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This article is part three of a three-part series discussing recent trends that warrant public companies to consider whether their insider trading policies should be updated. Part one provided practical guidance on mitigating risks associated with employees who may inadvertently share confidential information with others. Part two discussed practical suggestions to comply with U.S. Securities and Exchange Commission (SEC) guidance to public companies that insider trading policies should address cybersecurity risks.

Part three provides a primer on potential legislative changes involving stock trading plans (aka 10b5-1 plans) routinely relied on by corporate insiders to trade their company's stock legally.

Background and Historical Usage of Rule 10b5-1 Trading Plans

Counsel should be on the lookout for potential changes to the rules governing the stock trading plans corporate executives routinely rely on to trade company stock (commonly referred to as 10b5-1 plans). In 2000, the SEC enacted Rule 10b5-1 under the Securities Exchange Act of 1934 to facilitate legitimate trading by corporate insiders in their company's securities without violating insider trading laws. Rule 10b5-1 provides an affirmative defense to the prohibitions against a corporate insider trading securities while in possession of material nonpublic information, provided that the insider execute trades pursuant to a prearranged plan adopted in good faith and at a time when the insider was not aware of the material nonpublic information. Generally, a 10b5-1 plan must be established in good faith before the insider becomes aware of material nonpublic information and must specify (1) the amount of securities to be traded, (2) the price at which the securities may be sold, and (3) the date of execution or, alternatively, a formula or algorithm to determine these factors.

For almost 20 years, corporate insiders have used 10b5-1 plans to buy and sell their company's stock for legitimate reasons, for example, to diversify or liquidate their assets when the vast majority of their assets and/or future income consists of company stock. Such insiders otherwise would be frequently prevented from trading because they often possess material nonpublic information about their company. Even when corporate insiders believe they do not possess material nonpublic information and are therefore free to trade, insiders may be reluctant to trade without the protection of a 10b5-1 plan for fear that the government will disagree that the insider did not possess material confidential information at the time of the trade. As a result, many insiders have come to rely heavily on 10b5-1 plans.

The 10b5-1 plans can also provide protection against liability in private litigation. For example, in May 2017, a Massachusetts federal judge dismissed a shareholder securities fraud complaint in Harrington v. Tetraphase Pharmaceuticals based, in part, on the timing of trades in company stock by three executives because, among other reasons, the trades were executed pursuant to 10b5-1 trading plans. The court held that a 10b5-1 trading plan generally "rebuts an inference of scienter and supports the reasonable inference that stock sales were prescheduled and not suspicious."

Potential Changes Forthcoming to the Scope of 10b5-1 Plans

Despite its legitimate utility for corporate insiders, 10b5-1 plans have come under scrutiny by the media, academic studies, and government officials for being subject to manipulation by insiders. Some claim that many executives achieved above-average investment returns on trades made pursuant to 10b5-1 plans. Critics allege these inordinate returns prove 10b5-1 plans are susceptible to being exploited due to the ability to commence plan trading promptly after a plan is adopted, the ability to cancel or amend a plan at any time, and the lack of disclosure about the adoption and amendment of plans.

In response to calls for reform, on Jan. 28, 2019, the House of Representatives approved the Promoting Transparent Standards for Corporate Insiders Act (Corporate Insiders Act) by an overwhelming majority. The bill was received in the Senate the next day. The Corporate Insiders Act would mandate the SEC to undertake a one-year study to review whether Rule 10b5-1 should be amended to impose additional restrictions on 10b5-1 plans. The SEC would be directed under the Corporate Insiders Act to assess the following potential restrictions on 10b5-1 trading plans:

1. Limiting the timing of the adoption of trading plans to open trading window periods set by the company.
2. Limiting the ability to adopt multiple trading plans.
3. Establishing a mandatory delay between the adoption of a trading plan and the execution of the first trade under the plan.
4. Limiting the frequency of modifying or canceling trading plans.
5. Requiring filings with the SEC to disclose trading plan adoptions, amendments, terminations, and transactions.
6. Requiring the board of directors to adopt trading plan policies and monitor plan transactions.

Following completion of the study, the SEC would be required to revise Rule 10b5-1 consistent with the results of the study.

More recently, the Insider Trading Prohibition Act was approved by the Financial Services Committee of the U.S. House of Representatives in May 2019. The Insider Trading Prohibition Act focuses on clearly defining the circumstances under which it would be illegal for a person to trade if they obtain material nonpublic information. One aspect of the Insider Trading Prohibition Act addresses 10b5-1 plans. Specifically, it would endorse the continued use of 10b5-1 plans by allowing individuals to engage in "automatic trading transactions," defined as trades occurring "automatically" or pursuant to an "advance election" (and would require the SEC to determine the scope of permitted automatic trading transactions within six months of enactment).

Other insider trading legislation is possible in the near future given that former Southern District of New York U.S. Attorney Preet Bharara is leading a task force studying ways for Congress and the SEC to fix the insider trading laws. This task force could ultimately draft its own insider trading bill.

Conclusion

In-house counsel should monitor the status of these proposed legislation and be prepared to modify their company's policies, as well as educate executives, if legislation is enacted. As an interim measure, in-house counsel should consider proactively revising company policies to take into account the issues and concerns raised by critics and in the proposed legislation discussed above. More generally, public companies should routinely revisit their insider trading policies to ensure they are current with the realities of the workplace and compliant with the ever-changing regulatory landscape. As there is not a one-size-fits-all insider trading policy, companies should customize their policies to reflect their size, culture, business, and risk areas.

Michael J. Rivera is a member in the Washington, D.C., office of Bass, Berry & Sims. He represents businesses and individuals in securities enforcement proceedings and internal investigations. He may be reached at [email protected].

Abby Yi is an associate in the Washington, D.C., office of Bass, Berry & Sims. She represents companies in connection with internal and government investigations concerning white-collar and corporate compliance matters. She may be reached at [email protected].