading plan adopted before the insider was aware of any material nonpublic information.
In those States where the law purports to define "insider trading" as trading while in mere possession of or with knowledge of material nonpublic information, any civil lawsuit or government prosecution in derogation of a trading plan adopted pursuant to the SEC's new rule should be preempted by federal law. To be certain, Congress has not completely preempted the field of securities regulation. But State law also is preempted where it conflicts with federal law; that is, where it stands as an obstacle to the accomplishment and execution of the full purposes and objectives of federal law.[FN18] Here, to be certain, Congress has not spoke. But the SEC has, pursuant to its statutory authority. The SEC has made its purposes and objectives clear: it created the trading plan defense to allow insiders to sell their stock free from the fear of liability. To return to the passage from the Enacting Release that began this article, but with a different emphasis, according to the SEC:
We anticipate two significant benefits arising from Rule 10b5-1. First, the rule should increase investor confidence in the integrity and fairness of the market because it clarifies and strengthens existing insider trading law. Second, the rule will benefit corporate insiders by providing greater clarity and certainty on how they can plan and structure securities transactions. The rule provides specific guidance on how a person can plan future transactions at a time when he or she is not aware of material nonpublic information without fear of incurring liability.We believe that this guidance will make it easier for corporate insiders to conduct themselves in accordance with the laws against insider trading.
No credible argument can be made that it would not present a conflict between federal and State law if an insider followed the SEC's rules by adopting and following a good faith trading plan, yet neverthess "incur[ed] liability" for her actions under State law. In such a conflict, federal law, not State law, must prevail. There could scarcely be a greater waste of taxpayer money than a State agency attempting to penalize persons for following these federal guidelines. And a direct or derivative lawauit alleging harm from the execution of trading plans a Company approved, for the good reasons set forth above, would be frivolous.
[FNX] This article formerly was titled "The SEC's trading plan defense: at long last (hopefully) relief for the honest insider."
[FN1] See Release Nos. 33-7881, 34-43154, IC-24599, File No. S7-31-99 (the "Enacting Release").
[FN2] See Comments submitted to Securities & Exchange Commission on "program trading" defense to insider trading liability under proposed Rule 10b5-1.
[FN3] Enacting Release, page 37 of 59.
[FN4] 17 C.F.R. Section 240.10b5-1(c)(1)(i)(A)(2), (3) (emphasis added); see also FN15 and accompanying text.
[FN5] 17 C.F.R. Section 240.10b5-1(c)(1)(A); Enacting Release, page 20 of 59. Some persons have suggested that an insider may adopt a plan while in possession of meterial nonpublic information, provided that sales do not commence until that information becomes public. In my opinion, this is a mistake. The Enacting Release and May 2001 Telephone Guidance are replete with references to trading plans as being adopted when the insider is not aware of any material nonpublic information. Why take the risk of creating an issue where one does not exist?
[FN6] 17 C.F.R. Section 240.10b5-1(c)(1)(ii); Enacting Release, page 20 of 59.
[FN7] 17 C.F.R. Section 240.10b5-1(c)(1)(i)(B)(1)-(3); Enacting Release, page 20 of 59.
[FN8] 17 C.F.R. Section 240.10b-5(c)(1)(iii)(A)-(C).
[FN9] 17 C.F.R. Section 240.10b5-1(c)(1)(i)(C).
[FN10] Enacting Release, page 21 of 59 (emphasis added).
[FN11] Enacting Release, page 21 of 59.
[FN12] Enacting Release, page 20 of 59.
[FN13] 17 C.F.R. Section 240.10b5-1(c)(1)(i)(B)(3)
[FN14] 17 C.F.R. Section 240.10b5-1(c)(1)(C).
[FN15] 17 C.F.R. Section 240.10b5-1(c)(1)(C).
[FN16] See Answer to Question 15(b) in May 2001 Telephone Intereprations ("Termination of a plan, or the cancellation of one or more plan transactions, could affect the availability of the Rule 10b5-1(c) defense for prior plan transactions if it calls into question whether the plan was 'entered into in good faith and not as part of a plan or scheme to evade' the insider trading rules within the meaning of Rule 10b5-1(c)(1)(ii). The absence of good faith or presence of a scheme to evade would eliminate the Rule 10b5-1(c) defense for prior transactions under the plan.").
[FN17] Rosenberg v. Oolie, No. Civ. A. 11,134, 1989 WL 122084, at *4 (Del. Ch. Oct. 16, 1989) (quotation omitted); see also Strougo v. Carroll, 1991 WL 9978, at *1 (Del. Ch. Jan. 21, 1991) (directors sold stock knowing and on the basis of impending disclosure of financial difficulties); Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949) (directors' secretary purchased stock knowing and on the basis of fact that corporation secretly intended to purchase back its stock on the market).
[FN18] Freightliner Corp. v. Myrick, 115 S. Ct. 1483, 1487 (1995) (premption where State law "stands as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress") (quoting Hines v. Davidowitz, 312 U.S. 52, 67-68 (1941)). See also Pacific Gas & Elec. v. Energy Resources Comm'n, 461 U.S. 190, 204 (1982) (state law preempted where it conflicts with federal law); Florida Lime & Avocado Growers v. Paul, 373 U.S. 132, 142-43 (1963) (state law preempted where it obstructs the congressional objectives underlying federal law); Olde Discount Corp. v. Tupman, 1 F.3d 202, 209 (3d Cir. 1993) (state law preempted if it prevents use of remedy mandated by federal law "in any practical sense")