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Business Law Today

Rule 10b5-1 Plans
Staying out of Trouble
By Brandon C. Parris
In August of 2000, the Securities and Exchange Commission (SEC) adopted Rule 10b5-1 under the Securities Exchange Act of 1934 establishing that a person can face insider trading liability for trading securities while "aware" of material, nonpublic information about the issuer or its securities, even if the person does not actually "use" such information in making the trade. This standard significantly broadened the circumstances under which a person could face liability for insider trading. However, in connection with the adoption of Rule 10b5-1, the SEC also adopted several affirmative defenses, or exceptions to liability. These affirmative defenses effectively enable a person to trade securities in circumstances where they may otherwise be aware of material, nonpublic information at the time of the trade, without liability under Rule 10b5-1, where it is clear that such information was not a factor in the person's decision to trade. Of the affirmative defenses, one of the most common is the use of a preexisting written trading plan that complies with the requirements of Rule 10b5-1(c), the so-called 10b5-1 plan. Simply put, a properly implemented 10b5-1 plan can allow an executive the flexibility to purchase or sell securities at a time when the executive is otherwise aware of material, nonpublic information, providing the executive with an affirmative defense to potential allegations of insider trading.

Recently, 10b5-1 plans have come under heightened scrutiny. In late 2006, an academic study suggested that sales under the 10b5-1 plans examined were, on average, generating abnormal trade returns, and that such 10b5-1 plans appeared to be generally outperforming the market. In October 2007, Linda Thomsen, the SEC's Director of Enforcement, gave a speech indicating that the SEC was taking a close look at potential abuses by individuals in connection with 10b5-1 plans. This followed Ms. Thomsen's congressional testimony in September 2006 when she indicated that the SEC, due to increased allegations of insider trading claims, was going to be moving "aggressively" in investigating such claims.

With the increased focus on insider trading and the heightened scrutiny surrounding 10b5-1 plans, it is important to adhere to sound practices in connection with the adoption and use of 10b5-1 plans if the benefits of the affirmative defense are to be preserved. Failure to satisfy the requirements of Rule 10b5-1(c) in connection with the adoption and use of a 10b5-1 plan can lead to disastrous consequences, including potential loss of the affirmative defense and exposure to civil and criminal penalties for insider trading.

10b5-1 Plan Requirements
When adopting a 10b5-1 plan, it is important to ensure that the necessary requirements of Rule 10b5-1(c) are satisfied. In addition, issuers need to ensure that their policies and procedures regarding 10b5-1 plans are followed and enforced.

• Satisfy Minimum Requirements. To get any protection from the affirmative defense, it is important to ensure, regardless of how complex or simple a 10b5-1 plan may be, that at a minimum, the specified requirements of the affirmative defense for use of 10b5-1 plans set forth in Rule 10b5-1(c) are satisfied. These requirements include

(1) adopting the written 10b5-1 plan before becoming aware of any material, nonpublic information, as discussed in greater detail below;

(2) ensuring that the terms of the 10b5-1 plan specify either (a) the amount and price of the securities to be purchased or sold and the dates for such purchases or sales, or (b) a written formula or algorithm or computer program that determines the amount and price of the securities to be purchased or sold and the dates for such purchases or sales;

(3) ensuring that the terms of the 10b5-1 plan do not permit the executive to exercise any subsequent influence over how, when, or whether purchases or sales would be effected under the plan, and further ensuring that if the terms of the 10b5-1 plan permit a third party to exercise such subsequent influence, such third party does not do so at a time when aware of material, nonpublic information;

(4) being able to demonstrate that the purchase or sale of the securities actually occurred pursuant to the terms of the 10b5-1 plan;

(5) not altering or deviating from the terms of the 10b5-1 plan (by changing either the amount, price, or timing of the purchase or sale of the securities covered by the 10b5-1 plan) and not entering into or altering a corresponding or hedging transaction or position with respect to the securities covered by the 10b5-1 plan; and

(6) ensuring that the 10b5-1 plan was entered into in good faith, and not as part of a plan or scheme to evade the prohibitions of Rule 10b5-1.

• Satisfy the Absence of Material, Nonpublic Information Requirement. Possibly the most closely scrutinized element of the affirmative defense is whether a 10b5-1 plan was adopted at a time when the executive was free of any material, nonpublic information regarding the issuer or its securities. While this requirement must be satisfied at the time of the plan's adoption, the requirement may be scrutinized months, or sometimes years, later with the benefit of hindsight. One can imagine a multitude of corporate events or issues that, while at the time of adoption of the 10b5-1 plan may not seem material, but with hindsight after the passage of time, can be subsequently transformed into something that appears very material. Examples include, among others, potential legal claims that subsequently develop into material litigation, preliminary transaction discussions (such as a potential merger or acquisition/disposition of assets involving the issuer) that later develop into a publicly announced transaction, or preliminary signs of a potential slowing in the issuer's business that later transpire into an actual reduction in the issuer's business (having a negative impact on the issuer's financial results). As such, it is important prior to adopting a 10b5-1 plan that the executive be very comfortable that there is no information outstanding that, either at that point or later, with hindsight, could be construed as material. To the extent that an executive is contemplating adoption of a 10b5-1 plan at a time when the executive is aware of nonpublic information that is not then perceived as material, but later could become material (such as in the examples discussed above), careful consideration should be given as to whether adoption of the 10b5-1 plan at that time is prudent.

• Observe Corporate Formalities. Executives subject to issuer insider trading policies and procedures need to ensure that the adoption of the 10b5-1 plan complies with the formalities of such policies and procedures. Typically, an issuer's insider trading policy will require that 10b5-1 plans be precleared and adopted only in an open window period (e.g., the time period when trading in the issuer's securities is permitted pursuant to the terms of the policy). Likewise, to minimize the risk of negative publicity and potential scrutiny, an issuer will often want to ensure that, in addition to the executive, the issuer is free of any material, nonpublic information at the time the executive adopts the plan. Most brokerage firms also require an issuer's general counsel or other insider trading policy administrator to affirmatively confirm that the terms of the proposed 10b5-1 plan do not conflict with the issuer's insider trading policy.

• Consider Public Disclosure. The practice is mixed as to whether the adoption of a 10b5-1 plan should be publicly announced via press release or other form of public communication. While announcing to the public that an executive has adopted a 10b5-1 plan can provide a certain amount of transparency, asymmetrical disclosure should be avoided. In Ms. Thomsen's October 2007 speech, she indicated that the SEC is focused on issuersO practices of asymmetrical disclosure, such as publicly announcing that an executive has adopted a 10b5-1 plan but not announcing (timely or otherwise) when such 10b5-1 plan has been modified or terminated. While executives that file a Form 144 in connection with a trade are now required, pursuant to the recently enacted amendments to Rule 144, to specify if the trade was pursuant to a 10b5-1 plan, executives should make similar disclosures on their Section 16 reports; such disclosure can help facilitate a judge or court's ability to take judicial notice of the executive's 10b5-1 plan in the event that the executive is defending against an action alleging insider trading.

Formulating a 10b5-1 Plan
Whether an executive is adopting a 10b5-1 plan to provide for a long-term liquidity solution, to help provide for portfolio diversification, or to provide funding for certain financial milestones such as tuition payments or a home purchase, it is important to take the time to ensure that the 10b5-1 plan is tailored to the executive's specific needs.

• Determining the Length of the Plan. There is no limitation on the length of a 10b5-1 plan's term; however, to minimize the need for modification, special care should be given in determining the length of the plan's term. The probability that an executive's liquidity needs under a 10b5-1 plan will change increase with the passage of time. To minimize the potential need for a modification in this regard, consider limiting the term of the plan to no longer than 12 months. Conversely, a plan that terminates after a short period of time following adoption increases the potential for red flags--i.e., whether the 10b5-1 plan was entered into in good faith or as a means of manipulation. To mitigate potential scrutiny in this regard, consider requiring the plan to be in place no less than six months.

• Establishing the Number of Securities. There are no restrictions on the number of securities that may be covered by a 10b5-1 plan; the plan can be drafted to include as few or as many of an executive's securities as needed to implement the executive's liquidity strategy. However, it is important that the executive find the right balance--too few securities can leave the executive needing to modify the plan to include additional securities--too many securities may unduly restrict the executive's ability to take advantage of legitimate trading practices outside of the plan.

• Implementing a Waiting Period. As discussed above, the affirmative defense afforded by Rule 10b5-1(c) is only available to the extent that the 10b5-1 plan was adopted when the executive was not aware of material, nonpublic information, in addition to satisfying the other requirements of the affirmative defense. In Ms. Thomsen's October 2007 speech, she made it clear that if an individual is trading on inside information, and using a 10b5-1 plan for cover, the affirmative defense will not be available. A trade that is executed pursuant to a 10b5-1 plan a very short period of time after adoption can heighten the risk for scrutiny, and potentially create the perception that the executive was attempting to use the 10b5-1 plan as cover for a trade based on material, nonpublic information. Defending against this perception, and strengthening the availability of the affirmative defense, can be enhanced if a sufficient period of time passes between the adoption of the plan and the execution of the first trade under the plan. Likewise, maximizing this gap can help minimize challenges that the 10b5-1 plan was not entered into in "good faith." While some 10b5-1 plans may impose a prohibition on transactions under the plan until the next trading window opens, imposing a minimum period of 30 days is good practice.

• Maximize Simplicity; Minimize Complexity. While a 10b5-1 plan should be customized for an executive's specific liquidity needs, too much complexity can be problematic. No one's needs are effectively served if the administering broker is unable to accurately determine how trades are to be executed under a 10b5-1 plan. Both the executive and the administering broker should clearly understand the plan's trading requirements and mechanics prior to the plan's adoption. No detail is too small. Consider whether all of the variables under the 10b5-1 plan have been addressed, such as the specific order in which securities are to be sold (e.g., lowest tax basis to highest), the order in which stock options are to be exercised (e.g., lowest exercise price to highest), whether unexecuted trades should be carried forward (and whether the plan's term should be extended to accommodate such transactions), and the maximum number of securities to be sold in a given time period, among others. A brokerage firm's trading desk often has hundreds of 10b5-1 plans that it is administering at any given time--being able to rely on a simplified trading formula that is automated, rather than a complex formula that requires ongoing review and calculation by the administering broker, will help maximize proper execution of trades under a 10b5-1 plan and minimize potential confusion.

Strengthening the Affirmative Defense
In addition to following the practices outlined above, there are certain actions that can be taken, or avoided, to minimize potential scrutiny of an executive's 10b5-1 plan and maximize the likelihood that the requirements of the affirmative defense afforded by Rule 10b5-1(c) have been satisfied.

• Minimize Modifications. An executive should not enter into a 10b5-1 plan with the expectation that it will be subsequently amended to address the executive's changing needs. Modifications to a 10b5-1 plan can call into question whether the executive originally adopted the 10b5-1 plan in good faith and can create the perception that the executive is manipulating the 10b5-1 plan. For example, to maximize sales at higher stock prices, an executive who amends the terms of the plan to increase the number of shares to be sold at such price levels could be viewed as inappropriately manipulating the 10b5-1 plan. This would be particularly problematic if the executive had knowledge, based on nonpublic information, that the issuer was going to release favorable information that could have a positive effect on the issuer's stock price. While there may be certain circumstances where amendments to a 10b5-1 plan may be necessary and justifiable, amendments should only be made in limited situations and, generally, should be treated as a termination of the existing 10b5-1 plan and the adoption of a new 10b5-1 plan. The SEC has previously indicated that amendments to existing 10b5-1 plans are not prohibited, so long as all of the requirements of the affirmative defense can be satisfied at the time of amendment, including the absence of material, nonpublic information. As with adopting a 10b5-1 plan, the terms of the plan should provide for a waiting period, again 30 days is best, before any trade occurs pursuant to an amended 10b5-1 plan.

• Limit or Eliminate Plan Suspensions. An executive's ability to suspend a 10b5-1 plan can raise many of the same issues involved with the modification of a 10b5-1 plan. Depending on the terms of the 10b5-1 plan, to the extent that an executive is permitted to suspend and reinstitute trading under the plan at the executive's discretion, it would seem unlikely that the plan could withstand scrutiny or that the requirements of the affirmative defense could be satisfied (note the specific requirement of the affirmative defense discussed above that the terms of the 10b5-1 plan not permit the executive to exercise any subsequent influence over how, when, or whether purchases or sales would be effected under the plan). Where an executive does have limited rights to suspend trading under a 10b5-1 plan (for example, solely due to legal restrictions such as Regulation M), consider divesting from the executive the right to reinstitute trading under the plan. Further, any decision that may be made by the executive to reinstitute trading under the plan should be treated as a modification of the 10b5-1 plan, requiring satisfaction of each element of the affirmative defense at the time of reinstituting trading, including the absence of material, nonpublic information. Like modifications, suspension of trading under a 10b5-1 plan can call into question whether the executive originally adopted the 10b5-1 plan in good faith, and can create the perception that the executive is manipulating Rule 10b5-1(c). As such, if a 10b5-1 plan is to include limited, legitimate suspension rights, the 10b5-1 plan should make clear that the right to suspend is only for specifically enumerated, exceptional circumstances.

• Eliminate Communications with the Administering Broker. Once the 10b5-1 plan is adopted, other than notices that trades have been executed, there should be no communications between the administering broker and the executive. If the trading instructions under a plan are too complex or ambiguous, and the administering broker and the executive communicate on such matters to clarify the executive's intent or the terms of the plan, such discussions could later be characterized as an improper exercise of subsequent influence or discretion over the 10b5-1 plan by the executive. Not only can these communications erode the executive's ability to satisfy the affirmative defense, but a broker's deviation from the written parameters of the plan based on such communications can be viewed as a modification of the 10b5-1 plan.

• Considerations Involving Trading Outside of a 10b5-1 Plan. Other than entering into or altering a corresponding or hedging transaction or position with respect to the securities covered by the 10b5-1 plan, there are no formal restrictions on executing trades outside of a 10b5-1 plan. However, there are certain actions that, if taken outside of a 10b5-1 plan, can be viewed as "deemed" modifications of a 10b5-1 plan. For example, if an executive sells securities or exercises stock options outside of a 10b5-1 plan that were otherwise designated as plan securities, such action would most assuredly be viewed as a modification of the 10b5-1 plan--that is, since such securities are no longer available for the administering broker to sell pursuant to the terms of the 10b5-1 plan, the 10b5-1 plan has been effectively amended by the executive's "removal" of such securities. Similarly, if an executive sells securities outside of a 10b5-1 plan that has the effect of reducing the available volume limits under Rule 144 applicable to sales of the executive's securities, the 10b5-1 plan may be deemed modified to the extent that the administering broker is forced to sell less securities than would have otherwise been required by the plan due to the reduction in available volume under Rule 144 caused by the executive's sale. To avoid both of these situations, the executive must take care to not sell designated plan securities outside of the plan, and further ensure that any sales of securities outside of the 10b5-1 plan not adversely affect the volume limits under Rule 144 to the determent of plan sales.

• Do Not Maintain Multiple 10b5-1 Plans. Having multiple or overlapping 10b5-1 plans can increase the probability of scrutiny and can raise questions whether such plans were entered into in good faith, or as a scheme to evade the requirements of Rule 10b5-1. Consider the scenario where an executive adopts two 10b5-1 plans, each with different limit order thresholds (one plan has lower limit order thresholds than the other). To the extent that an executive determines to cancel the plan with the lower limit order thresholds when the stock price drops (to avoid sales at the lower price) and retain the plan with the higher limit order thresholds (to ensure that sales occur at the higher price when the stock price increases), it would be difficult to defend this practice as not being manipulative of Rule 10b5-1. While there may be a legitimate need for an executive to have more than one 10b5-1 plan, caution should be exercised as to whether such need outweighs the potential risk. If an executive does have a legitimate need to have more than one 10b5-1 plan in place, all such plans should be treated as one integrated plan--treating the termination of one plan as a termination of all other plans, or the modification of one plan as a modification of all of the other plans, etc.

• Consider the Effect of the Termination of a 10b5-1 Plan. The SEC has previously indicated that the termination of a 10b5-1 plan while aware of material, nonpublic information will not create liability under Rule 10b-5 because no sale or purchase has occurred--a purchase or sale of a security must be present for liability to attach. However, the SEC has also made clear that the termination of a 10b5-1 plan could affect the availability of the affirmative defense for prior plan transactions if such termination calls into question whether the 10b5-1 plan was originally entered into in good faith and not as part of a plan or scheme to evade Rule 10b5-1. As such, to minimize the risk of scrutiny and potential loss of the affirmative defense for pretermination transactions, other than the automatic termination of a 10b5-1 plan pursuant to its terms, an executive should only terminate a 10b5-1 plan under exceptional circumstances. Moreover, an executive's systemic termination and adoption of 10b5-1 plans could undercut the executive's ability to establish that such plans were adopted in good faith, and could lead to questions as to whether such actions were really just an attempt to evade the prohibitions of Rule 10b5-1.

Parris is a corporate finance partner in Morrison & Foerster LLP's San Francisco office. His e-mail is bparris@mofo.com.

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