Rule 10b5-1 Plans at 20: Enforcement Trends & Best Practices

2020 marks the 20^th anniversary of the Rule 10b5-1 plan. During its two-decade history, it has provided an affirmative defense against allegations of insider trading by corporate insiders that trade their company’s stock, even while in possession of material non-public information at the time of trading, through plans that are set up in advance. It has also attracted its fair share of controversy following certain academic studies that indicated that executives with Rule 10b5-1 plans receive better returns than their colleagues at the same company. These findings and specific high-profile instances of apparent abuse by executives led to negative news coverage and the presumption that Rule 10b5-1 plans may be used as cover to trade while exploiting inside information. However, to date, there have been no meaningful regulatory or legislative changes to Rule 10b5-1 plans. SEC action against executives trading pursuant to Rule 10b5-1 plans has been effectively nonexistent, and, although plaintiffs have made some inroads, the use of such plans continues to be an effective affirmative defense in private litigation.

Will the next decade finally see new restrictions on the use of Rule 10b5-1 plans? Approximately a year ago, the U.S. House of Representatives passed a bill directing the SEC to study Rule 10b5-1 plans and advise whether Rule 10b5-1 should be amended. The bill has been sent to the Senate and referred to committee. If passed by the Senate and enacted into law, the SEC may recommend amendments that could restrict the timing of plans, limit the number of plans a single insider can have, require public disclosure of plans, and limit modifications or cancellations of plans. Together with a bill on insider trading that passed the House late last year and is also in Senate committee, corporate insiders may soon find themselves under greater scrutiny when they profit from trades made in their company’s stock. Regardless of the outcome of this proposed legislation, corporate insiders and their advisors should consider adopting plans that withstand scrutiny from regulators, courts, and investors.

This alert provides an overview of enforcement trends regarding Rule 10b5-1 plans, discusses the proposed legislative changes to Rule 10b5-1 plans, and advises on best practices for Rule 10b5-1 plans – both as the law currently governs them and in line with anticipated changes.

For a detailed discussion of the benefits and requirements of Rule 10b5-1 plans, please refer to our recent alert, “Answers to Common Questions About Rule 10b5-1 Plans.”

What Is a Rule 10b5-1 Plan?

A Rule 10b5‐1 plan is a written plan for trading securities that is designed in accordance with Rule 10b5‐1(c) of the Securities Exchange Act of 1934 (the “Exchange Act”).

Section 10(b) and Rule 10b‐5 of the Exchange Act prohibit the purchase or sale of a security on the basis of material non‐public information in breach of a duty. However, any person executing pre‐planned transactions pursuant to a Rule 10b5‐1 plan that was established in good faith at a time when that person was unaware of material non‐public information has an affirmative defense against accusations of insider trading, 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 of the Exchange Act. Accordingly, Rule 10b5‐1 plans are especially useful for people presumed to have inside information, such as officers, directors, and other affiliates.

Government and Private Litigation Challenging Rule 10b5‐1 Plans

SEC Enforcement Actions

Very few SEC enforcement actions have alleged abuse of Rule 10b5-1 plans in the 20 years since the trading plans were introduced. The most recent of these dates from January 2012. The facts in two cases, against the former CEOs of Enron and Countrywide, are so egregious as to be of limited utility in determining when the SEC will challenge a Rule 10b5-1 plan. Nevertheless, there are a few takeaways. In Countrywide, the SEC focused on the fact that the former CEO created a series of plans during three consecutive months while aware of “Countrywide’s increasing credit risk and the risk regarding the poor expected performance of Countrywide-originated loans.” Similarly, in a case against former executives of WellCare Health Plans, Inc., the SEC’s complaint highlighted that the executives amended their plans less than a year after establishing them and with more than one year left on the plans.

Based on the SEC’s allegations in its enforcement actions involving Rule 10b5-1 plans, creating overlapping plans and altering plans before their scheduled termination may draw particular scrutiny. As discussed in the following section, courts also view these actions negatively.

Private Litigation

Plaintiffs frequently point to insider stock sales to support their claim that a defendant knowingly (i.e., with scienter) acted to mislead the market while in possession of inside information – thus allowing the defendant to take advantage of movement in stock prices. Courts have consistently found that contested trades made pursuant to a Rule 10b5-1 plan “do not raise a strong inference of scienter.” In re Lululemon Sec. Litig., 14 F. Supp. 3d 553, 584–86 (S.D.N.Y. 2014); see also In re Aratana Therapeutics Inc. Sec. Litig., 315 F. Supp. 3d 737, 764 (S.D.N.Y. 2018).

However, because the Rule 10b5-1 plan must be entered into in good faith, its use as an affirmative defense “must be pled and proved,” and a plaintiff “may present circumstantial evidence giving rise to an inference of bad faith and scienter . . . by showing that the corporate-insider’s trades under a 10b5-1 plan are unusual or suspicious.” Smilovits v. First Solar, Inc., 2019 WL 7282026, at *3 (D. Ariz. 2019) (citing In re Enron Corp. Sec., Derivative & ERISA Litig., 258 F. Supp. 2d 576, 593 (S.D. Tex. 2003)). As a result, certain courts began ruling in securities class actions that Rule 10b5-1 plans are not a defense to scienter if they were adopted during the class period. See Freudenberg v. E*Trade Financial Corp., 712 F. Supp. 2d 171, 200–01 (S.D.N.Y. 2010). This is somewhat counterintuitive, because the insider has no way of predicting what the class period will be in some hypothetical future class action litigation. Moreover, since class periods can be quite lengthy this development in the law in particular may limit the usefulness of the Rule 10b5-1 plan’s affirmative defense.

Additionally, some courts have found that creating, amending, modifying, or cancelling a Rule 10b5-1 plan can itself be evidence of scienter, rather than a defense. See In re Countrywide Financial Corp. Derivative Litig., 554 F. Supp. 2d 1044, 1068–69 (C.D. Cal. 2008). For example, where a Rule 10b5-1 plan was entered into shortly before the alleged fraud or negative corporate event, or was modified during time periods impacted by the alleged misconduct, the court may find a strategic intent “to capitalize on insider knowledge” based on the timing of plans. In re Lululemon, 14 F. Supp. 3d at 585. As such, a Rule 10b5‐1 trading plan may give rise to an inference of scienter because “a clever insider might ‘maximize’ their gain from knowledge of an impending price drop over an extended amount of time, and seek to disguise their conduct with a 10b5‐1 plan.” Freudenberg v. E-Trade Financial Corp., 712 F. Supp. 2d 171, 200 (S.D.N.Y. 2010) (internal citation omitted).

Thus, while the use of a Rule 10b5-1 plan is an affirmative defense to allegations of insider trading, plan-holders and their advisors should be aware that courts will look at several additional factors in determining whether or not a trade was suspicious, including the amount of net profits, the percentages of holdings sold, the number of insiders selling, the change in volume of the insider’s holdings, and whether the transaction occurred at a time that took advantage of an alleged misrepresentation to inflate the stock price or to avoid a price drop following bad news. See Gagnon v. Alkermes PLC, 368 F. Supp. 3d 750, 772–73 (S.D.N.Y. 2019).

Legislative Changes to Rule 10b5‐1 Plans

Previous Attempts at Reform

A few years after Rule 10b5-1 plans were authorized, certain academic studies and several high-profile news articles suggested that the plans were being abused by executives and providing cover for improper sales based on inside information. In November 2012, with a follow‐up request in May 2013, the Council of Institutional Investors (“CII”), an association of public, corporate and union pension funds and other employee benefit plans submitted a letter to the SEC requesting that it consider pursuing interpretive guidance or amendments to Rule 10b5‐1 that would impose certain restrictions and limitations on Rule 10b5-1 plans. However the SEC did not appear to take any concrete action. In January 2018, CII renewed its appeal to the SEC, citing a $39 million stock sale by Intel’s CEO in November 2017 pursuant to a trading plan that he had recently revised. The sale represented all of the CEO’s Intel stock other than the amount Intel required him to hold, and it took place approximately one month before Intel publicly disclosed a potentially significant security flaw in its products.

New Legislation

In January 2019, the House passed a bipartisan bill, H.R. 624, the Promoting Transparent Standards for Corporate Insiders Act (“Corporate Insiders Act”), which tracks many of the recommendations by CII for reforming Rule 10b5-1 plans, discussed further below. The bill has been sent to the Senate and referred to the Senate Committee on Banking, Housing, and Urban Affairs.

If passed by the Senate, the Corporate Insiders Act would require the SEC to carry out a one-year study of Rule 10b5-1 plans and determine whether Rule 10b5-1 should be amended to:

• Limit the ability of insiders to adopt a plan only in issuer-adopted trading windows;
• Limit the ability of insiders to adopt multiple trading plans;
• Establish a mandatory delay between the adoption of a trading plan and the execution of the first trade pursuant to such a plan;
• Limit the frequency with which insiders may modify or cancel trading plans;
• Require insiders to file trading plan adoptions, amendments, terminations, and transactions with the SEC; and
• Require boards that have adopted a trading plan to: adopt policies covering trading plan practices; periodically monitor trading plan transactions; and ensure that issuer policies discuss trading plan use in the context of guidelines or requirements on equity hedging, holding, and ownership.

The Corporate Insiders Act would also require the SEC to consider, during the course of its study of Rule 10b5-1 plans, what impact the above amendments would have on: the existing prohibitions against insider trading, a company’s ability to attract executives, capital formation, a company’s willingness to operate as a public company, and the general protection of investors.

The Future of Rule 10b5-1

Congress has attempted to reform Rule 10b5-1 plans previously. In July 2018, the House passed the JOBS and Investor Confidence Act of 2018, which contained a provision regarding Rule 10b5-1 plans similar to the Corporate Insiders Act. That bill failed in the Senate. However, unlike the 2018 JOBS Act, the Corporate Insiders Act is a standalone bill and has the benefit of bipartisan support (the vote was 413-3), which suggests it may fare better in the Senate. Moreover, in December 2019, the House passed H.R. 2534, the Insider Trading Prohibition Act, which has been sent to the same Senate Committee as the Corporate Insiders Act. The Insider Trading Prohibition Act would codify certain judicial precedent regarding insider trading, which some argue could make it easier to establish liability. The two acts together appear to stand for a renewed effort to prevent abuses by corporate insiders at the cost of investors.

Best Practices to Consider for Rule 10b5‐1 Plans

Currently, insiders wanting to establish a Rule 10b5-1 plan and their advisors have a good deal of flexibility in how they design the plan. However, as discussed above, certain choices made when creating, modifying, and terminating a Rule 10b5-1 plan may increase the likelihood of SEC action and/or result in greater skepticism by the courts that the plan was entered into in good faith. Additionally, the potential amendments contemplated by the Corporate Insiders Act would impose new requirements on Rule 10b5-1 plans to prevent possible abuses of the plans. To account for the current enforcement trends concerning Rule 10b5-1 plans and public perception of these plans, companies, directors, officers, and other employees should consider the following best practices for satisfying the good faith standard when adopting a Rule 10b5‐1 plan:

• Establishment of a Plan: Require company approval of any Rule 10b5‐1 plan and permit plans to be established only during an open trading window to avoid the appearance of establishing a plan while in possession of material non‐public information and to bolster the good-faith element.
• Waiting Period: Impose a mandatory waiting period between the establishment of a plan and the date the initial trade is made.
• Modifications, Terminations, Suspensions: Disallow any modification, termination, or suspension other than during open trading windows. In the event of any modification, termination, or suspension, companies should impose a waiting period before trades can be reinstated under a plan.
• Multiple Plans: Prohibit insiders from adopting multiple overlapping Rule 10b5‐1 plans.
• Trades Outside of the Plan: Once a plan is established, limit transactions outside of the plan.
• Term of Plan: Consider minimum and maximum terms for plans, such as a minimum of six or 12 months and a maximum of two years. This will enable users to establish new plans over time while preventing the need for any voluntary modifications, terminations, or suspensions.
• Disclosure: Consider disclosing all events in the lifecycle of a Rule 10b5‐1 plan – adoption, modification, termination, or suspension – either through a press release or by a Form 8‐K.
• Form of Plan: Consider adopting a pre‐approved form of plan.
• One Broker: Consider requiring all insiders to use a pre‐selected broker.
• Trading Parameters: Consider prohibiting large sales at initiation of the plan or plans that give the implementing broker discretion on sales.

In addition, the company should develop robust training programs regarding its insider trading and disclosure policies and the use of Rule 10b5‐1 plans and should consider periodic reviews of insiders’ trading plans to ensure compliance with the securities laws and company policies.