Over a decade ago, the U.S. Securities & Exchange Commission (the "SEC") promulgated Rule 10b5-1, which codified the SEC’s position that trading while in "possession" of material nonpublic information was sufficient to establish liability for insider trading under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 promulgated thereunder.1 Rule 10b5-1 also provides certain affirmative defenses for those under investigation for or charged with insider trading. The U.S. Department of Justice and government regulators recently initiated investigations into trades in securities of several companies made pursuant to Rule 10b5-1 trading plans by hedge funds and the people who manage them.
A Rule 10b5-1 trading plan permits corporate insiders and others to whom material nonpublic information has been entrusted to schedule in advance when to buy or sell securities, how much, and at what price, regardless of whether the trader possesses inside information at the time of the trade, so long as the trader satisfies specific criteria at the time the plan is implemented or amended. Most significantly, the plan needs to be entered into at a time prior to the possession of the material and nonpublic information. As innovative Rule 10b5-1 trading plans were developed, hedge funds and investment funds began to implement them to address the trading of securities of companies for which the fund manager was also a company insider, most often a board member, or a person to whom inside information was entrusted. Hedge funds, investment funds, fund managers, and corporations should consult with counsel to implement best practices for creating, revising, and utilizing Rule 10b5-1 trading plans to eliminate the appearance of impropriety and ensure they are afforded the protection of the Rule 10b5-1 affirmative defense.
Insider Trading Theories of Liability
Insider trading is the unlawful trading in securities based on material non-public information and is a violation of section 10(b) of the Securities Exchange Act of 1934 and Rule 10b–5. 2 A corporate insider is prohibited from trading on the basis of material nonpublic information in the securities of the corporation for which he or she owes a duty of trust and confidence to shareholders.3 A second theory, known as the misappropriation theory, forbids the trading of securities by non-corporate insiders to whom material non-public information has been entrusted in confidence and whose trading for personal gain would as a result breach a fiduciary duty or other relationship of trust and confidence to the source of the information.4
Individuals charged with insider trading face significant civil and criminal liability and sanctions. Insider trading violations may result in civil and potentially criminal penalties. The SEC may seek civil penalties, disgorgement of profits, and prejudgment interest as well as injunctive relief prohibiting individuals from serving as an executive or board member for a public company.5 Federal prosecutors may seek criminal penalties of up to $5,000,000 and up to 20 years in prison for individuals per violation, although criminal sentences in insider trading cases typically have been driven by the gain or the amount of loss avoided, which is the starting point in the sentencing guidelines analysis.6
Rule 10b5-1 Trading Plans
Rule 10b5-1 provides for affirmative defenses by which a trader’s purchase or sale of a security is not a violation under Section 10(b) and Rule 10b5-1, including in instances in which a trading plan was implemented to detail the timing and amount of securities to be purchased or sold, or a formula for determining the amount, price, and date to sell.7
The Rule 10b5-1 trading plan permits persons – including "non-natural person" (i.e., entities) – to create trading plans detailing the intentions to make trades in the relevant securities during periods when an individual may possess material and nonpublic information.8 Under Rule 10b5-1, the plan participant is prohibited from exercising any subsequent influence over how, when, or whether to effect transactions in the securities.9
In recent years, Rule 10b5-1 trading plans have become a popular vehicle for executives and non-employee directors to trade a company’s securities on their own and for funds that they manage despite their insider status. Because Rule 10b5-1 trading plans need not be disclosed to all shareholders, funds need not disclose the formulas and algorithms used to determine when to execute trades, thus protecting this proprietary information. Such trading plans by investment funds, however, have recently garnered increased scrutiny from federal prosecutors and regulators.
Regulators have expressed concerns regarding the results of academic studies that revealed that Rule 10b5-1 plans generate abnormally high returns compared to the returns of those trades made without Rule 10b5-1 plans. 10 Federal prosecutors and regulators have since indicated their intent to probe the abusive use of 10b5-1 plans.
Recent Government Inquiries into Hedge Fund Trading via 10b5-1 Plans
The Wall Street Journal (the "WSJ") recently reported that the U.S. Attorney’s Office for the Eastern District of New York sent subpoenas to three companies and three investment funds requesting information related to trades made by the funds pursuant to Rule 10b5-1 trading plans.11 The WSJ stated that the investigation is an outgrowth of a similar investigation launched in recent weeks by the U.S. Attorney’s Office for the Southern District of New York. The WSJ indicated that federal prosecutors and the SEC plan to meet to discuss the probes. The WSJ cited sources with knowledge of the U.S. Attorney’s Office for the Eastern District of New York’s investigation as stating that the government has requested documents and email communications related to trading pursuant to Rule 10b5-1 trading plans. In particular, the U.S. Attorney’s Office is interested in trades made by hedge funds managed by non-employee directors of the company in whose securities the fund executed trades. The Wall Street Journal stated that the U.S. Attorney’s probe for one company involves a 10b5-1 trading plan created for a fund whose manager serves as a board member for the company.
In recent years, hedge funds with significant positions in public companies have begun to use Rule 10b5-1 trading plans more frequently as a way to protect against liability under Rule 10b-5. This frequency of use has been driven, at least in part, by the increased attention that federal prosecutors and the SEC have devoted to insider trading investigations and proceedings in the hedge fund space.
We expect that federal prosecutors and regulators will focus on whether the Rule 10b5-1 trading plans were entered into, modified, and/or terminated in good faith and not as part of a plan or scheme to capitalize on inside information.
Investment funds and fund managers should strongly consider implementing best practices when creating, modifying, or terminating Rule 10b5-1 trading plans to maximize the availability and usefulness of the affirmative defense provided by Rule 10b5-1 in the event of a law enforcement or regulatory investigation. Importantly, following the best practices related to modifying, suspending, or terminating an existing 10b5-1 trading plan will greatly reduce the appearance that the trading plan is being manipulated to incorporate material nonpublic information. Paul Hastings can assist with the design of 10b5-1 trading plans and other policies designed to reduce the risk of Rule 10b-5 liability.