Insider Trading and the Use of 10b5-1 Plans

By Richard Friedman, The Ayco Company, L.P.
From the Ayco Compensation and Benefits Digest, January 2015

Formal charges, allegations or even hints of insider trading violations create significant reputational risks to individuals and their employers. While the Securities and Exchange Commission (SEC) continues to bring a significant number of enforcement actions for insider trading, a recent federal court decision (discussed below) could jeopardize the successful prosecution of those who receive and benefit from nonpublic information concerning a public company. This case should not impact corporate compliance policies. Most public companies now have written compliance policies which are updated periodically. Such policies usually include guidelines to avoid §16 short-swing trading violations by insiders, as well as separate rules to avoid charges of insider trading. These two distinct concepts are sometimes confused. Violations of short-swing trading rules by corporate insiders (key executives and directors) may be pursued by any shareholder or the company itself, while prosecution for insider trading is brought by the government through the SEC. We thought we would describe for you what can constitute insider trading and how executives can avoid being implicated. This updates a similar analysis we completed over two years ago.

Due in part to new investigative approaches and the innovative use of technology, the SEC’s enforcement activity relating to insider trading reached a record high last year. In fiscal year (FY) 2014 that ended in September, the SEC filed a record 755 enforcement actions, and obtained orders for penalties or profit disgorgement of $4.16 billion. In FY 2013, the numbers were 686 individuals charged and $3.4 billion in penalties.

Some of those charged with insider trading in 2014 include:

• Three software company founders;
• Three sales managers who learned of an acquisition at a sales meeting;
• A board member who tipped his brothers as to sale of the company;
• An executive who tipped his 6 golfing buddings over a 2 year period;
• Two clinical drug trial doctors;
• An investment banker who shared information with his golfing buddy;
• Two investor relations executives;
• An IT employee at law firm about a pending merger;
• A corporate attorney who tipped his wife;
• A CEO who tipped the owner of his favorite restaurant and his waiter;
• A law firm clerk who passed tips to his broker on post-it-notes which he then ate.

Insider Trading – What Is It?

Insider trading is, in effect, a means of defrauding investors. While there is no law that explicitly prohibits insider trading, the SEC issued rules based on authority granted under the Securities & Exchange Act of 1934 prohibiting the purchase or sale of a public company’s stock or other securities (such as bonds or stock options) while an individual is aware of material non-public information (“MNI”) about the company. The SEC approved rule 10b5-1 in 1942 after it received information that the president of a company was telling shareholders that it was doing poorly and then buying their shares when, in fact, the company was performing quite well. The rule generally prohibits making misstatements, omitting material facts, or employing any device to defraud investors. Most countries around the world have somewhat similar rules, although enforcement varies considerably.

There is actually a second theory on which the SEC can base a charge of insider trading. This is the misappropriation theory, which formed the basis for charges brought in 2008 against entrepreneur Mark Cuban, the owner of the Dallas Mavericks (he was found not guilty of the charges in 2013.) This was also the basis for charges last year against a consultant who was a roommate of a Herbalife employee and shared with a friend the not-yet public confidential details of William Ackerman’s hedge fund bet against Herbalife, leading to a $47,100 profit from the sale of a put option. Under SEC Rule 10b5-2, a duty of trust exists whenever a person agrees to maintain MNI in confidence, even if they are not a fiduciary or insider.

Anyone using or sharing MNI can be charged with insider trading including senior executives, other employees, consultants, directors, their family members, friends and associates, or anyone with whom they communicate. The concept of informing others of confidential information who then use it as the basis for a transaction, known as “tipping”, was first held to violate insider trading rules on a 1961 case (Cody, Roberts & Co.). A director of a public company, who was a partner in a brokerage firm, informed one of his partners of a pending dividend reduction at the company. The partner then sold stock for clients in advance of the public announcement. Yet it wasn’t until 2012 that Congress passed the STOCK (Stop Trading on Congressional Knowledge) Act to require public disclosure of trades valued at $1,000 or more (except mutual funds) and ban insider trading by members of Congress and other government officials who might profit from private information obtained while in government service. A section of the act that would have also required disclosure by “political intelligence” firms was stripped from the bill before it was passed. The first government official to use knowledge gained from his official position to benefit personally was William Duer, who was the Assistant Secretary to the first Secretary of the Treasury, Alexander Hamilton. He engaged in speculative trading in the first debt issued by the U.S. leading to our first market crash in 1792 and his personal bankruptcy.

Last month, the 2nd Cir. Court of Appeals issued an important decision which is likely to impact insider trading charges leveled against non-insiders who receive, trade, and profit from MNI (U.S. vs. Newman and Chiasson). The defendants in this case were portfolio managers who were four or five degrees removed from the original source of the MNI. They were found guilty of insider trading following a jury trial, but the federal appeals court overturned their conviction. The court concluded that the SEC must provide beyond a reasonable doubt that a tippee knew that the information was confidential and that the insider who leaked the information received a personal benefit for doing so. Unless overturned or new rules are issued by the SEC, this standard may impact the number of future cases against tippees brought by the SEC.

Material Nonpublic Information – There is no universal definition as to what constitutes “material” nonpublic information. Essentially, MNI is information that would influence an investor’s decision to buy or sell the security. It can be material if there is a substantial likelihood that a reasonable investor would consider the information important in deciding to trade the stock. This obviously is a subjective determination. It could include information that likely would have some impact on a company’s stock price, such as any information on mergers or acquisitions, the sale of a business unit, earnings changes, the gain or loss of a major customer, or even the pending retirement or serious health issues of a CEO. SEC Regulation FD (Fair Disclosure) requires that if a company unintentionally discloses MNI to anyone, it must publicly disclose such information.

Penalties – The SEC may seek both civil and criminal penalties for violations of the insider trading rules. These include disgorgement of all profit realized or loss avoided, civil penalties of up to three (3) times the profit/loss, a criminal fine of up to $5 million, and a jail term of up to 20 years. There are also potential monetary penalties payable by an employer. These are in addition to loss of reputation due to allegations of insider trading.

The longest jail sentence handed down? Twelve years given to a lawyer in 2012 who pleaded guilty to sharing private information about his corporate clients for over a decade. Raj Rajaratnam of the Galleon Group received 11 years when convicted in 2011, Matthew Martoma, former portfolio manager at SAC Capital, received a 9 year sentence upon being found guilty last year. Sam Waksal, who founded drug maker ImClone Systems pleaded guilty in 2003 and served 7 years, 3 mos. (Martha Stewart who also sold ImClone Shares served 5 months after being convicted of obstruction of justice). Meanwhile the godfather of insider trading, Ivan Boesky, served only 22 months of a 3.5 year sentence in 1987. The largest monetary penalty was the $1.2 billion that Steven Cohen’s SAC Capital Advisors agreed to pay last year, dwarfing the $600 million that Michael Milken agreed to pay in 1985 to settled charges against him.

Rule Change Leading to 10b5-1 Plans

Violations of insider trading rules proved difficult for the SEC to enforce through the 1980s and 1990s due to the fact that there needed to be evidence of an intent to violate the rules for a conviction. In 2000, the SEC modified its rules so that an individual could be found liable for insider trading simply by possessing MNI when trading in the security, or passing along the information to a third party who does the same.

One of the unintended consequences of this change was that trustees of charitable organizations who possessed MNI could be subject to severe penalties for selling stock donated or held by the entity. The best example was Bill Gates, a trustee of the Bill & Melinda Gates Foundation whose primary assets were shares of Microsoft stock. To alleviate this problem, the SEC created an affirmative defense to a charge of insider trading for situations in which a   person could demonstrate that any MNI known at the time of the transaction was not a factor in the trading decision. An example is a pre-planned arrangement to have a trade occur at a specified future date. This is described in SEC Rule 10b5-1, hence such trading plans are known as 10b5-1 plans. It should be noted that transactions made pursuant to a 10b5-1 plan are not automatically exempt from insider trading rules. Rather, an individual can use the existence of a valid plan to defend against possible charges made by the SEC.

Requirements For A Valid 10b5-1 Plan

An individual may establish a 10b5-1 plan by doing any of the following:

• Enter into a binding contract for the future purchase or sale of company stock; or
• Give instructions (preferably in writing) to a third party to purchase or sell securities; or
• Adopt and follow a written plan for a transaction.

To be effective, a 10b5-1 plan must:

• Be established only when the individual is not aware of MNI;
• Specify the number of shares to be bought or sold, plus either the date or the price at which the transaction is to occur, or include a formula for making such a determination;
• Prohibit the individual from later exercising any influence over the transaction, including how or when the transaction occurs;
• Be entered into and acted upon in “good faith”.

Any person can establish a plan, not only insiders. Plans typically are in writing and, in most cases, a broker’s prototype plan is utilized – although, this is not a formal requirement. An individual can create their own valid plan. The rules do not preclude individuals from establishing multiple plans or specify the length or term of the plan. If a valid plan is established, the transaction called for can take place even if the individual possesses MNI at that time. Many companies that authorize or recommend the use of 10b5-1 plans request that plans utilized by key executives or directors be submitted to their compliance department for review prior to adoption.

In general, an individual who adopts a 10b5-1 plan is expected to carry out all transactions called for under the plan. However, the SEC staff has indicated that a person who cancels a planned trade is not necessarily engaging in insider trading even if that person was aware of inside information when they cancelled the transaction. The reasoning is that there cannot be a violation without an actual purchase or sale of securities. However, cancellation of a transaction or a modification of a plan itself could call into question whether the plan was entered into in good faith. This can negate the protection a plan provides. Good faith is another subjective determination.

Transactions Where Plan Utilized

A 10b5-1 plan can be used for any of the following transactions by corporate insiders or any employee or individual who could be in possession of MNI:

• Sale of company stock either as of a specified date (market order) of when the stock price reaches a defined threshold (limit order);
• Purchase of company stock (even if to meet share ownership targets);
• Exercise of stock options or exercise and sale of options;
• Sale of company stock received upon vesting of restricted stock, delivery of RSUs, performance shares or other compensation in stock;
• Sale of shares acquired through Employee Stock Purchase Plan or ESOP;
• Purchase or sale of company stock in a 401(k) plan or IRA;
• Sale of company stock to pay required tax withholding or meet cash flow needs.

It should be noted that the hedging of company stock, pledging of stock through a margin account, or the use of puts and calls on company stock all can lead to insider trading charges if entered into when an individual has MNI. However, a gift of shares that are not immediately sold generally would not require a 10b5-1 plan.

Our Informal Survey Data

We recently updated our informal survey as to the utilization of 10b5-1 plans by Ayco financial counseling clients. We asked Ayco financial counselors to indicate how many of their Section 16 insider clients have adopted a Rule 10b5-1 plan within the past two years and which individuals modified or cancelled a plan within that time frame. Ayco works with over 1,700 individuals who are Section 16 insiders at public companies, including over 250 CEOs. Here is an indication of their utilization of 10b5-1 plans, including the percentage of individuals with plans currently in place (as of November 2014):

Just over 7% of those who adopted a plan within the past two years were reported to have modified or terminated their plan prior to all transactions called for under the plan.

Common and Best Practices

While not all companies require or even encourage executives to utilize 10b5-1 plans (in fact, several companies discourage or disallow plans), those that do allow plans generally have “rules of the road” for the design of plans. Typically, these include some or all of the following:

• Cooling Off or Waiting Period – This is the period between the adoption of a plan and when the first transaction under the plan can take place. Although there are no formal requirements, the administration of virtually all plans have a cooling off period of anywhere from two weeks to 90 days or until the next “window” period. Most prototype broker plans suggest a 60-90 day waiting period.
• Time Limits – While there are no specific timeframes for the length of a 10b5-1 plan, plans typically are designed for a period of 3 to 6 months and rarely more than a year. A series of short-term plans can suggest manipulation, while a lengthy plan can be inflexible when there are unexpected changes in the individual’s needs or the company’s condition.
• Number of Plans – The rules do not limit the number of active plans an individual can have at any one time. However, some companies require or request individuals have only one plan in operation at any time. Multiple plans can raise a suspicion of manipulating the rules or raise the possibility of bad faith.
• Transactions In or Outside of Window Period – 16 insiders are not required by SEC rules to have purchases and sales of company stock only in window periods, although some companies have corporate policies that mandate transactions occur only in window periods. These companies may request or require that 10b5-1 plans be adopted only in an open window. Most companies, even those with these types of restrictions, will permit a transaction pursuant to a 10b5-1 plan at any time, even outside of a window period. Thus, these plans can provide greater flexibility in some instances.
• Trades Outside of Plan – There is no prohibition under the rules for an individual who has adopted a plan to have other transactions – purchases or sales – outside of the plan. But an accelerated sale of securities covered by a plan is not recommended as this would be deemed a modification of the plan, would need to be done only when the individual was not aware of MNI, and could lead to suspicions as to the “good faith” required for a valid plan. For the same reasons, a best practice is to restrict any other stock transactions during the term of the plan to avoid the appearance of hedging the plan transaction.
• Modification, Termination or Suspension of Plan – In most cases, companies take no position with regard to whether a plan can be modified or cancelled. There are some companies which indicate that any such action must occur only when the individual is not aware of MNI. A modification can be viewed as the termination of the prior plan and adoption of a new plan – which can trigger a new waiting period for subsequent transactions. It should be noted that an individual’s termination of employment does not automatically end the plan – unless that was part of the plan to begin with. Plans can be designed to automatically terminate or be suspended upon stipulated events – such as the announcement of a merger or upon an individual’s termination of employment, or even upon a defined hardship.
• Whose Plan To Use – Many of Ayco’s corporate partners have a recommended plan for16 insiders or others who wish to adopt a plan. Typically, these are with the broker with which the company has a relationship and who administers the company’s stock plans. But an executive may use their own broker’s plan or make alternate arrangements. In these instances, the company compliance department may want to review and approve the terms of the plan. It will also be extremely important to confirm who is going to administer the plan to ensure that the transaction occurs as scheduled. If it does not, all protection that the plan was designed to provide can be lost. In addition, most companies require that they be notified prior to, or immediately upon, any transaction by a §16 insider so that a timely Form 4 can be filed with the SEC.
• Identifying Those With MNI – Not all insiders will be in possession of MNI, but certain non-insiders may be – such as members of the legal department and the staff to senior All who may have access to MNI should be made aware of the rules.
• Public Disclosure – No public disclosure is required upon the adoption of a But sometimes public disclosure can make sense to give advance notice of a scheduled future transaction. Companies are more likely to pro-actively disclose a plan adopted by the company’s CEO or named executive officers rather than other individuals. In most cases, this disclosure will be made in a Form 8-K filing – although, there are instances in which brief articles will appear in a financial publication stating simply that an individual had entered into an arrangement for the orderly sale of stock. Details of a plan are rarely provided.

Disclosure is required when §16 insiders sell or buy stock. Failure to file timely Form 4 electronically with the SEC, even if advertent, constitutes a violation of reporting rules under SEC §16(a). These filing violations historically have had minor consequences. But last September, the SEC announced charges and enforcement actions against 28 officers, directors, or major shareholders and 6 public companies for repeated violations of SEC public filing requirements.

Academic and Journalist Studies

There have been several academic and journalist studies relating to 10b5-1 plans. A significant early one was a 2006 analysis by Alan Jagolinzer from Stanford Univ. who reviewed 100,000 transactions by 3,000 executives at over 1,200 companies. Another one by Alexander Robbins of the University of Chicago analyzed transactions by executives at Nasdaq listed companies. Both of these studies found that trades under 10b5-1 plans resulted in a greater rate of return to executives compared to returns of those who did not enter into such plans. A follow-up study by Prof. Jagolinzer reported that 46% of plans that were terminated early occurred within 90 days prior to the company releasing positive news. Another more recent study of corporate merger deals by two professors from NYU and one from McGill University suggested that a  quarter of all such deals between public companies from 1996-2012 involved some kind of insider trading. The Wall Street Journal conducted their own analysis of trades by over 20,000 executives. It reported in July 2013 that 1,400 individuals made trades just before major news was publicly disclosed realizing average gains (or avoiding losses) of at least 10%.

Two years ago, the Council of Institutional Investors wrote to the SEC expressing concerns as to the potential misuse of 10b5-1 plans, and asked for “clear guidelines regarding the circumstances in which a 10b5-1 plan may be adopted, modified, or canceled.” The director of the SEC’s Division of Enforcement indicated that the SEC has increased scrutiny of executives who utilize 10b5-1 plans in an inappropriate manner. Yet, the SEC has not, to date, issued guidance or mandated public disclosure when a 10b5-1 plan is entered into. Only actual reportable transactions by §16 insiders are disclosed to the public on a Form 4. It has become commonplace for insiders who file these forms to footnote that the transaction was pursuant to a pre-arranged plan – a 10b5-1 plan. This voluntary disclosure actually helps academics trace transactions, along with 8-K disclosures. However, these fail to address canceled trades which need not be disclosed.

Potential Issues With Plans

10b5-1 plans do not eliminate the risk of a charge of insider trading. If the rules are not followed, including if a plan is entered into or modified when the individual is in possession of MNI, any protection the plan might appear to provide could be lost. Plans also can deprive an individual of flexibility by requiring a transaction at a defined time. In many cases, at least where the individual is not regularly in possession of MNI, there may be no real need for a plan – shares can be sold in a window period or pursuant to company compliance policy. An unexpected event – such as a sudden rise or fall in stock price, termination of employment, divorce, or similar situation can lead to desiring that the plan be cancelled (it generally can be, but protection may be lost and the matter of “good faith” can be raised).

Sometimes, proving a negative – that the individual is not aware of MNI – can be difficult. This is the reason many companies prefer a plan to be entered into during an open window period, or have legal counsel or corporate compliance authorize entry into a plan. Plans or trades under plans do not relieve insiders of their reporting requirements, including Form 144 and Form 4 filings. But plans can be critical in some instances. For example, if stock options will expire with a year or less and the executive is regularly in possession of MNI, that executive definitely should consider entering into a plan in case they are prevented from exercising the option or selling stock even in an option window due to the MNI.

Conclusion

Rule 10b5-1 trading plans can be an important part of a company’s overall compliance program. It is in the interest of the company and its shareholders, as well as key executives and directors, to avoid insider trading and even the suggestion that it could have occurred. We are seeing more companies tighten corporate compliance policies in light of the significantly greater interest that the SEC has taken in uncovering insider trading. We are also seeing more companies educate officers and directors about insider trading and adopt a policy with regard to the use and design of 10b5-1 plans. If you’d like a sanitized example of a corporate policy discussing the use of Rule 10b5-1 plans, please contact us at Rfriedman@ayco.com.

About This Article:

This information is prepared for colleagues and friends of The Ayco Company, L.P. by its Benefits & Compensation Group (BCG) and is designed only to give notice of, and general information about, the developments actually covered. It is not intended to be a comprehensive treatment of recent legal developments or the topics included in the newsletter, nor is it intended to provide any legal advice. The information contained in this correspondence cannot be used, and it is not intended by Ayco to be used, for the purpose of avoiding any penalty that the Internal Revenue Service might assess upon challenging any tax treatment discussed in this correspondence and attachments, if any. For more information contact Richard Friedman, Vice President, BCG (518-640-5250) or email us at rfriedman@ayco.com.