SEC Rule 10b5-1


SEC Rule 10b5-1

SEC Rule 10b5-1 is an administrative rule [http://www.sec.gov/rules/final/33-7881.htm enacted] by the United States Securities and Exchange Commission (SEC) in 2000. The SEC states that Rule 10b5-1 was enacted in order to resolve an [http://www.sec.gov/rules/final/33-7881.htm#P222_87971 unsettled issue] over the definition of insider trading, which is prohibited by SEC Rule 10b-5.

Different courts of appeals had come to different conclusions about what constituted insider trading under Rule 10b-5 --- specifically, whether someone could be held liable for insider trading simply by trading while in possession of inside information, or whether a trier of fact must find that the person actually used that inside information when making the trade.

"Possession" versus "use"

Paragraph (a) of the Rule essentially repeats the holding of the U.S. Supreme Court in [http://www.law.cornell.edu/supct/html/96-842.ZO.html United States v. O'Hagan] , 521 U.S. 642, ), which defines insider trading under the misappropriation theory. It states, in full, that

The "manipulative and deceptive devices" prohibited by Section 10(b) of the Act and Rule 10b-5 thereunder include, among other things, the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information. [http://www.law.uc.edu/CCL/34ActRls/rule10b5-1.htm ]

Paragraph (b) addresses the unsettled "possession" versus "use" issue, stating that a person violates Rule 10b-5 simply by trading while in "possession" of inside information. It states, in full, that

Subject to the affirmative defenses in paragraph (c) of this section, a purchase or sale of a security of an issuer is "on the basis of" material nonpublic information about that security or issuer if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale. [http://www.law.uc.edu/CCL/34ActRls/rule10b5-1.htm ]
In other words, under 10b5-1(b) a person could be liable for insider trading simply by possessing inside information regarding a given security, breaching a fiduciary duty to the source of the information, and then trading it with a self-serving intent, even if he or she would have made the trade anyway. See U.S. v. O'Hagan, 521 U.S. 642, 652 (1997). But it is unlikely the SEC will detect or particularly care about a small trade that would have occurred anyway. A large trade or series of trades that reap unusual benefits for a trader, however, will likely be detected, and it would be difficult to prove that the material non-public information did not contribute to the decision to make the trade.

Affirmative legal defense for planned trades

In paragraph (c), however, the SEC created an affirmative defense to any charge of insider trading, "designed to cover situations in which a person can demonstrate that the material nonpublic information was not a factor in the trading decision." [http://www.sec.gov/rules/final/33-7881.htm#P264_100527 ] The [http://www.law.uc.edu/CCL/34ActRls/rule10b5-1.html provision] allows an affirmative defense to insider trading when the trade was made pursuant to a contract, instructions given to another, or a written plan that " [d] id not permit the person to exercise any subsequent influence over how, when, or whether to effect purchases or sales" ( [http://www.law.uc.edu/CCL/34ActRls/rule10b5-1.html 10b5-1(c)(1)(i)(B)(3)] ), and where the plan (or contract or instructions) was created before the person had inside information.

For example, a CEO of a company could call a broker on January 1 and enter into a plan to sell a particular quantity of shares of his company's stock on March 1, find out terrible news about his company on February 1 that will not become public until April 1, and then go forward with the March 1 sale anyway, saving himself from losing money when the bad news becomes public. Under the terms of Rule 10b5-1(b) this is insider trading because the CEO "was aware" of the inside information when he made the trade. But he can assert an affirmative defense under Rule 10b5-1(c), because he planned the trade before he learned the inside information.

A possible loophole: canceling plans

After Rule 10b5-1 was enacted, the SEC staff publicly took the position that canceling a planned trade made under the safe harbor does not constitute insider trading, even if the person was aware of the inside information when canceling the trade. The SEC [http://www.sec.gov/interps/telephone/phonesupplement4.htm stated] that, despite the fact that 10b5-1(c) requires trades to be irrevocable, there can be no liability for insider trading under Rule 10b-5 without an actual securities transaction, based on the U.S. Supreme Court's holding in "Blue Chip Stamps v. Manor Drug Stores", 421 U.S. 723 (1975).

This staff interpretation raises the possibility that executives can exploit this safe harbor by entering into 10b5-1 trading plans before they have inside information while retaining the option to later cancel those plans based on inside information. Although paragraph (c)(1)(i)(C) does deny the affirmative defense to offsetting or hedged transactions, in that case there would still be an actual trade (whichever of the offsetting trades was not canceled) that could constitute insider trading and violate Rule 10b-5. The SEC's position is that there can be no insider trading without a trade, so that a person could cancel a planned trade based on inside information and avoid liability. Although technically any plan that is cancelable does not come under the 10b5-1 safe harbor, proving that an executed trade was hypothetically cancelable might be very difficult.

A few academic commentators have written about this issue, [http://papers.ssrn.com/abstract=330520 arguing] that insiders can make systematically above-market profits by using 10b5-1 plans that they are still able to cancel. One empirical study has [http://ssrn.com/abstract=541502 found] that insiders using 10b5-1 plans do in fact make above-market profits (the paper also alludes to other potential loopholes that might explain this result), and [http://ssrn.com/abstract=941238 another] has found that the presence of publicly-announced 10b5-1 plans has economic effects on securities markets that are generally associated with insider trading.

SEC investigation

Noted in a [http://www.sec.gov/news/speech/2007/spch030807lct2.htm speech] by Linda Chatman Thomsen, the SEC chief enforcement officer, the SEC is now investigating why 10b5-1 trades appear to [http://ssrn.com/abstract=541502 outperform the market] . [http://blogs.wsj.com/law/2007/04/04/sec-scrutinizing-10b5-1-selling-plans Allegations of improper 10b5-1 trades] were noted during the insider trading trial of Joseph Nacchio, former Qwest CEO. There are also [http://www.buchananingersoll.com/media/pnc/8/media.1898.pdf preliminary investigations] into 10b5-1 trades by Angelo Mozilo, from Countrywide.

Best practices emerging

Some companies are starting to offer best practice advice [http://www.wsandco.com/press_release_pdf/10b5-1_Trading_Plans_-_NEW.pdf (example 1,] [http://www.mondaq.com/article.asp?articleid=48990 example 2) ] to assist firms and insiders with compliance and perception issues.

External links

* [http://wikileaks.org/wiki/Whistleblower_exposes_insider_trading_program_at_JP_Morgan Whistleblower exposes insider trading program at JP Morgan] , Wikileaks


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