In August 2000 when the Securities and Exchange Commission adopted the highly publicized Regulation FD which mandates simultaneous "fair disclosure" to all investors (see October 2000 ACE Report), the SEC also adopted new Rules regarding insider trading by directors, officers and others. Although over-shadowed by Regulation FD, these new Rules are quite important in defining the scope of improper insider trading and how D&Os should handle routine trades. Companies wanting to actively maintain effective securities loss prevention programs should amend their insider trading policies to reflect these new Rules and should inform their directors and officers of the protective opportunities created by the new Rules.
Insider Trading Liability
The primary focus of Rule 10b5-1 (which became effective October 23, 2000) is to formalize the SEC's long-standing position that a person may be liable for illegal insider trading if that person trades while in knowing possession of material non-public information, whether or not the person used the information for trading purposes. Several recent federal courts of appeal decisions rejected that SEC position, holding that the person must not only possess but also use the material non-public information in making the trading decision. Those recent decisions apparently convinced the SEC that it should issue for the first time formal Rules defining illegal insider trading.
The new Rule creates a presumption that a purchase or sale of a security by an insider is on the basis of material non-public information (and therefore illegal) if the person making the purchase or sale was aware of the non-public information at the time of the transaction. This presumption can be rebutted (and personal liability avoided) only if the inside trader proves that before becoming aware of the non-public information, he or she had:
- entered into a binding contract to make the trade,
- instructed another person to make the trade for his or her account, or
- adopted a written plan for trading pursuant to which such trade was made.
Under the Rule, such a contract, instruction or plan must have either:
- specified the amount to be purchased or sold, the price (which may be either a particular dollar price or the market price on a particular date or a limit price) and the date on which the securities were to be traded, or
- included a written formula or computer program for determining the amount, price and date, or
- precluded the trading person from exercising any influence over how, when or whether to effect purchases or sales.
This "safe harbor" applies only to claims seeking a disgorgement of the insider's illegal trading profit and does not directly apply to shareholder class action lawsuits against directors and officers arising out of a sudden drop in the company's stock price. Plaintiffs in securities class actions typically allege that the defendant directors and officers traded in the company's stock during the class period and then use the existence of that trading to show the defendants had a motive to artificially inflate the stock price.
Class action plaintiffs do not seek to disgorge the defendants' insider trading profits. Therefore, the safe harbor in new Rule 10b5-1 does not directly apply to the defense of those securities class actions.
Defending Against Class Actions
However, a trading program consistent with new Rule 10b5-1 may be helpful in defending a securities class action lawsuit against directors and officers who traded during the class period. By adopting the new Rule, the SEC is acknowledging that trading by insiders consistent with the "safe harbor" is proper and therefore should not constitute evidence of securities violations. Plaintiffs will likely argue, though, that even under a trading program pursuant to new Rule 10b5-1, directors and officers may still know that shares owned by them will be sold and therefore those directors and officers arguably still could be motivated to inflate the company's stock price in order to benefit from that prearranged sale. Stated differently, although compliance with the new Rule's trading program safe harbor will not hurt the defense of a securities class action, it is unclear whether in many cases it will materially help the defense. Unquestionably, though, a safe harbor trading program will help prevent liability in claims by the SEC for illegal insider trading.
It is likely that securities brokers and other financial advisers will be aggressively contacting directors and senior officers with information about the new Rule in order to convince those directors and officers to enter into a safe harbor trading program with the broker or financial adviser, such as setting up blind trusts, discretionary accounts, hedging strategies, etc. Companies should consider a proactive approach to this topic, providing their directors and officers with objective information and advice regarding the value and necessary terms of such a prearranged trading program.
Corporate general counsel should find this new Rule particularly helpful. Most public companies currently have pre-established trading windows in which directors and officers are normally permitted to trade in the company's securities. However, the company's general counsel usually has the obligation under a trading window program to monitor the flow of material non-public information and, when appropriate, to shut the window and prohibit trading by directors and officers. This is a rather subjective responsibility that at times can be politically and personally challenging to the general counsel, particularly when a senior officer or director strongly desires to trade during a period when the general counsel has subjectively "shut the window." A trading program consistent with the new Rule eliminates this subjectivity and takes the general counsel off the "hot seat."