Rule 10b5-1 Trading Plans Under Scrutiny: Are They Subject To Insider Trading Abuse?

by | Jul 2, 2021 | Blog | 0 comments

The U.S. Securities and Exchange Commission (SEC) is working to overhaul the rule that protects corporate executives from insider trading accusations when they buy or sell their company’s stocks.

Executives are regularly exposed to material nonpublic information (MNPI) and would be at risk of violating insider trading laws when trading shares they own in a corporation they are controlling.  In 2002, the Securities and Exchange Commission (SEC) provided an affirmative defense against allegations of insider trading by adopting Rule 10b5-1. To qualify for protection under Rule 10b5-1, executives of corporation may enter into a nonbinding contract that instructs a third party to execute trades on their behalf according to a written plan called a 10b5-1 plan.

In many cases corporate executives have relied on the existence of a Rule 10b5-1 trading plan in order to have securities claims against them dismissed. SEC Chair Gary Gensler has said that those plans have led to cracks in the U.S. insider trading regime. The Rule 10b5-1 plan has been the subject of criticism for a while.

The Rule 10b5-1 plan must be adopted when the executive is not aware of MNPI. The plan must specify a set of instructions regarding the trades to be made such as the number of shares to be transacted, the frequency of the transactions, the price limits, etc. The plan can be modified as long as the modifications are made at a time when the executive is not aware of any MNPI. The plan and any trade associated to it can be cancelled at any time even if the executive is in possession of MNPI. Rule 10b5-1 does not specify a minimum number of transactions and an executive can use a 10b5-1 plan for a single trade. The SEC does not require public disclosure of 10b5-1 plans. Executives are not required to indicate whether the trades they report on Form 4 are made pursuant to such plans. Executives are required to notify the SEC if a 10b5-1 plan is used to sell stock through Form 144 and provide the date the plan was adopted. The electronic submission of Form 144 is not required by the SEC and such forms can be sent by mail. Form 144 filed by mail are not publicly available through EDGAR. The paper filings are stored for 90 days by the SEC and are then destroyed.

Results from some studies have suggested that 10b5-1 plans may be used as an offensive strategy by high-level executives in order to reap abnormally high trade profits, contrary to the legal intentions of Rule 10b5-1.

A recent study provided evidence on the trading behavior of corporate executives using a dataset of over 20,000 10b5-1 trading plans, including associated adoption dates and trade dates. That study showed that a subset of executives use 10b5-1 plans to engage in large-scale opportunistic selling of company shares. That study identified three red flags associated with that opportunistic use of 10b5-1 plans:  1) plans with a short cooling-off period; 2) plans that include only a single trade; and 3) plans adopted in a given quarter that begin trading before that quarter’s earnings announcement.

The study found that trades of plans with short cooling-off period of less than 30 days are associated with subsequent industry-adjusted return of -2.5 percent. When the first planned trade has a cooling-off period between 30 to 60 days it is associated with a subsequent -1.5 percent return. When the cooling off period is extend beyond 60 days, evidence of loss avoidance disappears. The authors of the study recommended a cooling-off period of 4 to 6 months.

About single-trade plans, the study found that they are consistently avoiding loss regardless of the cooling-off period. Single-trade plans with short cooling-off periods exhibit the highest average loss avoidance. The authors of the study recommended to disallow single-trade 10b5-1 plans.

The study examined the timing of plan trades in relation to the quarterly earnings announcement immediately after the plan was adopted. Senior executives are routinely aware of corporate performance between the end of quarter and the earnings announcement. It is unlikely that they can enter a plan during this period without having MNPI. The study shows that plans that execute a trade in the window between when the plan is adopted and quarter’s earnings announcement anticipate large losses and foreshadow stock price declines. The authors of the study recommend removing the affirmative defense of Rule 10b5-1 for plans that are both adopted and start selling shares before the next earnings announcement.

The authors of the study concluded that plans with those three red flags are indicative of an opportunistic use of such plans and recommend modifications to Rule 10b5-1 to prevent opportunistic trades.

Some other studies have shown that some insiders use 10b5-1 plans to trade on insider information by establishing plans to sell and then cancel them if they become aware of MNPI. That strategy is allowed under the law and does not constitute a violation of insider trading laws.

Courts have consistently found that trades made pursuant to a Rule 10b5-1 plan do not raise a strong inference of scienter.[1] But some courts decided in securities class actions that Rule 10b5-1 plans are not a defense to scienter if they were adopted during the class period.[2] Some courts have found that creating, amending or cancelling a Rule 10b5-1 plan can be evidence of scienter rather than a defense.[3]

SEC Chair Gary Gensler has said that the SEC is drafting a proposal to revise the Rule 10b5-1 trading plan. Gensler has said that the prospect of creating a cooling-off period of four to six months between the adoption of a 10b5-1 plan and the execution of its first trade has received bipartisan support.

Insiders can cancel a plan when they have material public information. Gensler said that the SEC is considering limitations on when plans can be canceled.  Gensler indicated that he has concerns about the lack of any disclosure requirements regarding 10b5-1 plans regarding adoption, modification or the terms of the plans. Gensler also expressed the idea that a limit on the number of 10b5-1 plans that corporate executives are allowed to adopt could be beneficial because the ability to enter into multiple plans and then cancel certain ones could be misconstrued by insiders as an option to pick among the most favorable plans as they please. Gensler also has asked the SEC staff to look at potential abuses involved with company’s adoption of Rule 10b5-1 trading plan in connection with stock buybacks. While trading plans adopted pursuant to Rule 10b5-1 can be abused, the adoption of trading plans is still a good idea. It provides corporate insiders with a way to trade their company securities. But there are aspects of the 10b5-1 trading plan’s requirements that need to be addressed in order to prevent potential abuse that can undermine investor confidence.

[1] See In re Lululemon Sec. Litig., 14 F. Supp. 3d 553, 585 (S.D.N.Y. 2014), aff’d, 604 F. App’x 62 (2d Cir. 2015); In re Aratana Therapeutics Inc. Sec. Litig., 315 F. Supp. 3d 737, 764 (S.D.N.Y. 2018).

[2] See Aratana Therapeutics, 315 F. Supp. at 764; Freudenberg v. E*Trade Fin. Corp., 712 F. Supp. 2d 171, 200-201 (S.D.N.Y. 2010).

[3] See In re Countrywide Fin. Corp. Derivative Litig., 554 F. Supp. 2d 1044, 1068-1069 (C.D. Cal. 2008).