Rule 10b5-1 Plans in the Hot Seat, Subject To Close Scrutiny By SEC, DOJ

Washington, D.C. (March 9, 2023) – Federal regulators are increasingly scrutinizing inside trading (Rule 10b5-1) plans, which allow corporate insiders to trade securities under a forward looking written plan adopted when they are not aware of material nonpublic information. See SEC Commissioner Allison Herren Lee, Stock Trading Plans Should Prevent – Not Enable – Insider Trading: Statement on Proposed Amendments to Rule 10b5-1 (Dec. 15, 2021).

The Securities & Exchange Commission (SEC) adopted Rule 10b5-1 in 2000 to help clarify when liability may arise for insider trading. The rule sets forth certain conditions, which, if met, give rise to an affirmative defense against insider trading liability. Those conditions created a safe harbor for trading pursuant to a plan entered into in good faith before the person trading under the plan is aware of material nonpublic information. The idea being that if a person establishes a regular, pre-established program of buying or selling their company’s securities, that trading, when it later occurs, will not be considered to be on the basis of material nonpublic information potentially acquired after the adoption of the plan. Id.

Rule 10b5-1 plans have gained widespread popularity among corporate insiders. For example, in 2021, the SEC reported that approximately 5,800 officers and directors at 1,600 companies traded under Rule 10b5-1 plans. See Insider Trading Arrangements and Related Disclosures, 87 Fed. Reg. 80362, 80397 (Dec. 29, 2022).

Recently, however, likely due in part to their growing popularity, the SEC and DOJ have signaled they are concerned that executives are abusing Rule 10b5-1 plans and using them as tools to engage in insider trading under the veil of statutory protections. Using its rulemaking powers, in December 2022, the SEC adopted several amendments and new disclosure requirements, which will soon go into effect, intended to address what it perceives may be abusive practices relating to Rule 10b5-1 trading plans. See SEC Adopts Amendments to Modernize Rule 10b5-1 Insider Trading Plans and Related Disclosures (Dec. 14, 2022).

In addition to rulemaking in this area, the SEC and DOJ have initiated enforcement actions within the last few months that take an aggressive stance on 10b5-1 plans. On March 1, 2023, the SEC and DOJ jointly announced that they had brought civil and criminal charges against the former CEO of Ontrak Inc., a publicly traded healthcare company, for allegedly engaging in an insider trading scheme in which he fraudulent used Rule 10b5-1 trading plans to trade Ontrak stock. Specifically, the former CEO was alleged to have dumped more than $20 million in company stock based on inside knowledge that it was about to lose a contract with Cigna, its largest customer. The 10b5-1 criminal insider trading case is the first of its kind for DOJ.

As the DOJ explained in a press release:

“Today’s groundbreaking insider trading indictment demonstrates that the Department of Justice, together with our law enforcement partners, will not allow corrupt executives to misuse 10b5-1 plans as a shield for insider trading,” said Assistant Attorney General Kenneth A. Polite, Jr. of the Justice Department’s Criminal Division. “As this case shows, we have embraced the use of data to proactively identify and investigate fraud as we continue to ensure that ordinary investors are on an equal playing field with corporate insiders.”

Previously, on September 21, 2022, the SEC announced that it had brought a settled cease and desist action against the CEO of Cheetah Mobile for selling the company’s securities, pursuant to a purported 10b5-1 trading plan, while in possession of material nonpublic information. See SEC Charges Cheetah Mobile’s CEO and its Former President with Insider Trading.

While the Cheetah Mobile and Ontrak cases, as alleged, represent robust cases of executives attempting to manipulate their Rule 10b5-1 plans to be able to buy or sell shares while possessing inside information, it remains to be seen how closely the SEC and DOJ will be inclined to scrutinize other executives’ plans in less extreme circumstances, and whether their aggressive enforcement stances will continue.

When determining whether to bring an action, federal regulators will examine what is going on in the life of the company, in terms of important undisclosed events, at the time an executive enters into a Rule 10b5-1 plan. For example, is the company undergoing merger talks, did it lose a key customer, did the FDA reject a pipeline drug, etc. The more significant an event, positive or negative in the life of the company, the more likely the SEC will scrutinize an executive’s Rule 10b5-1 plan executed during that period. In addition, the SEC will examine the details of the trading plan – the more terms and conditions in a plan, in terms of employing caps, limits, options, or other types of derivatives to direct or control trading activities, the more scrutiny the plan may attract from regulators.

The attorneys of Lewis Brisbois’ SEC Enforcement & Litigation and Government Investigations & White Collar Defense Practices, which include former federal prosecutors with experience in investigating and prosecuting securities violations, can assist companies with analyzing their Rule 10b5-1 plans to ensure compliance and provide assistance in corresponding with federal regulators. For more information on this topic, contact the author or editor of this alert.

Author:

Paul W. Kisslinger, Partner

Editor:

Steven H. Lee, Partner