Rule 10b5-1

A. Understanding Rule 10b5-1

• What is “Rule 10b5-1”?
• At what point in a securities transaction must a person be unaware of material nonpublic information under Rule 10b5-1?
• Does Rule 10b5-1 define “material nonpublic” information?

B. Rule 10b5-1’s Affirmative Defenses

• Does Rule 10b5-1 absolutely bar an investor from buying or selling securities at a time when he or she is aware of material nonpublic information?
• What is the difference between an “affirmative defense” and a “safe harbor?”
• What is a “binding contract?”
• What constitutes “instructions?”

C. Rule 10b5-1(c) Trading Plans

• What is a “trading plan?”
• What is the difference between a “trading plan” and a “trading window?”
• How do you create a trading plan?
• Are there any restrictions (e.g., when to buy and sell) when structuring a trading plan?
• How long may trading plans last?
• May a company construct a Rule 10b5-1 plan for itself?
• What is involved in structuring a company stock repurchase plan?
• Must a company be involved in the adoption of a trading plan on behalf of an employee?
• Must a broker be involved in a trade under a trading plan?
• What is a “blind trust?”
• Will use of a “blind trust” gain the protections of Rule 10b5-1’s affirmative defenses?
• What happens if a person buys or sells less - or more - than what was dictated by the terms of his or her trading plan?
• What happens if a person buys or sells securities “outside” an existing trading plan?
• May a trading plan be terminated?
• Does the existence of trading plan have to be publicly disclosed? If not, should it?
• If a trading plan involves the sale of “restricted securities” pursuant to Rule 144, when should a Form 144 be filed?

D. Rule 10b5-1 Electronic Roundtable

In June 2002, three lawyers and a representative from a broker exchanged their thoughts on some of these issues. The names of these panelists and topics they discussed are below.

Charles Bowen, Assistant General Counsel, Cox Enterprises (charles.bowen@cox.com)
Ron Mueller, Partner, Gibson Dunn & Crutcher (rmueller@gibsondunn.com)
Keith Schnaars, VP of Marketing for Concentrated Stock Strategies, Merrill Lynch (keith_schnaars@ml.com)
Larry Spirgel, Of Counsel, Morrison & Foerster (lspirgel@mofo.com)

• What is the typical role of in-house counsel in developing these plans? What should it be?
• How much can a plan’s terms vary depending on the insiders’ objectives?
• Can a company keep a plan’s existence confidential? Should it?
• Can a broker’s plan be negotiated? What terms should be changed?
• Can an officer terminate a plan when in possession of material nonpublic information?

A. Understanding Rule 10b5-1

What is “Rule 10b5-1”?

Rule 10b5-1 contains the SEC’s definition for determining trading “on the basis of” material public information in insider trading cases.

Under Rule 10b5-1, trading is “on the basis of” material nonpublic information if the trader was aware of the material, nonpublic information when the person made the purchase or sale.

The courts have not reached a consensus on the issue. Some courts have held that a trader may be liable for insider trading while in “knowing possession” of material nonpublic information. The contrary view held by other courts is that a trader is not liable unless it is shown that he or she “used” the information for trading.

Source: Rule 10b5-1 is promulgated under the Securities Exchange Act of 1934 (17 CFR 240.10b5-1). The adopting release is SEC Release No. 34-43154 entitled “Selective Disclosure and Insider Trading.” As noted in footnote 97 to this release, there are three U.S. Court of Appeals cases that have interpreted the use/possession issue differently. The three cases recognize the practical difficulty of divorcing a trader’s knowing possession, or awareness, of inside information from its “use” in a trade. In United States v. Teicher, 987 F.2d 112, 120-21 (2d Cir.), cert. denied, 510 U.S. 976 (1993), the Second Circuit suggested that “knowing possession” is sufficient to trigger insider trading liability, for precisely this reason. In SEC v. Adler, 137 F.3d 1325, 1337 (11th Cir. 1998) , the Eleventh Circuit held that “use” was the ultimate issue, but that proof of “possession” provides a “strong inference” of “use” that suffices to make out a prima facie case. In United States v. Smith, 155 F.3d 1051, 1069 & n.27 (9th Cir. 1998) , cert. denied, 525 U.S. 1071 (1999), the Ninth Circuit required that “use” be proven in a criminal case.

At what point in a securities transaction must a person be unaware of material nonpublic information under Rule 10b5-1?

The investor cannot be aware of material nonpublic information at the time of the investment decision.

For example, the purchase of a put option involves an investment decision at the time of the purchase of the option and at the time of the exercise of the option. Therefore, if the investor was aware of material nonpublic information at either time, there may be a violation of Rule 10b5-1.

Source: Rule 10b5-1(b). SEC Manual of Publicly Available Telephone Interpretations, (fourth supplement) , telephone interpretation no. 5, and SEC Release No. 34-43154 entitled “Selective Disclosure and Insider Trading” at fn. 115 indicate that the purchase and exercise of an option involve separate investment decisions.

Does Rule 10b5-1 define “material nonpublic” information?

No. The SEC relies on existing definitions of these words established in case law.

Under the case law, information is “material” if “there is a substantial likelihood that a reasonable shareholder would consider it important” in making an investment decision. To fulfill the materiality requirement, there must be a substantial likelihood that a fact “would be viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”

Information is nonpublic if it has not been disseminated in a manner making it available to investors generally. See more in Section B of realcorporatelawyer.com’s FAQs regarding Regulation FD.

Note that the adopting release does provide guidance of what is “material nonpublic” information in the context of Regulation FD.

Source: SEC Release No. 34-43154 entitled “Selective Disclosure and Insider Trading” at Section II.B.2. The case law referenced in this release include TSC Industries, Inc. v. Northway, Inc. , 426 U.S. 438, 449 (1976) and Basic v. Levinson , 485 U.S. 224, 231 (1988) (materiality involves a balancing of probability and magnitude of the event). The release also cites the identical definitions of “material” contained in Securities Act Rule 405 and Exchange Act Rule 12b-2 (substantial likelihood that a reasonable shareholder would consider it important). A controversial cite in the release is to the SEC’s Staff Accounting Bulletin No. 99 (August 12, 1999) which discusses materiality for purposes of financial statements. In assessing whether information relating to the financial statements is material, SAB 99 requires an analysis of qualitative as well as quantitative factors. One factor that must be considered in weighing materiality is how the market would likely to react to the disclosure of the information. See more See more in Section B of realcorporatelawyer.com’s FAQs regarding Regulation FD.

B. Rule 10b5-1’s Affirmative Defenses

Does Rule 10b5-1 absolutely bar an investor from buying or selling securities at a time when he or she is aware of material nonpublic information?

No. At the same time the SEC adopted the “awareness” standard for determining insider trading liability, it also adopted affirmative defenses for someone who trades at the time he or she is aware of material, nonpublic information. See more @ “What is the difference between an “affirmative defense” and a “safe harbor”?

Rule 10b5-1 sets forth three general conditions for successfully claiming the affirmative defenses:

• The investor must demonstrate that prior to becoming aware of the material nonpublic information, he or she had entered into a binding contract, provided instructions to another, or adopted a written plan for trading securities;
• The binding contract, instructions, or written plan must either expressly specify (or provide by written formula, algorithm, or computer program) the amount, price, and date of the transaction or not allow the person to exercise any subsequent influence over how, when, or whether to effect purchases or sales; and
• The person must demonstrate that the purchases or sales were pursuant to the prior binding contract, instruction, or written plan.

In addition to these affirmative defenses, trading parties that are entities (as opposed to individuals) may claim an additional affirmative defense. An entity will not be liable if it demonstrates that the individual making the investment decision on behalf of the entity was not aware of material nonpublic information at the time of the trade, and the entity had implemented reasonable policies and procedures to prevent insider trading.

Source: Rule 10b5-1(c). Any subsequent influence over a decision to purchase or sell securities will eliminate the protections of the affirmative defenses. For example, if a person defaults on a loan or a broker makes a margin call, the subsequent sale of any securities pledged as collateral for that loan or contained in the margin account will not be covered by Rule 10b5-1(c) because the person has discretion to pay back the loan or deposit additional securities in the margin account to avoid the sale of the securities. See SEC Manual of Publicly Available Telephone Interpretations, (fourth supplement), telephone interpretations nos. 8 and 9.

What is the difference between an “affirmative defense” and a “safe harbor?”

Rule 10b5-1 does not provide a catch-all defense - also known as a non-exclusive safe harbor. Instead, it merely provides affirmative defenses.

The distinction means that the existence of a Rule 10b5-1 trading plan will not absolutely shield the individual from insider trading liability. The SEC or a private plaintiff could overcome the rule’s affirmative defenses by showing that the plan was not adhered to, or that it was not entered into in “good faith” and was a part of a plan or scheme to avoid the prohibitions of Section 10(b) and Rule 10b5-1.

For example, a person establishes a trading plan to sell 1,000 shares of common stock on the last day of the month for the next twelve months. After two months of sales, the person decides not to sell the third month because he or she learns that a ruling favoring the company is soon to be publicly released by a government agency. The person’s two prior sales may not receive the protections of the rule’s affirmative defenses if it can be proved that the person only intended to sell if he or she was not aware of any favorable nonpublic material information.

Source: Rule 10b5-1(c)(1)(ii) requires that the contract, instruction or plan be entered into in good faith. SEC Release No. 34-43154 entitled “Selective Disclosure and Insider Trading” at III.A.1 explains that the Rule provides affirmative defenses instead of a non-exclusive safe harbor or catch-all defense. SEC Manual of Publicly Available Telephone Interpretations, (fourth supplement), telephone interpretation no. 15(b) points out that prior transactions may lose the protections of the affirmative defenses if it is shown that the plan was not entered into in good faith and/or as a plan or scheme to avoid the prohibitions of Section 10(b) and Rule 10b5-1.

What is a “binding contract?”

Any agreement - oral or in writing - that is enforceable, such as an offer to buy or sell when the person to whom it is made accepts it and communicates acceptance.

An example of a binding contract would be “I agree to sell and you agree to buy 1,000 shares of the company’s common stock at the market price at the close of trading on the last day of the month.” As long as the seller was not aware of any material nonpublic information at the time the binding contract was entered into, it would not matter if the seller became aware of material nonpublic information at the time that the sale was executed.

Source: Rule 10b5-1. SEC Manual of Publicly Available Telephone Interpretations , (fourth supplement), telephone interpretation no. 17 makes clear that as long as an oral agreement would be considered binding under applicable state law, the binding contract does not have to be in writing to gain the affirmative defense protections of the Rule.

What constitutes “instructions?”

A person - orally or in writing - directs another person (e.g., a broker) to purchase or sell securities when the person is not aware of material nonpublic information.

For example, at a time when a person is not aware of any material nonpublic information, that person calls a broker and places a limit order for purchase of 10,000 shares of the company’s common stock. Once the limit order is given, discretion over the transaction has been removed. From this point onward, the person’s awareness of material nonpublic information will not jeopardize reliance on the affirmative defenses of Rule 10b5-1(c).

Source: Rule 10b5-1. SEC Manual of Publicly Available Telephone Interpretations , (fourth supplement), telephone interpretation no. 17 makes clear that oral instructions are sufficient to gain the affirmative defense protections of the Rule.

C. Rule 10b5-1(c) Trading Plans

What is a “trading plan?”

A written program for trading securities designed to gain the protections of Rule 10b5-1’s affirmative defenses against insider trading. See more @ What is the difference between an “affirmative defense” and a “safe harbor”?

A trading plan is the most commonly used mechanism for seeking the protections of Rule 10b5-1’s affirmative defenses. Basically, the plan sets forth the parameters for purchases and/or sales of the company’s securities.

The plan may be crafted in a variety of ways as long as the person does not retain discretion over the plan’s future transactions. A trading plan can be simple (“buy x shares on x date”) - or complex (“sell y shares whenever the company’s stock falls first below $ z price and the Dow Jones Index remains above 9500 points for 7 straight business days”).

Source: SEC Release No. 34-43154 entitled “Selective Disclosure and Insider Trading” at III.A.2. Footnote 116 of the Release makes clear that the person who creates a trading plan must not retain any future discretion over the purchases or sales to preserve the protections of the Rule’s affirmative defenses. SEC Manual of Publicly Available Telephone Interpretations , (fourth supplement), telephone interpretation no. 17 makes clear that unlike a binding contract or instruction, a trading plan must be in writing to gain the affirmative defense protections of the Rule.

What is the difference between a “trading plan” and a “trading window?”

A trading plan involves a prescribed set of criteria for engaging in purchases or sales established by the trader. A trading window is established by an issuer and permits discretionary trading in its securities during a prescribed period of time.
Some companies have voluntarily adopted insider trading policies to protect themselves from controlling person liability under Section 10(b) and Rule 10b-5. These insider trading policies often include pre-clearance procedures for key executives as well as trading windows for various levels of employees/stockholders.

Typically, the timeframe for a trading window begins a couple of days after a company announces its quarterly or year-end financial results and often continues for one or two weeks. During this window period, employee stockholders generally are permitted to trade in the company’s securities because the presumption is that no one is in possession of material nonpublic information. During all other times, commonly referred to as “blackout periods,” employee stockholders are prohibited from trading in the company’s securities. See more about blackout periods in realcorporatelawyer.com’s FAQ regarding Analyst Communications.

Though a trading plan does not allow for discretion on the part of the person (like during a trading window), it does permit trading at any time - as long as the criteria for the trading was set in the past at a time when the person was not aware of any material nonpublic information.

Some companies have revised their trading policies to retain trading windows but allow employees to adopt trading plans that would permit transactions during blackout periods.

Source: Rule 10b5-1(c) expressly endorses written trading plans as a means of gaining the affirmative defenses of the Rule. Insider trading policies are not expressly endorsed by the federal securities laws. Section 21A(b)(1) of the Exchange Act imposes liability on anyone who “controls” a person that violates Section 10(b) or Rule 10b-5. Section 21A(b)(1)(A) of the Exchange Act conditions controlling person liability on a showing that “such controlling person knew or recklessly disregarded the fact that such controlled person was likely to engage in the act or acts constituting the violation and failed to take appropriate steps to prevent such act or acts before they occurred.” Companies have historically used insider trading policies as a prophylactic device to guard against claims that the companies “knew or recklessly disregarded the fact that” certain of their employees were likely to commit insider trading violations.

How do you create a trading plan?

You must establish the criteria for future purchases and sales and then memorialize them in writing. All of this must take place when you are not in possession of material nonpublic information. See more @ Are there any restrictions (e.g., when to buy and sell) when structuring a trading plan?

The criteria include the:

• amount of securities to be purchased or sold,
• price(s) at which the securities will be purchased or sold, and
• date(s) of purchase or sale.

The amount, price, and date may also be determinable by written formula, algorithm, or computer program. For example, a plan may say “buy x shares on x date,” or “sell y shares whenever the company’s stock falls first below $z and the Dow Jones Index remains above 9500 points for 7 straight business days.”

Another alternative is to transfer decision-making power to a third person with no discretion retained as to how, when, or whether to effect purchases or sales. If the third party decision-maker is not in possession of material nonpublic information about the company, then the purchases and sales should gain the protections of the Rule’s affirmative defenses. Once constructed, an effective Rule 10b5-1 plan should be “self-executing” because no discretion is left with its creator.

Source: Rule 10b5-1(c)(1)(i)(B)(1), (2) and (3). SEC Manual of Publicly Available Telephone Interpretations , (fourth supplement), telephone interpretations nos. 3 and 10 discuss how the Rule permits the transfer of influence over how, when, or whether to effect purchases or sales to a third party.

Are there any restrictions (e.g., when to buy and sell) when structuring a trading plan?

Yes, there are a variety of considerations that can impact how a plan is structured.

For example, a company’s directors and officers and stockholders who hold 10% or more of the company’s stock are still subject to the limitations imposed by the reporting provisions of Section 16(a) and the short-swing profit rules of Section 16(b) of the Securities Exchange Act of 1934. In addition, a person may only sell “restricted securities” in compliance with Rule 144 or some other exemption from the Securities Act of 1933.

A trading plan should also comply with a company’s insider trading policy. A company’s repurchase plan must comply with Rule 10b-18. See more @ May a company construct a Rule 10b5-1 plan for itself?

Source: SEC Release No. 34-43154 entitled “Selective Disclosure and Insider Trading” at Section III.A.1.2 makes clear that Section 16 of the Exchange Act is not preempted by Rule 10b5-1. SEC Manual of Publicly Available Telephone Interpretations, (fourth supplement), telephone interpretation nos. 1 and 2 discuss the interplay of Rule 144 and Rule 10b5-1. Rule 10b-18 is designed to prevent market manipulation of the company’s stock as a result of the company’s repurchases.

How long may trading plans last?

As long as the creator wants. Rule 10b5-1 does not prescribe any minimum or maximum timeframe for a trading plan. As a result, a trading plan could be created where transactions pursuant to the plan take place over a couple of days - or for an indefinite time period. See more @ May a trading plan be terminated?

For example, a plan instructing a broker to sell 10,000 shares (50,000 shares total) at the opening of trading on the NYSE each day that the company’s stock price opens at least at $50 per share could be completed in five days or never (if the price never reaches $50 for five days).

Source: Rule 10b5-1(c)(1)(i)(B)(2) permits the use of a formula to determine the dates for transactions under a trading plan.

May a company construct a Rule 10b5-1 plan for itself?

Yes. Companies may structure repurchase plans as Rule 10b5-1 plans - and may want to do so if implementing a stock repurchase program.

If structured properly, the company will gain the protections of the affirmative defenses, including the affirmative defense available to institutions. A company must also comply with Rule 10b-18 when structuring Rule 10b5-1 repurchase plans.

Source: SEC Release No. 34-43154 entitled “Selective Disclosure and Insider Trading” at Section III.A.2. SEC Manual of Publicly Available Telephone Interpretations , (fourth supplement), telephone interpretation no. 18 makes clear that the institutional affirmative defense is available to companies.

What is involved in structuring a company stock repurchase plan?

As with all Rule 10b5-1(c) trading plans, the criteria for repurchases under the plan (e.g. dates, amounts, and prices for repurchases) must be set, or established by formula, for the plan to gain the protections of the Rule’s affirmative defenses.

An issuer stock repurchase plan must also comply with Rule 10b-18 promulgated under the Securities Exchange Act of 1934. Rule 10b-18 provides a non-exclusive safe harbor from liability under certain market manipulation rules under the Exchange Act as they relate to an issuer’s or affiliated purchaser’s repurchase of its shares. Rule 10b-18 contains a rather complex system of conditions for the timing, price, volume, and manner of bids for and purchases of common stock from or through a broker-dealer. Under Rule 10b-18, there are four conditions to an issuer’s or affiliated purchaser’s repurchase of its equity securities:

• Generally, an issuer’s daily repurchases must be made through one broker or dealer;
• An issuer and its affiliates are prohibited from repurchasing the issuer’s equity securities in the marketplace at the opening or during the half-hour (or last ten minutes, for issuers with an average daily trading volume (“ADTV”) of $1 million or more and a public float of $150 million or more) before the scheduled close of trading;
• Repurchases by an issuer of its securities must be at a price that does not exceed the highest independent bid or the last independent transaction price, whichever is higher; and
• Daily repurchases by an issuer may not exceed 25% of the ADTV in the preceding four weeks (with special rules for “block purchases” as defined in the Rule).

Source: SEC Release No. 34-43154 entitled “Selective Disclosure and Insider Trading” at Section III.A.2. SEC Manual of Publicly Available Telephone Interpretations, (fourth supplement), telephone interpretation no. 18 makes clear that institutional affirmative defense is available to companies. Rule 10b-18 promulgated under the Securities Exchange Act of 1934.

Must a company be involved in the adoption of a trading plan on behalf of an employee?

This is not required, but is certainly helpful. See more @ What is the typical role of in-house counsel in developing these plans?

Rule 10b5-1 is directed at the person who trades while in possession of material non-public information. The burden of complying with the conditions to the Rule’s affirmative defenses is imposed on the person who trades - not the company.

However, in most cases, the company will be the employer of the person seeking to use a trading plan, and the employee’s trading activities will be restricted by the employer’s trading policies as a condition to employment.

For example, many companies impose blackout periods and/or trading windows on their employees. Without an employer’s concurrence, an employee’s trading plan—although otherwise compliant with Rule 10b5-1—might improperly permit purchases or sales during a designated blackout period. Under many of these trading policies, such action could be grounds for disciplinary action, including dismissal. Therefore, at a minimum for most persons, compliance with Rule 10b5-1 must be coupled with compliance with an employer’s trading policies.

Since the adoption of Rule 10b5-1, numerous companies have amended their trading policies to permit Rule 10b5-1 trading plans with some level of oversight by the companies.

Source: For an example of a Rule 10b5-1 trading plan that was structured in compliance an issuer’s trading policies, see e.g., the stock selling plan of Clifton H. Morris, Jr. filed as Exhibit 99 to January 5, 2001 Item 5, Form 8-K of AmeriCredit Corp, file no. 1-10667 at Recital C to the plan.

Must a broker be involved in a trade under a trading plan?

This is not required, but is certainly helpful. See more @ If a trading plan involves the sale of “restricted securities” pursuant to Rule 144, when should a Form 144 be filed?.

Few people execute their own transactions. If you decide to develop a Rule 10b5-1 trading plan and intends to have a broker execute all purchases and sales, you must make sure that the broker is capable of executing the plan pursuant to your instructions.

For example, depending on the trading volume of a company’s stock, a broker may not be able to effect a purchase or sale in a specific amount at a designated time. Often, brokers require flexibility to execute orders.

With the emergence of online trading, individuals can execute a Rule 10b5-1 without their broker’s involvement. However, there are still market complications that could delay or cancel a mandated purchase or sale. For example, if a person is unable to log-on to his or her proprietary account, the person may be unable to execute a transaction according to the terms of a plan. Hence, several of the conditions that are imposed on a Rule 10b5-1 plan by brokers are still relevant when an individual decides not to include a broker in the implementation of a Rule 10b5-1 plan.

Source: For an example of a Rule 10b5-1 trading plan that was structured to effect sales through a broker, see e.g., the stock selling plan of Clifton H. Morris, Jr. filed as Exhibit 99 to January 5, 2001 Item 5, Form 8-K of AmeriCredit Corp, file no. 1-10667 at Recital B to the plan.

What is a “blind trust?”

A trust where the trustee rather than the creator makes the decisions to purchase or sell securities.

For example, a person places 40,000 shares of common stock in a trust on January 1 with the general instruction to the trustee to sell 10,000 shares each quarter. The trustee has complete discretion over the timing, price, and amount of each sale.

Source: SEC Release No. 34-42259 entitled “Proposed Rule: Selective Disclosure and Insider Trading” at fn. 91.

Will use of a “blind trust” gain the protections of Rule 10b5-1’s affirmative defenses?

Yes. A person does not have to set all of the parameters of a future sale or purchase to claim the affirmative defenses. Any variables left open may be left to the discretion of a third person, who in the case of a blind trust would be the trustee.

Source: SEC Release No. 34-42259 entitled “Proposed Rule: Selective Disclosure and Insider Trading” at fn. 91 and SEC Manual of Publicly Available Telephone Interpretations, (fourth supplement), telephone interpretation no. 3. Telephone interpretation no. 4 makes clear makes clear that the person may not exercise subsequent influence over trust sales.

What happens if a person buys or sells less - or more - than what was dictated by the terms of his or her trading plan?

Such action is considered a modification of the trading plan - and the person’s purchase or sale will not gain the protections of the Rule’s affirmative defenses afforded previous transactions under the plan.

Changing the amount to be bought or sold under a trading plan currently in effect results in an alteration of - or deviation from - the plan’s terms. Consequently, purchases or sales pursuant to the altered amounts would not be deemed made pursuant to the existing plan. Future purchases or sales that are consistent with the plan’s original terms most likely will not lose the protections of the affirmative defenses unless the person continues to deviate from plan’s original terms when it is in the person’s best interest to do so.

A person acting in good faith may modify a trading plan if at the time of the modification, the person is not aware of material nonpublic information. In this case, the purchase or sale made pursuant to the modified terms of the plan, and all subsequent transactions, would be considered made pursuant to a new plan.

Source: Rule 10b5-1(c)(1)(i)(C) makes clear that an alteration to or deviation from an existing trading plan will lose the protections of the affirmative defenses for that transaction. SEC Release No. 34-43154 entitled “Selective Disclosure and Insider Trading” at fn. 111 and SEC Manual of Publicly Available Telephone Interpretations , (fourth supplement), telephone interpretation no. 14 indicate the treatment of a non-conforming purchase or sale and all subsequent transactions under the Rule.

What happens if a person buys or sells securities “outside” an existing trading plan?

Transactions outside a plan do not get the benefit of the affirmative defenses and could affect the availability of the affirmative defenses for the plan transactions if the non-plan transactions reduced or eliminated the economic consequences of the transactions under the plan (e.g., contemporaneous hedging transactions). The non-plan purchases and sales independently would gain the protections of the affirmative defenses if they were made at a time when the person was not in possession of material nonpublic information. Section B of realcorporatelawyer.com’s FAQs regarding Regulation FD describes the term “material nonpublic” information.

For example, a person has in place a plan to sell 10,000 shares on the first day of each month for a 12-month period. A few months into the plan, the person learns that the company will soon make a very positive public announcement. After becoming aware of the impending announcement (but before it is publicly announced), the person purchases 10,000 shares at the same time 10,000 shares are to be sold under a trading plan. Under this scenario, the plan’s sales may lose the protections of the affirmative defenses because the non-plan purchases will be viewed as a hedge against the plan’s sales in response to material nonpublic information. However, if the person sells an additional 10,000 shares outside the plan while aware of material nonpublic information, the non-plan sales will likely violate Rule 10b-5 but will not affect the protections of the affirmative defenses for the plan sales because the non-plan sales don’t reduce or eliminate the economic consequences of the contemporaneous plan sales.

Source: Rule 10b5-1(c)(1)(i)(C) and SEC Manual of Publicly Available Telephone Interpretations , (fourth supplement), telephone interpretation no. 13.

May a trading plan be terminated?

Yes - even at times when the trader is in possession of material nonpublic information. See more @ How long may trading plans last?

The mere act of terminating a plan when the person is in possession of material nonpublic information does not, alone, expose someone to Rule 10b5-1 liability because of the absence of a purchase or sale. However, the SEC has said that a termination can call into question whether the person originally entered into the plan in good faith - and not as a scheme or plan to evade Section 10(b) or Rule 10b-5.

For example, if a chief executive officer designs a plan to purchase stock 10 days before every earnings conference call, proof of an intention to terminate or a pattern of canceling individual purchases whenever it looks as if earnings results will fall short of analysts’ expectations will fail to gain the protections of the affirmative defenses.

Source: See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975) and SEC Manual of Publicly Available Telephone Interpretations, (fourth supplement), telephone interpretation no. 15(a) for the proposition that a purchase or sale must be present for liability under Section 10(b) or Rule 10b-5 to attach. SEC Manual of Publicly Available Telephone Interpretations, (fourth supplement), telephone interpretation no. 15(b) indicates that the absence of good faith or the presence of plan or scheme to evade would eliminate the affirmative defenses for prior transactions.

Does the existence of trading plan have to be publicly disclosed? If not, should it?

No, neither the terms nor the existence of a trading plan must be disclosed.

However, there are many situations where some form of prior disclosure of a trading plan may be desirable for the person and the company. Whenever a director or officer of the company engages in a purchase or sale just prior to the public announcement of a significant event, the timing of the two events will surely raise eyebrows and lead many to believe that the events were connected.

This uncertainty could lead to unwarranted volatility in the company’s stock price. If the director or officer has previously disclosed the existence and/or terms of a trading plan, the market will be able to better evaluate whether the proximity of the two events was merely due to coincidence.

Source: Rule 10b5-1 does not require that the person or the company publicly disclose a trading plan. Nevertheless, numerous persons and companies have disclosed the existence and/or terms of trading plans. For example, the CEO of Daleen Technologies filed his written trading plan as an exhibit to his December 18, 2000 Schedule 13D filing for Daleen Technologies. JDS Uniphase Corporation (0-22874) filed an Item 5 Form 8-K on December 8, 2000 to identify members of the company’s board of directors and executive officers who adopted trading plans, but did not disclose the specifics of these plans. Egghead.com, Inc. (0-29184) filed an Item 5 Form 8-K on November 13, 2000 to disclose that the company’s co-chairman of the board had entered into a sales plan. The Form 8-K also provided detail as to the amount and timing, but not the price, of the plan’s future sales.

If a trading plan involves the sale of “restricted securities” pursuant to Rule 144, when should a Form 144 be filed?

The Form 144 should be filed concurrently with either the:

• placement of a sell order for a brokerage transaction, or
• execution of such sale directly with a market maker, as provided in Rule 144(h).

The adoption of the plan often does not take place at the same time as placement of a sell order. The Form 144 requires the seller to make the representation that he or she is not aware of any material nonpublic information. This representation can be clarified in the “Remarks” section of the Form 144 to speak as of the plan adoption date.

Source: SEC Manual of Publicly Available Telephone Interpretations, (fourth supplement), telephone interpretation nos. 1 and 2.

D. Rule 10b5-1(c) Electronic Roundtable

What is the typical role of in-house counsel in developing these plans? What should it be?

Bowen: There’s a lot to be said for a company taking the lead and discussing the availability of these plans with its officers and directors, rather than waiting for them to be approached by their financial advisors. Being involved from the outset is a good way to make sure that expectations are developed in a way that’s consistent with the company’s insider trading policies and stock ownership guidelines.

Mueller: I agree. It will be hard for a company to avoid having some role in its insiders’ use of 10b5-1 plans. At a minimum, most brokerage firms will want some confirmation that a plan they agree to administer will not violate or be inconsistent with the company’s insider trading policy. This is due to the simple fact that firms do not want a company to stop settlement of a trade. So companies need to consider the extent to which their policies reflect the newly codified possession standard of Rule 10b5-1(b) and the extent to which their “window period” or trading restriction policies will accommodate Rule 10b5-1(c) plans.

Bowen: At a minimum, counsel should be involved in drafting or reviewing the plan document, to create a record of diligence and a good faith effort to comply with the requirements of the rule. To encourage this, most companies have pre-clearance procedures that require the insider to give the company advance notice of any transactions. This also gives the company the information it needs to respond to any inquiries from stockholders or the media after the trades are reported.

Spirgel: In fact, I think company-sponsored Rule 10b5-1 plans provide employees with a tremendous opportunity to effectively manage their investment in their employers. From a PR standpoint, companies could certainly foster goodwill among employees by offering 10b5-1 plans instead of more restrictive trading windows. To accomplish this, in-house counsel probably must play the role of “promoter” and coordinate these plans with the companies’ trading policies.

Bowen: However, there should be a limit to the company’s involvement in creating the terms of a trading plan, so that the company doesn’t get into the role of being an investment adviser to its officers and directors. But as long as the ultimate buy or sell decision remains with that person or their broker, the company’s involvement should be a positive factor.

Spirgel: Yes, how aggressively these plan are “marketed” to employees depends on the degree of control that companies want to maintain over their employees or directors. Small publicly traded technology companies often have trading policies that apply to all employees. These policies may require that their employees only transact in the company’s stock during specified trading windows. As an alternative to this rather rigid and non-user friendly system, 10b5-1 plans offer great flexibility in trading company stock while continuing to minimize insider trading exposure. For larger public companies, there usually is less control imposed on employees’ trading. It may make more sense in these cases to offer 10b5-1 plans only to those who are likely to come into contact with material nonpublic information about the company.

Mueller: Overall, there really are no insurmountable obstacles to companies becoming involved with 10b5-1(c) plans and there are some good reasons for them to be involved, such as:

First, the insiders’ and the company’s goal are the same: to reduce the likelihood that insiders’ transactions result in insider trading or other legal problems (unlike, for example, section 16, where companies freely assist their insiders even though the company actually profits if the insider runs afoul of the statute).

Second, the company is probably in the best position to ensure that the insiders understand the benefits and the limitations of 10b5-1(c) arrangements. Brokerage firms are limited in the assistance they can provide, since they do not want to be in the position of providing legal advice. And it is unlikely that brokerage firms will fully explain the broad variety of ways that Rule 10b5-1(c) can be utilized without having to enter into a written plan with a broker.

Third, companies may want to be aware of when 10b5-1(c) transactions are likely to occur so that they can consider publicity and investor reaction with respect to the arrangements and can consider the effect of 10b5-1(c) arrangements on the timing of corporate actions or announcements.

Finally, companies may be in the best position to assist insiders in negotiating favorable terms for plans with brokerage firms, both in terms of the commissions and as to the terms of the agreement between the broker and the insider.

Spirgel: My recommendation is that in-house counsel contemplate having a form of a plan available for employees. The form would contain the necessary standard representations and company-desired restrictions present in all employees’ plans, such as no knowledge of material nonpublic information, notification requirements and automatic termination provisions. Employees could supplement the model plan with their own selling and/or purchasing instructions. I think this creates a nice balance where an employee is free to be creative in structuring transactions within the company’s set of trading rules.

How much can a plan’s terms vary depending on the insiders’ objectives?

Mueller: The sky’s the limit, here. The SEC adopted an amazingly flexible rule in 10b5-1(c). While we talk generically of “trading plans,” Rule 10b5-1(c) allows for contracts, instructions, or written plans. Although most of the focus has been on plans that are administered by brokerage firms, there are many other ways that Rule 10b5-1(c) can be used to help insulate trades from insider trading liability. For example, a single limit order placed with a broker can constitute an instruction that satisfies Rule 10b5-1(c).

The Rule can be used to protect periodic purchases of employer stock that occur pursuant to payroll deductions under a 401(k) plan (insiders should consider whether their deduction and employer stock fund allocation elections were made at a time when they did not possess material non-public information and, more importantly, whether they are ever changing those elections at a time when they do possess material non-public information). It’s also entirely possible to conduct a self-administered Rule 10b5-1(c) plan.

Bowen: Think simple. An insider’s short-term goals in particular can benefit from using even a very simple trading plan, which could be as short as a one-page limit order. This could allow an insider to set a more aggressive limit price, and keep the order in place for a longer time, than would have been possible under the pre-10b5-1 regime. Under the old system, the limit order would have to be withdrawn if an officer or director became aware of inside information while the order was pending.

Schnaars: I agree. Some executives create quite complex formulas to insulate themselves from any insider trading knowledge. These formulas often include ratios to underlying indexes, or to other non-issuer related items. Although the information is often readily available, most broker/dealers will not build a special computer program to monitor the information. Furthermore, if an individual is monitoring the formula, one could get into a situation where the market would move faster than the individual could calculate the formula. The result would be a missed trade, or a missed execution opportunity.

Mueller: Even with simple plans, the specific terms of a plan can contain infinite varieties. From working with clients, I have a number of suggestions for insiders designing their plans, such as:

• Investment Planning - If you are going to use a broker-managed plan, talk with the broker about various trading strategies. If you are buying or selling large amounts of stock, the broker can talk to its trading desk in New York and provide valuable input as to whether trades need to be spread out over a number of days or can be quickly executed in one or a few days.
• Section 16 reporting - Consider how your trades will look if/when they are disclosed on Section 16 filings. If you either give the broker discretion to spread trades out over a large number of days in any one month or specify that transactions are to be spread out, be prepared to file a multi-page Form 4 detailing each transaction.
• Hide investment strategy - Consider whether those reports are going to reveal your trading strategy. Review with the broker in advance the specific elements of the trading instructions to ensure that both you and the broker are interpreting the terms in the same way and so you will understand how the trades will actually be conducted. Remember, if you have granted any degree of discretion to the broker in implementing the plan, you will have evidentiary problems in demonstrating that Rule 10b5-1(c) is available and that you did not “tip” material nonpublic information to the broker if you discuss implementation issues once trades have commenced under the plan.
• Maintain defense - Also keep in mind that one of the main objectives of 10b5-1(c) arrangements is to provide a defense against insider trading allegations in case a transaction ever occurs while you are aware of material nonpublic information. This means you may want to avoid the temptation to establish an overly elaborate plan: Think about having to explain and justify the terms of your plan to a skeptical lawyer at the SEC’s Division of Enforcement.

Schnaars: From the flip-side perspective, you may want to try to avoid some common problems that we see in some plans, such as:

• Limited termination clauses - We have seen plans that indicate the number of shares to be sold at a certain price (limit order) however the executive neglected to have a termination date. If the price limit were never reached, in theory the plan would never end. Other plan termination/suspension provisions that executives often neglect to consider are mergers, acquisitions, or employment termination.
• Concern with origination of shares, rather than efficient execution. Tax minimum strategies often involve segregating groups of shares into tax lots by basis or by capital gains holding periods. However, some executives try to provide different execution prices for each lot, resulting in a plan that can create confusion for the person monitoring the plan. Trades can be missed if the monitor requires time to determine which tax lot should be sold at what price.
• Ambiguous language. The English language can provide words with more than one meaning. When setting up a plan that states to “sell the underlying shares when the exercise price is ….” Does the client mean the grant price or the fair market value of the stock? Also, if the client has multiple limit orders, the client should indicate if sales at lower limit orders should be executed if the stock were to open up trading at a much different price than where it closed in the previous trading session.
• Failure to consider other Section 16 trades. Insiders subject to Section 16 must remain cognizant of other offsetting transactions. The insider must keep in mind any hedging strategy that could be cash settled, or the dividend reinvestment program that is not Rule 16b-3 exempt. Disgorgement can occur if the insider has a transaction that results in a “purchase” when they have committed to a selling plan.

Can a company keep a plan’s existence confidential? Should it?

Bowen: This is an area where we might see practices evolve over time. Currently there’s no requirement for public disclosure of trading plans. The SEC’s guidance on Form 144 filings (i.e., file at the time of execution of the trade, not when the plan is adopted) is consistent with this position.

Spirgel: Although prior disclosure is not required by the Rule, depending on the person’s position with the company, it may be advisable. Disclosure of insiders’ transactions is generally required by Section 16. From a practical perspective, without a public explanation, the market could misconstrue the reasons for an insider’s transactions. But if you disclose that a transaction was triggered by a 10b5-1 plan, the market is properly informed.

Bowen: That falls in line with the many commentators who recommend disclosing the existence - but not the terms - of insider stock trading plans, to support a good public relations message after transactions are executed and reported. This definitely makes sense in the case of the sale of a large position of company stock. But companies should also be mindful of the public relations - and even market manipulation issues - that could arise from early disclosure of an insider’s trading plan if that plan does not materialize. There was an article in the 8/9/00 Forbes.com that criticized one public company for touting a large executive purchase of company stock, when in fact the transaction wound up being mostly unfulfilled.

Spirgel: I agree; a company should not require that management disclose the specific terms of their plans. Trying to reduce volatility should not come at the expense of management having to divulge their personal investment goals. The most effective course of action may be to file a Form 8-K announcing who at the company only trades in the company’s stock pursuant Rule 10b5-1 plans. This allows officers and directors to keep their investment strategies private but not help prevent negative reaction by the market after trading is disclosed.

Bowen: Interestingly, an article in the 5/9/01 Wall Street Journal features several analysts that complain about the lack of a 10b5-1 disclosure requirement, claiming that it hampers the market’s ability to monitor trading by insiders. However, since disclosure of actual executed transactions on Forms 4 and 144 is not affected by the rule, it’s hard to see how there is a net loss of information to the marketplace.

Can a broker’s plan be negotiated? What terms should be changed?

Mueller: Most of the major brokerage firms have “standard form” trading plan agreements. These help to establish the predicates for claiming the protection of Rule 10b5-1(c), but also have contractual terms regarding the relationship between the brokerage firm and the insider. Some of these provisions may be virtually non-negotiable, such as a provision that any disputes will be handled by arbitration. But some of them should be carefully examined and negotiated. For example, be wary of provisions limiting the broker’s liability to a gross negligence standard. Also, I have found that, while most forms have some terms dealing with the insider’s indemnification of the brokerage firm, the scope of the indemnification has varied.

Spirgel: You should have the mindset that everything is negotiable. If your broker presents you with a model plan, encourages you to execute one but tells you that you can’t change or add a thing - it’s time to get a new broker. The broker plays an important role in creating and executing a 10b5-1 plan, but in most cases, he or she is just implementing the investment strategies of the client. The client is the one who is trying to gain the protections of the affirmative defense from insider trading by drafting a plan, so a plan should be tailored to best meet the client’s goals without shifting risk to the broker.

Mueller: In fact, there should be no “negotiation” over the terms of the actual trading instructions; you should be able to establish whatever parameters you want. However, listen to what the broker recommends as a feasible trading strategy; put the brokerage firm’s expertise to work. Also, you may be asking too much if you expect to get perfect execution of trades pursuant to an elaborate trading formula and you negotiate for a rock-bottom low commission rate. If you have a large amount of stock and wish to establish complex instructions, you may want to explore hiring a money manager to assist in implementing your plan.

Spirgel: Yes, the client should be able to set his or her own selling or purchasing metrics. An effective model plan should allow for creativity on the part of the client. Usually you can provide for this by having the client’s selling or purchasing transactions as an appendix to the base plan. The base plan will contain all the standard reps and procedural requirements (e.g. no knowledge of material public information, notification procedures if required by the company, Section 16 status, etc.) Attached to this base plan will be the client’s instructions to the broker: “Sell x shares of stock at the beginning of the first trading day of a month if the opening price of the company’s stock is x% higher than the closing price on the first trading day of the prior month.”

Can an officer terminate a plan when in possession of material nonpublic information?

Bowen: Under current rules and interpretations of them, there’s nothing to prevent an insider from terminating a trading plan, even if he or she uses material nonpublic information to make that decision. Some of the analysts quoted in the Wall Street Journal article complained that this gives an unfair advantage to insiders, since they can cancel a planned trade based on inside information, while a non-insider with a similar trading plan would be stuck with a bad deal. But under the current system, there is no liability for an insider’s decision not to trade.

Mueller: Yes, the SEC staff has now confirmed that termination of a plan when in possession of material nonpublic information is possible. BUT the staff has said that terminating a plan while in possession of material nonpublic information may raise questions as to whether the plan was entered into in good faith, and thus whether Rule 10b5-1(c) is available with respect to trades that were executed before the plan was terminated.

Bowen: The question is whether a termination runs against the spirit of 10b5-1 as expressed in the SEC’s implementing release, which says that insiders who create trading plans can “carry out those pre-planned transactions at a later time.”

Spirgel: The risk is that plan termination may call earlier purchases or sales into question. Rule 10b5-1(c) does warn that changing the terms of a plan when in possession of material public information will eliminate the protections of the affirmative defense. However, a cause of action for insider trading must be premised on a purchase or a sale, and if an insider terminates a plan before a transaction, there is no purchase or sale that is actionable. However, if there were trades under the plan, the SEC or a plaintiff could challenge those transactions by arguing that plan was not entered into in good faith as required under the Rule. The argument would be: based on the insider’s recent trading, it is clear that the insider intended that the plan only be executed if the transaction was not detrimental to the person. In other words, the insider tried to place itself in a “no lose” scenario.

Bowen: As many commentators have pointed out, the bottom line is that an excessive number of terminations might raise questions over whether the plan was entered into in good faith. To avoid this, the company should require a waiting period before a new plan can be established, or perhaps limit the number of plans that could be created during a specified period.

Mueller: One issue that has been discussed in this regard is whether a written plan should have a provision indicating that the insider may terminate the plan at any time. I’m in favor of such a provision because, if termination of a plan is ever questioned, at least the action will not be inconsistent with the actual terms of the plan.

In contrast, if the plan does not specifically address the insider’s right to terminate the plan, the insider will have the added burden of showing why an action that was inconsistent with the express terms of the plan does not suggest he was acting in bad faith.

Even if the plan does have an express right to terminate it before all sales are complete, any actual termination will need to be evaluated for whether it raises questions of bad faith.

I believe there are numerous situations that should not be viewed as raising questions of bad faith, such as

• If an executive is aware of adverse material nonpublic information and wishes to cancel a selling plan to avoid the bad publicity that could result if the plan results in selling a large number of shares in advance of a particularly serious decline in the stock price, or
• If a company is engaged in merger negotiations, the acquiring company may seek to have the target company’s executives terminate selling plans, in order to obtain lock-up voting agreements on the executives’ stock.

However, in evaluating whether to actually terminate a plan, it’s not the transaction that is avoided through the plan termination that is examined in light of the good faith standard; it is whether any past transactions lose the protection of the defense. For example, if the insider allowed sales to occur when he knew adverse information, and thereby was able to realize profits in advance of stock declines, but cancels the plan when he is aware of very positive information that has not been disclosed, then, absent some other factors, the insider’s good faith could be called into question.

A related issue is whether a broker should be able to terminate its administration of a sales plan. That action could cause real hardship to the insider; the insider may be aware of material nonpublic information at the time of the termination, and the availability of the defense would be uncertain if the insider tried to implement a plan with a different broker at that time (one could argue that the insider should be able to implement the same instructions with a different broker and it not be viewed as a “new” plan, but it’s unclear whether this argument would prevail). Therefore, the broker’s right to terminate the plan should be limited to developments beyond its control, such as regulatory changes that affect the broker’s ability to administer the plan.