The Legality of Opportunistically Timing Public Company Disclosures in the Context of SEC Rule 10b5-1

Ever since the SEC adopted Rule 10b5-1in 2000 the rule has been the subject of controversy. Some have questioned its validity, others have claimed that it has been abused. The commentary that follows addresses one suspected abuse of Rule 10b5-1, whether persons who have created plans under Rule 10b5-1 and then time corporate disclosure to improve trading outcomes under those plans have violated the law.

The SEC’s position is that a trade made when an insider is in possession of material nonpublic information (MNPI) about the company is unlawful under the classical theory of insider trading. Rule 10b5-1 was designed to permit trades by insiders when they are aware of MNPI so long as the trade was planned when the insider was not aware of MNPI. One alternative under Rule 10b5-1 allows insiders to establish a 10b5-1 plan (“Plan”) administered by a broker who is beyond the control of the insider. The Plan provides for future transactions in company securities in accordance with specific instructions or parameters that are followed by the broker. A later trade made strictly in accordance with the terms of a Plan created in accordance with the rule is not “on the basis of” MNPI and thus not unlawful. Many corporate executives have established Plans to facilitate portfolio diversification, among other purposes.

Empirical studies of insider trades made pursuant to Plans have suggested that those trades tend to be more successful than trades by outsiders in the same security. One explanation for this success is that the Plan was established when the insider was aware of MNPI. There have, however, been very few SEC enforcement actions for noncompliance with Rule 10b5-1 in this respect.

Another posited explanation for the abnormal returns is that the insider, knowing when a trade will occur under the Plan, influenced the timing of corporate disclosure so that the outcome of the trade was more profitable than would otherwise have been the case. For example, the insider knows that a Plan sale is scheduled for Day X, she learns on Day X minus 3 of some nonpublic material bad company news, and she takes action to delay the disclosure of the bad news beyond Day X, so that her sale is made before the release of the bad news causes the market price of the stock to drop. This presents the question whether it is unlawful to delay corporate disclosure, “disclosure timing,” for this purpose when the delay does not violate an SEC mandatory disclosure rule, such as the obligation under Form 8-K to disclose certain events no later than a specified number of days after the event.

The obvious place to start with an analysis of whether disclosure timing is unlawful is Rule 10b-5. For this analysis it is assumed that there has been no public disclosure of or about the Plan. Disclosure timing, an undisclosed internal process, does not, however, involve a public misrepresentation or half-truth (a failure to state facts necessary in order to make any statements that were made not misleading), which is prohibited by clause (b) of the rule. If, as is assumed, there has been no breach of an SEC public company disclosure rule, there has been no breach of a duty to speak that would make the insider’s silence about his disclosure timing actionable. While some courts, and the SEC itself, recognize “scheme liability” under clauses (a) and (c) of Rule 10b-5, this reaches only conduct that creates a false appearance of some kind in the market. Again, silence by the insider who tampers with the ordinary timing of corporate publicity creates no false appearance when there has not been a failure to comply with an SEC disclosure rule. That is, there is no basis for investors to infer from corporate silence that there is no undisclosed material fact. No other securities law statute or rule is violated by the insider’s undisclosed internal machinations. (Stock exchange listing rules that require disclosure of material events more promptly than required by Form 8-K do not provide the basis for either an SEC or private claim; the sanction for a violation is exchange delisting of the company’s stock.)

If disclosure timing occurs and should be prohibited, the means to address it under the current federal securities laws are limited. There are three possible approaches – prohibition and disclosure. There are, however, impediments to adopting a rule that would directly prohibit disclosure timing. A rule adopted under Section 10(b) of the Securities Exchange Act can prohibit only manipulation – a term of art far narrower than the conduct posited here – or deception.  Undisclosed internal disclosure timing is not a deceptive act, and so it is doubtful that a rule adopted under Section 10(b) that expressly prohibited disclosure timing would be lawful. This analysis is apart from the late Justice Scalia’s concern about agencies such as the SEC defining crimes through rulemaking.

A second approach would be to preclude use of the Rule 10b5-1 affirmative defenses to those who deliberately engage in disclosure timing, without purporting to deem disclosure timing deceptive in and of itself. A rule amendment may be easy to draft but difficult to apply, just as any incident of disclosure timing within the scope of otherwise lawful discretion may be hard to prove.

The third option at the federal level is to revive the SEC’s rule proposal in 2002, never formally acted on, to require some corporate disclosure of Rule 10b5-1 Plans. (Today any disclosure about Plans is voluntary, limited, and irregular at best.) Disclosure of even limited information about an insider’s Plan could expose the insider’s trades to hindsight scrutiny in light of post-trade corporate disclosures that might suggest there had been inappropriate (that is, morally if not legally improper) influence over the timing of disclosures. This could subject the insider to public shaming and result in a reassessment of his fitness to retain his current position. Proxy advisory firms may weigh in on the implications of this behavior.

More likely, a disclosure requirement would deter disclosure timing. This may result in insiders canceling plans when unexpected information materializes before a scheduled Plan trade, foregoing a less profitable trade. This approach is permissible in light of the SEC Staff’s recognition that canceling a Plan in reliance on MNPI does not violate Rule 10b-5.

There is a state common law of insider trading. Some states do not classify insider trading as a breach of any corporate fiduciary duty. Other states recognize a breach of duty when there is trading based on MNPI and the company is damaged by that conduct, which does not, however, occur as a result of disclosure timing. Most notably, Delaware has long recognized a fiduciary duty that prohibits personally profiting by trading in company securities using material nonpublic information, whether or not the trading damages the company. This prohibition on the use of corporate information for personal profit may be applicable to the disclosure timing context, where the insider uses his knowledge of corporate information to influence the timing of disclosure to improve the outcome of a personal trade made pursuant to a Plan.

While this principle of the law of Delaware, and perhaps a few other states, might be applied to insiders of corporations organized in the state, the calculation of recoverable damages on behalf of the corporation in a derivative suit may be difficult. It would be necessary to ascertain when disclosure would have been made had the insider not interfered with the disclosure process and, within reasonable bounds, what the stock price would have been had the Plan trade occurred in the context of a disclosure process that was not interfered with by the insider. Moreover, there is little likelihood of, and probably no basis for, state public enforcement authority action against disclosure timing. (Other common law claims, such as option backdating, spring-loading, and bullet-dodging, as well as the corporate opportunity doctrine, provide far less compelling parallels to disclosure timing than does the state law of insider trading.)

If disclosure timing is a problem – and it is perceived by some commentators as undesirable conduct that explains the unusually favorable outcomes of many Plan trades – then as with many securities law issues the best solution is disclosure regarding the creation of Plans rather than overreaching using existing rules or expansion of prohibitions that would have a questionable legal basis.

The preceding post comes to us from Allan Horwich, Professor of Practice at Northwestern Priztker School of Law and Partner at Schiff Hardin LLP.  The post is based on his paper, which is entitled “The Legality of Opportunistically Timing Public Company Disclosures in the Context of SEC Rule 10b5-1” and available here.