How to Curb Abuses of Insider Abstention and Rule 10b5-1 Plans

Company insiders will typically possess material non-public information (MNPI) about their companies. To allow them to trade, the SEC in 2000 adopted Rule 10b5-1, which provides an affirmative defense to insider trading liability if the trades are made pursuant to a written plan or trading instruction entered into when the trader was not aware of MNPI.  Since the adoption of the rule, 10b5-1 plans have become increasingly common: By one estimate, in 2019 more than half of S&P 500 companies had executives who used Rule 10b5-1 plans.[1]

Over the years there has been considerable concern that insiders could be abusing the Rule 10b5-1 safe harbor by adopting last minute trading plans, adopting multiple trading plans, or even cancelling plans that turned out to be unprofitable. The SEC recently adopted amendments to Rule 10b5-1 designed to curb some of the more egregious practices, including a requirement for a cooling-off period between the adoption of the plan and the onset of trading.[2]  But one significant problem remains: Insiders sometimes terminate previously adopted plans while they have MNPI to avoid potential losses, which is substantively indistinguishable from insider trading. Although Rule 10b5-1 plans are supposed to be irrevocable, insiders who back out of a plan have so far escaped liability under the central anti-fraud provision of the federal securities laws (Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder) principally because a violation of that provision requires an actual trade. In a new paper, I discuss another possible basis for insider trading liability in the context of a cancelled or terminated Rule 10b5-1 plan.

When the SEC was considering the recent amendments to Rule 10b5-1, Chairman Gary Gensler gave a speech in which he bemoaned the ability of a person to cancel Rule 10b5-1 plans even if that person possessed MNPI, noting that this seemed “upside down” because cancellation could be “as economically significant as carrying out an actual transaction.”[3] Nonetheless, the amended rules did not directly prohibit termination or cancellation of Rule 10b5-1 plans.

The issue of “insider abstention” – insiders who decide not to trade based on MNPI – has long bedeviled insider trading law and policy.[4]  Insider abstention is typically undetectable, raising insurmountable issues of proof. But Rule 10b5-1 plans stand on a different evidentiary footing: they are written plans, communicated to third parties, creating a clear record of intent. The only real question is whether legal liability can attach in the absence of an actual purchase or sale of a security. Traditionally, the answer has been no: The SEC staff has stated on a few occasions that cancellation of a Rule 10b5-1 plan would not in itself lead to liability under Section 10(b) and Rule 10b-5 because the U.S. Supreme Court has held that a violation of those provisions requires an actual trade in a security, rather than a decision not to trade.[5]  Rule 10b-5 prohibits fraud “in connection with” the purchase or sale of a security, and terminating a plan would not meet the “in connection with” requirement.

However, Rule 10b-5 is not the only statutory provision that has been used to prosecute insider trading. The SEC has frequently used Section 17(a) of the Securities Act of 1933, a provision that applies not only to the “sale” of securities but also more broadly to “offers” to sell securities.[6]  While termination of a Rule 10b5-1 plan does not constitute fraudulent conduct within the meaning of Rule 10b-5 because it does not involve an actual purchase or sale of a security, the same issue does not exist with respect to Section 17(a) liability.  In addition, there is a lower legal standard for violations of certain provisions of Section 17(a): While a violation of Rule 10b-5 always requires a showing of scienter, violations of Section 17(a)(2) and 17(a)(3) require only a showing of negligence.[7]

Notably, the SEC recently brought two insider trading cases involving the misuse of Rule 10b5-1 plans (though not the termination of plans) where the charges included violations of Section 17(a).[8]  In one case, the SEC charged violations of Section 17(a)(2) and 17(a)(3) and specified in the order that such violations do “not require scienter and may rest on a finding of negligence.”[9]

In addition, criminal authorities have increasingly been prosecuting insider trading under the general mail and wire fraud statutes, as well as under a more recently adopted securities fraud statute (Title 18 Section 1348) that is modeled on the mail and wire fraud statutes and is not even part of the federal securities laws.[10]  Critically, the mail and wire fraud statutes do not have an “in connection with” requirement at all,[11]  and Section 1348’s “in connection with” provisions do not always require a securities trade.[12]

The reach of the mail and wire fraud statutes is very broad, and the Supreme Court has twice unanimously blessed their use to criminally prosecute insider trading, first in Carpenter v. United States[13] in 1987 and 10 years later in United States v. O’Hagan.[14]  Most important, the mail and wire fraud statutes cover conduct beyond that which may be prohibited under Section 10(b), while Section 1348 was specifically designed to capture fraudulent conduct that might not meet the technical requirements of Section 10(b) fraud.[15]

These other statutory provisions could provide a basis for insider trading liability in the context of a cancelled or terminated Rule 10b5-1 plan and going forward we may see both the SEC and criminal authorities taking a closer look at potential liability in the context of suspiciously timed plan terminations.

ENDNOTES

[1] Jeffrey Cohen, The 10b5-1 Plan: What Executives Need to Know, CORP. COUNS. BUS. J. (2019).

[2] See Press Release, SEC, SEC Adopts Amendments to Modernize Rule 10b5-1 Trading Plans and Related Disclosures (Dec. 14, 2022).

[3] See Gary Gensler, Chairman, SEC, Prepared Remarks Before the WSJ’s CFO Network Summit (June 7, 2021).

[4] See, e.g., Jesse M. Fried, Insider Abstention, 113 YALE L.J. 455 (2003).

[5] SEC, Division of Corporation Finance: Manual of Publicly Available Telephone Interpretations: Fourth Supplement (May 2021) citing Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975).

[6] Securities Act of 1933 § 17(a), 15 U.S.C. § 77q(a) (“It shall be unlawful for any person in the offer or sale of any securities …”).

[7] See Aaron v. SEC, 446 U.S. 680 (1980).

[8] Press Release, SEC, SEC Charges Ontrak Chairman Terren Peizer With Insider Trading (Mar. 1, 2023); In the Matter of Sheng Fu and Ming Xu, Securities Act Release No. 11104, Exchange Act Release No. 95847 (Sep. 21, 2022).

[9] In the Matter of Sheng Fu and Ming Xu, Securities Act Release No. 11104, Exchange Act Release No. 95847 (Sep. 21, 2022).

[10] See Karen E. Woody, The New Insider Trading, 52 ARIZ. ST. L.J. 594 (2020).

[11] See 18 U.S.C. §§ 1341 (mail fraud), 1343 (wire fraud). The required elements of a violation are simply (1) a scheme to defraud or deprive someone of property, and (2) use of the mails or an interstate wire. See, e.g., Schmuck v. United States, 489 U.S. 705, 721 (1989).

[12] There are two parts to Section 1348, and both have an “in connection with” requirement, but the two sections are worded differently. While Section 1348(2) specifies that the fraudulent conduct must be in connection with “the purchase or sale of a security,” Section 1348(1) is more broadly worded to encompass fraud “in connection with . . . any security.” Thus, under Section 1348(1) the fraud must have some nexus to a security, but there is no need for a purchase or sale.  See 18 U.S.C. § 1348.

[13] Carpenter v. United States, 484 U.S. 19 (1987).

[14] United States v. O’Hagan, 521 U.S. 642 (1997).

[15] See 148 Cong. Rec. S7420-7421 (July 26, 2002) (statement of Sen. Leahy).

This post comes to us from Professor David Rosenfeld at Northern Illinois University College of Law.  It is based on his recent article, “Insider Abstention and Rule 10b5-1 Plans,” available here.

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