Rule 10b5-1: Fix the Cracks But Save the Baby

       

_{From left to right: Gregory A. Markel, Daphne Morduchowitz, and  Renée B. Appel}

On June 7, 2021, U.S. Securities and Exchange Commission Chair Gary Gensler announced at the CFO Network Summit that he has asked his staff to make recommendations for the Commission’s consideration on how it might “freshen up” Rule 10b5-1, which provides officers and directors with a way to limit risks associated with the purchase or sale of their company’s securities. Chair Gensler critiqued what he identified as “real cracks” in the present insider trading regime, including the absence of : (1) mandatory cooling off period requirements before an insider can make their first trade; (2) limitations on insiders’ ability to cancel plans when they do have material nonpublic information; (3) disclosure requirements regarding trading plans; and (4) limitations on the number of trading plans a company can issue. Chair Gensler appears to be advocating for tightening of the rules in these respects, rather than abolishment of important Rule 10b5-1 trading plans.

Overview of Rule 10b5-1

While Exchange Act Section 10(b) and Rule 10b-5 generally prohibit the purchase or sale of securities “on the basis of” material nonpublic information, Rule 10b5-1, adopted in 2002, establishes an affirmative defense for insider trading allowing insiders to purchase or sell securities pursuant to pre-formulated trading plans. A purchase or sale is not considered to be made “on the basis of” material nonpublic information if the person making the purchase or sale demonstrates that before becoming aware of the information, the person 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;

and the contract, instruction or plan meets certain elements set forth in the rule. See 17 CFR § 240.10b5-1.

10b5-1 Plans as Applied

By executing pre‐planned transactions under a Rule 10b5‐1 plan entered in good faith, an individual is insulated from liability, even if actual trades made pursuant to the plan are executed at a time when the individual may be aware of material, non‐public information that would otherwise subject that person to liability under Section 10(b) or Rule 10b5‐1. When properly created and implemented, Rule 10b5-1 trading plans permit company insiders to sell their shares without litigation risk or exposure. Specifically, through the Rule, insiders can effectively refute any inference of scienter by demonstrating that the trades were pre-scheduled and therefore not likely to indicate misuse of material inside information.

In addition to insulating officers and directors from liability for insider-trading claims, such plans also can protect against unfounded allegations of scienter premised on insider sales (i.e., securities fraud and breach of fiduciary duty claims). Insider sales can sometimes be used by plaintiffs as part of their attempt to show a strong inference of knowledge of fraudulent activity. For example, plaintiffs typically allege that the sale of company stock by insiders shortly prior to public knowledge of alleged fraud is indicative of scienter. However, where such sales are effectuated pursuant to trading plans that were implemented prior to the alleged fraud, the inference of knowledge of fraud from those sales is in many cases mitigated.

Notably, however, Rule 10b5-1, may not protect officers and directors where there is evidence that the trading officer or director had knowledge of material, nonpublic information at the time the plan was enacted.

Observations and Considerations

Officers and directors are expected by many companies to invest in the company at some level. In most cases such ownership has the beneficial effect of aligning the interest of directors and officers with those of shareholders whose only connection to the company is ownership of the shares. While current trends in many public companies are questioning of the maximization of shareholder value being the sole proper goal of officers and directors, (see, e.g., Directors Roundtable publications) it is certainly one of the goals that directors and officers must consider. 10(b)-5-1 is well designed to help officers and directors avoid the risks of being sued criminally or in widespread and sometimes baseless civil actions when impact purchases and sales are for financial planning purposes rather than to take advantage of material inside information. By allowing directors and officers to adopt a financial plan which is developed based on their own financial needs, 10(b)5-1 allows for directors and officers to avoid in some cases potential liability when they are simply following a financial plan unrelated to material inside information.

Based on the comments from Chair Gensler, it is likely that we will see some additional restrictions on Rule 10b5-1 plans in the future, including mandatory cooling off periods between the adoption of a plan and when it goes into effect, limitations on cancellation, modifications and overall number of plans, as well as mandatory disclosure. However, Rule 10b5-1 trading plans remain an important risk mitigation tool for officers and directors and we hope and expect that Chair Gensler is very thoughtful in proposing restrictions on their use.

Assuming Mr. Gensler’s proposed changes when described in more detail are limited to eliminating misuse of such plans they are to be applauded. What remains to be done is to see that the changes do not accidently throw out valuable aspects of these plans. In other words, the baby with the bath water. 10(b)-5-1, properly used, is very beneficial in several respects, including in encouraging able directors to serve in that capacity.