How not to create a trading plan defense: Securities and Exchange Commission vs. Lipson
Originally published on this site July 29, 2001
Updated February 14, 2002
In Securities & Exchange Commission v. Lipson, 128 F. Supp. 2d 1148 (E.D. Ill. 2001), a jury rejected a corporate insider's claim that questioned stock sales had been made pursuant to a preexisting sales plan (an estate plan). In Securities & Exchange Comm'n v. Lipson, No. 01-1226, ___ F.3d ___, 2002 WL 22113 (7th Cir. Jan. 9, 2002) (Posner, J.), the Seventh Circuit Court of Appeals affirmed the judgment in its entirety. While the facts of the case are extreme, and the purported "plan" was allegedly undertaken prior to the enactment of the Rule 10b5-1 defense, the case does serve as an object lesson of how not to create a Rule 10b5-1 trading plan.
The District Court Decision
In the district court, a jury found that the defendant, then the Chairman and CEO of Supercuts Inc., violated Securities Exchange Act Sections 10(b) and 17(a) by selling 365,000 shares of stock from an account in his son's name while he possessed inside information regarding the company's expected poor earnings. The written opinion concerns the district court's decision that defendant violated Section 16(a) by failing to report the transactions.
The defendant's contentions, at least as reported, were incredible on their face. He asserted that he did not read or pay attention to the financial reports submitted to him by the CFO that signaled the poor earnings because he believed such reports to be inaccurate; every other Board member testified that they had never heard the defendant say this. The defendant also claimed that he was not fully knowledgeable about the financial performance of the company of which he was the CEO. The defendant further claimed that he had signed the company's insider trading policy without reading it. The defendant also asserted that the anticipated stock price after the earnings announcement was not a factor in his determination to sell. Finally, and of most interest to us, the defendant asserted that that the stock sales in question were not for the purpose of avoiding losses, but rather a part of a preexisting estate plan.
The jury rejected these arguments in their entirety, and the Court concurred. With respect to the trading plan defense, the Court found that while the defendant had tried to orchestrate his attorneys and accountants to concoct the defense, their testimony was not credible. The Court also found "extremely troubling" and indicative of further violations the fact that the day after the defendant was fired as CEO, he ordered the sale of the rest of his holdings knowing that the company was in danger of defaulting on loan covenants and "against" the "advice" of his personal attorney: "It appears from the testimony that when asked, [the attorney] would intone in a formalistic manner the legal caveat regarding material non public information and then propose to sanction whatever course of conduct Mr.. Lipson desired. Even [the attorney], however, had obvious doubts as to the propriety of this last attempted sale, although he could not bring himself to utter the word 'no' to his affluent client and instead constrained himself to simply warn Mr. Lipson of likely criticism."
Another interesting point is that even though Supercuts' stock trading windows were "recommended" only, the Court said that the CEO's trading outside the windows "violated the policy's recommendation . . ." Other judges and juries may not reach the same conclusion under less egregious facts, especially given the CEO's surreptition, but of course there can be no guarantee.
The Court also slammed the defendant for protesting his innocence and contesting the proceedings (both in court and publicly), and for being "totally self-reliant and extremely confident in defining his own course of conduct." The Court ordered disgorgement of the avoided losses plus prejudgment interest (as the defendant had invested the ill-gotten gains for profit), and imposed the maximum civil penalty.
It may not be surprising that the jury and later the Court ruled against a defendant whose arguments were so specious and supported, and who is so financially sophisticated that he "owns no personal property directly, treating even his living space as a partnership investment." Nevertheless, the case reinforces the wisdom of putting a trading plan in writing (which is required by Rule 10b5-1(c)(i)(3) in any event); and in consulting in good faith with your lawyers, accountants, or other advisors before you start trading.
The Appellate Decision
At the Court of Appeals, Judge Posner wrote that the evidence "was overwhelming that [the CEO] had inside information when he sold the shares. The jury was not required to believe his implausible testimony that he paid no attention to the financial reports that his subordinates gave him. His inside information gave him an incentive to sell his shares before the information became public because it showed that [the company] was worth less than its market valuation. Even skeptics about the prohibition of insider trading tend to look askance at an insider who profits from the poor performance of his company-poor performance for which he may be responsible."
Thus, the only issue was the standard of liability and assignment of the burden of proof. Judge Posner affirmed the jury instruction that an inference that the CEO used material nonpublic information at the time of his sales if he possessed such information may be rebutted by "evidence that there was no connection between the information that the defendant possessed and the trading, in other words, that the information was not used in trading.... If you conclude that the trades ... would have occurred on the same dates and involving the same amounts of stock regardless of whether [the CEO] possessed the inside information ..., then you should find that [he] did not use the inside information in selling ... stock."
Part of the opinion, while probably dicta, supports a solid concept of Rule 10b5-1(c) trading plans: they create a safe harbor. Judge Posner reasoned that the last sentence in the jury instruction gave the CEO "a safe harbor, and is unobjectionable." He also said that the new SEC regulation "creates a similar safe harbor," citing Rule 10b5-1(c)(1). As the Court explained, this meant that if the CEO "would have sold the shares in the same amounts and on the same dates that he did sell them even if he had not possessed any inside information, then he would be home free, because then the existence of a causal connection between his inside information and the challenged sales would be negated."
The rest of Judge Posner's analysis concerned underlying liability standards. He reasoned that the first part of the jury instruction was acceptable, because it allowed "the jury to infer that if he had inside information, the trades were influenced by it. To infer Y from X just means that, if X happened, Y probably happened. If [the CEO] possessed nonpublic information which showed that [the stock] stock was overpriced, and having this information he sold a large quantity of that stock shortly before the information became public and the stock dropped sharply in value, common sense tells us that it is probable that his decision to sell when he did and how much he did (rather than sell later or sell less) was influenced by the information." In a civil case, this "inference is sufficiently compelling to shift to a defendant . . . the burden of production, that is, the burden of presenting some rebuttal evidence, on pain of suffering an adverse judgment as a matter of law if he does not." That is what the middle sentence in the instruction did, while the CEO's proposed alternative -if the jury found that he "had a legitimate, alternative purpose for selling" it would have to find in his favor - was "absurd": "He might well have had two purposes, one to transfer wealth to his son and the other to avoid a loss that his inside information told him was coming. The existence of the legitimate purpose would not sanitize the illegitimate one."
Note that according to Judge Posner, the SEC did not go further in arguing for dictum in the Teichler case that trading while one knowingly possesses material inside information is per se sanctionable. Interestingly, the Court found that this rule had since been adopted by SEC Rule 10b5-2, which was enacted to accompany Rule 10b5-1(c). Judge Charler Breyer also held that the new regulations created new definitions of insider trading in United States v. Kim, No. CR-01-0193 CRB, ___ F. Supp. 2d ___, 2002 WL 75846 (N.D. Cal. Jan. 15, 2002).
Judge Posner also found that it was proper for the judge to decide the amount of the civil penalty (after the jury determined liability), as this was an equitable remedy. Here, it noted that "[t]rading on insider knowledge by a major shareholder who is also the corporation's chief executive officer is a breach of fiduciary obligation," citing the United States Supreme Court's decision in Chiarella. The Court also approved the district court's imposition of the maximum penalty on the ground that the CEO had maintained his innocence: "The evidence against [the CEO] was overwhelming, and his insistence in the face of it that he is a shorn sheep argues for heavy punishment to bring him to his senses."