In a typical year, the Securities and Exchange Commission (SEC) brings a few dozen enforcement cases against individuals for insider trader. These cases are typically settled before a decision by a court. Many of the issues raised by insider selling are less frequently litigated in stand-alone cases than in securities fraud class actions that allege a corporation issued a material misrepresentation that inflated its stock. Private plaintiffs will often argue that because a material misrepresentation coincided with sales by insiders who knew of the misrepresentation, the misrepresentation was not just due to negligence but part of a scheme to defraud investors. In doing so, they satisfy the element of scienter required under Rule 10b-5.

In a new book chapter, I discuss insider trading allegations in securities class action complaints. I present data on the decline of the number of cases making insider trading allegations over the last decade and offer some explanations for the decline.

Because it is common for executives to sell their shares for innocuous reasons, courts have been skeptical that allegations of insider trading in a securities fraud case necessarily support a finding of scienter. They have thus developed an extensive doctrine that governs whether insider sales are sufficiently “unusual” or “suspicious” so that they can support an inference of fraudulent intent. A substantial number of decisions thus essentially define when sales by corporate managers should trigger judicial scrutiny.

Some commentators have argued that these doctrines are used by courts to arbitrarily dismiss securities class actions. Professor Hillary Sale has documented that courts over the years have developed additional “judicial heuristics” to find that insider sales are not “unusual” or “suspicious.”[1] Sale concludes that “district courts have eagerly and overwhelmingly” used such “heuristics to eliminate cases on motions to dismiss that are arguably better preserved for summary judgment.”[2] Professors Stephen Bainbridge and Mitu Gulati have raised the possibility that these insider trading tests were developed by busy judges to move complex cases off their dockets. They question whether such tests were developed through thoughtful consideration of whether the greater prevalence of stock compensation means that insider sales are less likely to be “suspicious”.[3] Professors Ann Morales Olazabal and Patricia Sanchez Abril offer a different perspective..[4] They conclude that judicial tests developed to identify abnormal insider trading are an appropriate way for courts to identify greed by corporate insiders that typifies scienter.[5]

Insider trading allegations are an important part of securities fraud claims, but a significant majority of securities class actions do not include such claims. Table 1 presents data on insider trading allegations in securities class actions filed from 1996 to 2019.

Table 1: Insider Trading Allegations in Securities Class Action Filings

Insider trading allegations in securities fraud cases declined significantly starting around 2010 through most of the decade, suggesting that the link between insider trading and securities fraud is not always constant. One possibility is that the judicial heuristics have made it unlikely that a securities class actions complaint can establish scienter through an allegation of insider trading. Allegations have declined as plaintiffs’ attorneys have realized that courts are likely to reject the theory that insider trading evidences fraudulent intent. Plaintiffs are often able to find evidence of recklessness by corporate managers and thus do not always need to allege that individual managers were enriched by an alleged securities fraud.

The decline in the frequency of insider trading allegations in securities fraud lawsuits may indicate that certain types of insider trading have become less frequent. The introduction of Rule 10b5-1 plans in 2001 increased the incentive of executives to plan their stock sales over time. Such plans may have reduced the number of abrupt sales that are typical of insider trading and would be reflected in securities class action complaints. Moreover, by the end of the 2000s, federal appellate courts had ruled that trading under a Rule 10b5-1 plan can create a presumption that stock sales do not support a finding of scienter. The increased use of Rule 10b5-1 plans may thus have made it more difficult for plaintiffs to use evidence of insider sales to satisfy the scienter element of Rule 10b-5. With the SEC’s new amendments to Rule 10b5-1 in 2023, there is a possibility that insider sales will become even less likely to support claims that an executive acted with fraudulent intent.

ENDNOTES

[1] Hillary A. Sale, Judicial Heuristics, 35 U.C. Davis L. Rev. 903 (2002).

[2] Sale, supra note 1, at 904-05.

[3] See Stephen M. Bainbridge & G. Mitu Gulati, How Do Judges Maximize? (The Same Way Everyone Else Does – Boundedly): Rules of Thumb in Securities Fraud Opinions, 51 Emory L.J. 83, 132-33 (2002).

[4] See Ann Morales Olazabal & Patricia Sanchez Abril, In Honor of Walter O. Weyrauch: The Ubiquity of Greed: A Contextual Model for Analysis of Scienter, 60 Fla. L. Rev. 401 (2012).

[5] Id. at 440.

This post comes to us from Professor James J. Park at UCLA School of Law. It is based on his recent book chapter, “Insider Trading and Securities Fraud,” available here.