Insider trading has long been a primary focus of the SEC’s enforcement efforts. Now, even company executives and insiders trading pursuant to Rule 10b5-1 stock trading plans are being subjected to SEC scrutiny. On March 8, 2007, the director of the SEC’s Division of Enforcement, Linda Chatman Thomsen, announced in a speech that the SEC intends to investigate trading under 10b5-1 plans that yield suspicious results. As a current high profile example, stock sale plans used by at least two senior executives of New Century Financial Corp., the sub-prime mortgage lender that just filed for bankruptcy court protection on April 2, 2007, apparently are under scrutiny.
Rule 10b5-1, promulgated by the SEC in 2000 pursuant to Section 10(b) of the Securities Exchange Act, permits individuals with access to material nonpublic information to trade in specified circumstances designed to ensure that material nonpublic information is not a factor in the decision to trade. For example, where the trading plan specifies “the amount of securities to be purchased or sold[,]” the price, and the date; specifies “a written formula or algorithm” for determining the amount of securities to be purchased or sold, the price, and the date; or precludes the individual from exercising “any subsequent influence” over the trades, the trading is deemed to “not [be] ‘on the basis of’ material nonpublic information . . . .” Certain other exceptions apply as well. Consequently, Rule 10b5-1 trading plans adopted in good faith prior to possession of any material nonpublic information afford individuals an affirmative defense against insider trading claims.
The SEC’s interest seems to have been triggered by a recent study conducted by Professor Alan D. Jagolinzer of Stanford University’s Graduate School of Business. Professor Jagolinzer found that executives entered into Rule 10b5-1 selling plans immediately prior to significant declines in the company’s stock price. In addition, the study indicates that trades by individuals pursuant to Rule 10b5-1 stock trading plans outperformed non-Rule 10b5-1 trades by almost 6 percent, a possible implication of which is the manipulation or misuse of such plans to take advantage of material nonpublic information in making trades.
During her speech in early March, Thomsen announced that the SEC intends to prevent unfair exploitation of Rule 10b5-1 stock trading plans. She said that the “safe harbor” is designed “to give executives regular opportunities to liquidate their stock holdings – to pay their kid’s college tuition, for example – without risk of inadvertently facing an insider trading inquiry. If executives are in fact trading on inside information and using a plan for cover, they should expect the ‘safe harbor’ to provide no defense.” The SEC’s recent comments and the disclosure of the inquiry concerning the New Century executives strongly suggest that insiders trading under Rule 10b5-1 plans could become enforcement targets.
Since the advent of the adoption of 10b5-1 plans, it has been crucial to avoid the temptation to deviate from such plans for any reason or even no reason. Now, in light of the newly announced regulatory focus on insiders’ sales under such plans, it is even more important to consult counsel when modifying or creating a new 10b5-1 trading plan. All of the circumstances surrounding the original adoption of a plan, the reasons for modifying or adopting a new plan, and the historical and current circumstances surrounding the performance and activities of the subject company, must be carefully evaluated to avoid regulatory suspicion or scrutiny of an insider’s 10b5-1 plan and his or her trades pursuant to such plan.