QWest Communications: the first test case for the impact of Rule 10b5-1 trading plans in a securities class action lawsuit?

Originally published on this site August 12, 2001

Personally, I think the defendant, Joseph Nacchio, was not treated fairly in the parallel criminal case, as the Tenth Circuit stretched to find liability.  That being said, the District Court issued some fine decisions in both cases.

A private 10b-5 class action lawsuit has been filed that may end up testing the impact of Rule 10b5-1 trading plans -- actually, the effect of announcing and then almost immediately abandoning a plan.

On July 27, 2001, a plaintiffs' law firm announced the first lawsuit against Qwest Communications International, Inc. and certain of its officers, including CEO Joseph Nacchio. The supposed class period is from March 22, 2001 to July 23, 2001. The supposed false statements are the financial statements or the alleged gloss on them. The statements alleged were rendered false by the failure to write down the value of a subsidiary, KPNQwest -- a second-guessing claim that we can expect to see with increasing frequency as companies implement the new rules for accounting for acquisitions, goodwill and intangible assets (SOP 141 and SOP 142); an unannounced change in the discount rate used to calculate pension obligations; the "aggressive use of capitalization to classify tens of millions of dollars of interest and software development costs as assets rather than expenses." As is typical, individual stock sales are alleged, here to the tune of $49.5 million.

What makes this lawsuit interesting is that Qwest was one of the first companies to announce that a high-ranking executive had adopted a trading plan. According to Yahoo! Finance, prior to the plan, Mr. Nacchio had sold large blocks of shares during mid-quarter trading windows. He sold 550,00 shares (including shares held by an affiliate) from July 31 through August 8, 2000; 725,000 shares from October 30 through November 17, 2000; and 300,000 shares from January 26 through February 8, 2001. (Oddly enough, he also sold 619,467 shares on January 2-3, 2001.) The prices for these sales ranged from $39.35 to $53.34 per share.

On February 16, 2001, the QWest Board and Mr. Nacchio issued a press release jointly announcing what they characterized as "a planned and structured daily stock sales program for Nacchio to sell the stock issuable upon the exercise of Qwest stock options that expire on June 30, 2003." Under than plan, Mr. Nacchio planned to sell the 6.1 million options on a pro rata basis --11,500 shares daily, at the market price, from February 20, 2001 until June 30, 2003 -- rather than in trading windows. Thus, this trading plan was unique in that the CEO had to exercise the options or lose them. The press release further stated that the Board had asked the CEO "to commit to the program to avoid the bunching of sales during and at the end of the exercise period of the June 1997 options." The press release also explained that the CEO held other shares and options that were not included in the plan.

Mr. Nacchio started on the plan by selling 11,500 shares per day from February 20 through March 1, at prices ranging from $34.84 to $38.12. But on March 2, the Company issued a second press release announcing that Mr. Nacchio had ended the February 16 plan. The press release quoted Mr. Nacchio as stating, "I will not continue to sell shares daily at these prices given the current uncertainty in the markets . . . Because my reasons for entering into the daily sales program in the first place have not changed, I would expect to return to my prior practice of making sales in quarterly trading windows or, in appropriate circumstances, consider entering into a new daily sales program if I believe the stock price is more realistic." The press release further explained that in 2001, Qwest stock had traded between $48.18 and $33.88. As promised, Mr. Nacchio resumed his prior practice of selling during mid-quarter windows. Between April 26 and May 15, he sold 1,250,000 shares at prices ranging from $37.23 to $41.12 per share. (It is possible that other sales were conducted, but not yet reported on Yahoo! Finance.)

It is unclear how the temporary trading plan will play out in the lawsuit. Plaintiffs may allege that Mr. Nacchio's termination of the plan evidences his intent to push up Qwest's stock price before selling any more shares. However, the number of shares data undermines such an argument. By terminating the plan mid-stream and waiting until the open trading window in the next quarter, Mr. Nacchio forswore the 11,500 shares per day that he would have been able to sell under his plan starting on the day after the supposed fraud started (March 22) until the day the window opened (April 26). By my calculations, this represented a loss of 276,000 shares that could have been made. Mr. Nacchio also gave up the sales that could have been made from March 2 through March 22, or an additional 172,500 shares. While this period predates the purported class period, it should be counted if plaintiffs contend that Mr. Nacchio had decided to terminate the plan in order to commit fraud. Mr. Nacchio further could have sold 701,500 shares (61 trading days * 11,500 shares per day) from April 26 through July 24, the date the Company made the announcement that ended the class period. Thus, in total, had Mr. Nacchio chosen to stick with his plan, he would have sold 1,152,000 shares (from March 2 through the end of the class period.) This number is within 100,000 of the actual number of shares (1,250,000) that he actually sold during the open window and class period. (And perhaps he had to sell a slightly high number of shares to realize the proceeds he had planned to garner under the previous plan, had the stock price reflected what he considered to be a "realistic" number.)

In fact, in can be argued that Mr. Nacchio's termination of the trading plan is inconsistent with plaintiffs' theory of fraud. This argument is based on stock price of the sales. Mr. Nacchio's stock sales during the class period ($37.23 to $41.12 per share) were not at a radically higher value than his sales through the trading plan ($34.84 to $38.12). Had Mr. Nacchio truly intended to artificially inflate the stock price, why wouldn't he have kept the plan in place? This would have allowed him to sell during a substantial period (May 16 through July 24) after the close of the Q201 trading window, gaining the full advantage of the higher stock prices he supposedly was trying to achieve. I would make this argument, if at all, very carefully, so as not to undermine the good faith of the trading plan that Mr. Nacchio had adopted.

Thus, I don't think that plaintiffs are going to be able to benefit from the announced and abandoned 10b5-1 trading plan, and in fact they may lose ground due to the circumstances of this termination. It will be interesting to see if either side attempts to introduce the plan on a motion to dismiss. It was announced in a formal press release, and the reported sales were consistent with the plan. Thus, it would defy credibility to dispute its existence. However, the sequence of press releases suggests that Mr. Nacchio was not the sole author of his plan; rather, he had adopted it at the suggestion of the Company's Board.