SEC Rule 10b5-1, codified at , is a
regulation
Regulation is the management of complex systems according to a set of rules and trends. In systems theory, these types of rules exist in various fields of biology and society, but the term has slightly different meanings according to context. For ...
enacted by the
United States Securities and Exchange Commission
The U.S. Securities and Exchange Commission (SEC) is an independent agency of the United States federal government, created in the aftermath of the Wall Street Crash of 1929. The primary purpose of the SEC is to enforce the law against market ...
(SEC) in 2000. The SEC states that Rule 10b5-1 was enacted in order to resolve an unsettled issue over the definition of
insider trading
Insider trading is the trading of a public company's stock or other securities (such as bonds or stock options) based on material, nonpublic information about the company. In various countries, some kinds of trading based on insider information ...
, which is prohibited by
SEC Rule 10b-5 SEC Rule 10b-5, codified at , is one of the most important rules targeting securities fraud promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10(b) of the Securities Exchange Act of 1934. The rul ...
.
Different
courts of appeals had come to different conclusions about what constituted
insider trading
Insider trading is the trading of a public company's stock or other securities (such as bonds or stock options) based on material, nonpublic information about the company. In various countries, some kinds of trading based on insider information ...
under
Rule 10b-5 SEC Rule 10b-5, codified at , is one of the most important rules targeting securities fraud promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10(b) of the Securities Exchange Act of 1934. The rule ...
— 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
A trier of fact or finder of fact is a person or group who determines which facts are available in a legal proceeding (usually a trial) and how relevant they are to deciding its outcome. To determine a fact is to decide, from the evidence prese ...
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
United States Supreme Court
The Supreme Court of the United States (SCOTUS) is the highest court in the federal judiciary of the United States. It has ultimate appellate jurisdiction over all U.S. federal court cases, and over state court cases that involve a point o ...
in ''
United States v. O'Hagan'',, which defines
insider trading
Insider trading is the trading of a public company's stock or other securities (such as bonds or stock options) based on material, nonpublic information about the company. In various countries, some kinds of trading based on insider information ...
under the
misappropriation theory. It states, in full, that
Paragraph (b) addresses the unsettled "possession" versus "use" issue, stating that a person violates
Rule 10b-5 SEC Rule 10b-5, codified at , is one of the most important rules targeting securities fraud promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10(b) of the Securities Exchange Act of 1934. The rule ...
simply by trading while in "possession" of
inside information
Insider trading is the trading of a public company's stock or other securities (such as bonds or stock options) based on material, nonpublic information about the company. In various countries, some kinds of trading based on insider information ...
. It states, in full, that
In other words, under 10b5-1(b) a person could be liable for insider trading simply by possessing inside information regarding a given
security
Security is protection from, or resilience against, potential harm (or other unwanted coercive change) caused by others, by restraining the freedom of others to act. Beneficiaries (technically referents) of security may be of persons and social ...
, breaching a fiduciary duty to the source of the information, and then trading it with a self-serving intent, even if the trade would have been made anyway. See '
United States 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
An affirmative defense to a civil lawsuit or criminal charge is a fact or set of facts other than those alleged by the plaintiff or prosecutor which, if proven by the defendant, defeats or mitigates the legal consequences of the defendant's o ...
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." The 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 not permit the person to exercise any subsequent influence over how, when, or whether to effect purchases or sales" (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
A chief executive officer (CEO), also known as a central executive officer (CEO), chief administrator officer (CAO) or just chief executive (CE), is one of a number of corporate executives charged with the management of an organization especially ...
of a company could call a broker on January 1 and enter into a plan to sell a particular quantity of
shares
In financial markets, a share is a unit of equity ownership in the capital stock of a corporation, and can refer to units of mutual funds, limited partnerships, and real estate investment trusts. Share capital refers to all of the shares of an ...
of his company's
stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
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
An affirmative defense to a civil lawsuit or criminal charge is a fact or set of facts other than those alleged by the plaintiff or prosecutor which, if proven by the defendant, defeats or mitigates the legal consequences of the defendant's o ...
under Rule 10b5-1(c), because he planned the trade before he learned the
inside information
Insider trading is the trading of a public company's stock or other securities (such as bonds or stock options) based on material, nonpublic information about the company. In various countries, some kinds of trading based on insider 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
Insider trading is the trading of a public company's stock or other securities (such as bonds or stock options) based on material, nonpublic information about the company. In various countries, some kinds of trading based on insider information ...
, even if the person was aware of the
inside information
Insider trading is the trading of a public company's stock or other securities (such as bonds or stock options) based on material, nonpublic information about the company. In various countries, some kinds of trading based on insider information ...
when canceling the trade. The SEC stated that, despite the fact that 10b5-1(c) requires trades to be irrevocable, there can be no liability for
insider trading
Insider trading is the trading of a public company's stock or other securities (such as bonds or stock options) based on material, nonpublic information about the company. In various countries, some kinds of trading based on insider information ...
under
Rule 10b-5 SEC Rule 10b-5, codified at , is one of the most important rules targeting securities fraud promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10(b) of the Securities Exchange Act of 1934. The rule ...
without an actual securities transaction, based on the U.S. Supreme Court's holding in ''
Blue Chip Stamps v. Manor Drug Stores
''Blue Chip Stamps v. Manor Drug Stores'', 421 U.S. 723 (1975), was a decision by the United States Supreme Court, which ruled that only those suffering direct loss from the purchase or sale of stock had standing to sue under federal securities la ...
'',
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
Insider trading is the trading of a public company's stock or other securities (such as bonds or stock options) based on material, nonpublic information about the company. In various countries, some kinds of trading based on insider information ...
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, 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 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 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.
Others contend that rather than timing trades, executives may time news or
press releases
A press release is an official statement delivered to members of the news media for the purpose of providing information, creating an official statement, or making an announcement directed for public release. Press releases are also considere ...
to move the stock before a 10b5-1 plan sale.
SEC reaction
Noted in a speech by
Linda Chatman Thomsen
Linda Chatman Thomsen was the director of the Division of Enforcement for the U.S. Securities and Exchange Commission from 2005 until early 2009. Since arriving at the SEC in 1995, she worked under four SEC Chairmen: Arthur Levitt, Harvey Pitt, ...
, the SEC chief enforcement officer, the SEC is now investigating why 10b5-1 trades appear to outperform the market.
Allegations of improper 10b5-1 trades were noted during the insider trading trial of Joseph Nacchio, former Qwest CEO. There are also preliminary investigations into 10b5-1 trades by
Angelo Mozilo
Angelo R. Mozilo (born 1938) was the chairman of the board and chief executive officer of Countrywide Financial until July 1, 2008.
Life and career
Mozilo was born in New York City, the son of a Bronx butcher. He received a Bachelor of Science deg ...
from
Countrywide Financial
Countrywide is one of the UK's largest integrated property services group including residential property surveying, a collaboration of estate agents, and corporate services. It employs circa 8,500 personnel nationwide, working across 650+ estate ...
. The SEC sent a
Wells Notice
A Wells notice is a letter that the U.S. Securities and Exchange Commission (SEC) sends to people or firms at the conclusion of an SEC investigation that states the SEC is planning to bring an enforcement action against them. The notice informs t ...
to Mozilo in May 2009, suggesting intent to pursue civil charges in relation to alleged illegal trades through his 10b5-1 plan.
On March 25, 2009, the SEC staff revised its interpretative guidance regarding the circumstances under which the affirmative defense in Rule 10b5-1(c) is available.
In particular, the staff followed the approach previously urged by some commentators
to clarify (1) that the cancellation of a 10b5-1 plan could call the good faith of other, executed plans into doubt and (2) that the Supreme Court's decision in ''
Blue Chip Stamps v. Manor Drug Stores
''Blue Chip Stamps v. Manor Drug Stores'', 421 U.S. 723 (1975), was a decision by the United States Supreme Court, which ruled that only those suffering direct loss from the purchase or sale of stock had standing to sue under federal securities la ...
'', 421 U.S. 723 (1975), did not affect the SEC's ability to bring an enforcement action against a would-be insider trader who canceled a trading plan and did not trade in a particular transaction because a subsequent decision, ''
Merrill Lynch, Pierce, Fenner & Smith, Inc., v. Dabit'', 547 U.S. 71 (2006), made clear that ''Blue Chip Stamps'' dealt only with the implied private right of action for violations of Rule 10b-5 and not the "in connection with" requirement for all Rule 10b-5 violations.
References
{{reflist
Rule 10b5-1
Rule 10b5-1