We have written extensively on Rule 10b5-1 trading plans in the last 12 months (and 10 years). However, the courts have not issued an extensive number of decisions on Rule 10b5-1 trading plans cases during this period. A Fourth Circuit Court of Appeals case decided last month, Yates v. Municipal Mortgage & Equity, LLC (4th Cir. 2014), did not focus on 10b5-1 trading plans, but the defendants’ use of one was a significant factor in their avoiding liability.  

The Yates case involves class claims that Municipal Mortgage & Equity and certain of its officers and directors committed securities fraud by (1) falsely representing that the company was in full compliance with a new accounting standard enacted in 2003; and (2) concealing the substantial cost of correcting the accounting error. The district court had dismissed plaintiffs’ claims under § 10(b) of the Securities Exchange Act of 1934 because they failed to adequately plead scienter, or wrongful intent. The Fourth Circuit affirmed that result.

To succeed with a Rule 10b-5 claim, plaintiffs must prove scienter (amongst other things) and, therefore, plaintiffs often allege (or provide evidence of) personal financial gain by insider trading as motive. InYates, the plaintiffs alleged that the company insiders were motivated to conceal its accounting problems in order to benefit improperly from insider trading. In Yates, plaintiffs pointed to stock sales by the chairman of the board and the chief executive officer as evidence of scienter.

The Court observed that allegations of “personal financial gain may weigh heavily in favor of a scienter inference.” The Court further observed, however, that “the inferential weight that may be attributed” to any claim of motive must be evaluated in context. Insider trading allegations will only support an inference of scienter “if the timing and amount of a defendant’s trading were unusual or suspicious.” To determine whether an insider’s sales were “unusual in scope,” we consider factors such as “the amount of profit made, the amount of stock traded, the portion of stockholdings sold, or the number of insiders involved.”

In Yates, the overall value of company shares sold during the “class period” was higher than in previous years. Six company insiders had sold 470,210 shares for a total of $12,004,901 in gross proceeds during the class period, as compared to the sale of 298,002 shares and $7,139,835 in gross proceeds for a similar period. The Court noted that these numbers could be consistent with an inference that the insiders who traded during the class period had a motive to commit fraud. 

However, the Court found that the inference that the trades were innocent was stronger. Nor is the extent of any insiders’ divestiture particularly alarming. The board chairman had sold approximately 37% of his shares in a recent 14-month period. Some of these sales coincided with the lead-up to the company’s announcement of the first earnings restatement. The CEO had sold just over 28% of his holdings during the class period. 

Sounds suspicious, right?  But the chairman and the CEO each sold company shares under a non-discretionary Rule 10b5-1 trading plan. This fact “weakens any inference of fraudulent purpose.” The Court stated:

"Under Rule 10b5-1, corporate insiders can set up trading plans to sell company shares at predetermined times and amounts to avoid accusations of illegal insider trading. See 17 C.F.R. § 240.10b5-1(c) (stating that it is an affirmative defense in insider trading cases that the defendant’s purchases or sales were made pursuant to a 'written plan for trading securities'); [citations omitted]."

The CEO had created his trading plan in 2003, more than one year before the alleged fraud and the beginning of the “class period.”  The chairman had instituted his Rule 10b5-1 plan after the start of the class period and the alleged fraud, but on a date that was one year before the complaint alleged that any officer at the company knew the company’s accounting was wrong. Each trading plan provided for sales occurred at regular intervals and amounts compared to earlier periods. The complaint did not allege that either man traded outside of his plan.

So, there you have it. One more good reason to use a 10b5-1 trading plan and follow best practices in its implementation.