SEC Rule 10b5-1
Encyclopedia
SEC Rule 10b5-1 is a regulation
enacted by the United States Securities and Exchange Commission
(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
, which is prohibited by SEC Rule 10b-5
.
Different courts of appeals
had come to different conclusions about what constituted insider trading
under Rule 10b-5
--- 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
must find that the person actually used that inside information when making the trade.
, which defines insider trading
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
simply by trading while in "possession" of inside 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
, breaching a fiduciary duty to the source of the information, and then trading it with a self-serving intent, even if he or she would have made the trade anyway. See U.S. 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.
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."http://www.sec.gov/rules/final/33-7881.htm#P264_100527 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]id 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 of a company could call a broker on January 1 and enter into a plan to sell a particular quantity of shares of his company's stock
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
under Rule 10b5-1(c), because he planned the trade before he learned the inside information
.
does not constitute insider trading
, even if the person was aware of the inside 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
under Rule 10b-5 without an actual securities transaction, based on the U.S. Supreme Court's holding in Blue Chip Stamps v. Manor Drug Stores
, 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
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 to move the stock before a 10b5-1 plan sale.
, 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, from Countrywide. The SEC sent a Wells Notice
to Mozilo in May 2009, suggesting intent to pursue civil charges in relation to alleged illegal trade 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, 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.
Regulation
Regulation is administrative legislation that constitutes or constrains rights and allocates responsibilities. It can be distinguished from primary legislation on the one hand and judge-made law on the other...
enacted by the United States Securities and Exchange Commission
United States Securities and Exchange Commission
The U.S. Securities and Exchange Commission is a federal agency which holds primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation's stock and options exchanges, and other electronic securities markets in the United States...
(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
Insider trading is the trading of a corporation's stock or other securities by individuals with potential access to non-public information about the company...
, which is prohibited by SEC Rule 10b-5
SEC Rule 10b-5
SEC Rule 10b-5, codified at 17 C.F.R. § 240.10b-5, is one of the most important rules promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10 of the Securities Exchange Act of 1934...
.
Different courts of appeals
Court of Appeals
A court of appeals is an appellate court generally.Court of Appeals may refer to:*Military Court of Appeals *Corte d'Assise d'Appello *Philippine Court of Appeals*High Court of Appeals of Turkey*United States courts of appeals...
had come to different conclusions about what constituted insider trading
Insider trading
Insider trading is the trading of a corporation's stock or other securities by individuals with potential access to non-public information about the company...
under Rule 10b-5
SEC Rule 10b-5
SEC Rule 10b-5, codified at 17 C.F.R. § 240.10b-5, is one of the most important rules promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10 of the Securities Exchange Act of 1934...
--- 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
Trier of fact
A trier of fact is a person, or group of persons, who determines facts in a legal proceeding, usually a trial. To determine a fact is to decide, from the evidence, whether something existed or some event occurred.-Juries:...
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 in United States v. O'Hagan, 521 U.S. 642)Case citation
Case citation is the system used in many countries to identify the decisions in past court cases, either in special series of books called reporters or law reports, or in a 'neutral' form which will identify a decision wherever it was reported...
, which defines insider trading
Insider trading
Insider trading is the trading of a corporation's stock or other securities by individuals with potential access to non-public information about the company...
under the misappropriation theory. It states, in full, that
The "manipulative and deceptive devices" prohibited by Section 10(b) of the Act and Rule 10b-5 thereunder include, among other things, the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic informationInside InformationInside Information is the sixth studio album by American rock band Foreigner, released in 1987. The album hit #15 on the Billboard 200 Albums Chart and was certified Platinum in the U.S. for sales exceeding one million copies....
.http://www.law.uc.edu/CCL/34ActRls/rule10b5-1.htm
Paragraph (b) addresses the unsettled "possession" versus "use" issue, stating that a person violates Rule 10b-5
SEC Rule 10b-5
SEC Rule 10b-5, codified at 17 C.F.R. § 240.10b-5, is one of the most important rules promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10 of the Securities Exchange Act of 1934...
simply by trading while in "possession" of inside information
Inside Information
Inside Information is the sixth studio album by American rock band Foreigner, released in 1987. The album hit #15 on the Billboard 200 Albums Chart and was certified Platinum in the U.S. for sales exceeding one million copies....
. It states, in full, that
Subject to the affirmative defenses in paragraph (c) of this section, a purchase or sale of a security of an issuer is "on the basis of" material nonpublic information about that security or issuer if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale.http://www.law.uc.edu/CCL/34ActRls/rule10b5-1.htm
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
Security is the degree of protection against danger, damage, loss, and crime. Security as a form of protection are structures and processes that provide or improve security as a condition. The Institute for Security and Open Methodologies in the OSSTMM 3 defines security as "a form of protection...
, breaching a fiduciary duty to the source of the information, and then trading it with a self-serving intent, even if he or she would have made the trade anyway. See U.S. 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 defenseAffirmative defense
A defendant offers an affirmative defense when responding to a plaintiff's claim in common law jurisdictions, or, more familiarly, in criminal law. Essentially, the defendant affirms that the condition is occurring or has occurred but offers a defense that bars, or prevents, the plaintiff's claim. ...
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."http://www.sec.gov/rules/final/33-7881.htm#P264_100527 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]id 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 of a company could call a broker on January 1 and enter into a plan to sell a particular quantity of shares of his company's stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
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
Affirmative defense
A defendant offers an affirmative defense when responding to a plaintiff's claim in common law jurisdictions, or, more familiarly, in criminal law. Essentially, the defendant affirms that the condition is occurring or has occurred but offers a defense that bars, or prevents, the plaintiff's claim. ...
under Rule 10b5-1(c), because he planned the trade before he learned the inside information
Inside Information
Inside Information is the sixth studio album by American rock band Foreigner, released in 1987. The album hit #15 on the Billboard 200 Albums Chart and was certified Platinum in the U.S. for sales exceeding one million copies....
.
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 harborSafe harbor
The term safe harbor has several special usages, in an analogy with its literal meaning, that of a harbor or haven which provides safety from weather or attack.-Legal definition:...
does not constitute insider trading
Insider trading
Insider trading is the trading of a corporation's stock or other securities by individuals with potential access to non-public information about the company...
, even if the person was aware of the inside information
Inside Information
Inside Information is the sixth studio album by American rock band Foreigner, released in 1987. The album hit #15 on the Billboard 200 Albums Chart and was certified Platinum in the U.S. for sales exceeding one million copies....
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
Insider trading is the trading of a corporation's stock or other securities by individuals with potential access to non-public information about the company...
under Rule 10b-5 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
Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 , 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 law....
, 421 U.S. 723
Case citation
Case citation is the system used in many countries to identify the decisions in past court cases, either in special series of books called reporters or law reports, or in a 'neutral' form which will identify a decision wherever it was reported...
(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
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
, 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
Insider trading is the trading of a corporation's stock or other securities by individuals with potential access to non-public information about the company...
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
Legal liability
Legal liability is the legal bound obligation to pay debts.* In law a person is said to be legally liable when they are financially and legally responsible for something. Legal liability concerns both civil law and criminal law. See Strict liability. Under English law, with the passing of the Theft...
. 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 to move the stock before a 10b5-1 plan sale.
SEC reaction
Noted in a speech by Linda Chatman ThomsenLinda 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 has worked under four SEC Chairmen: Arthur Levitt, Harvey Pitt, William H. Donaldson, and Christopher Cox. ...
, 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, from Countrywide. The SEC sent a Wells Notice
Wells notice
A Wells Notice is a letter that the U.S. Securities and Exchange Commission sends to people or firms when it is planning to bring an enforcement action against them...
to Mozilo in May 2009, suggesting intent to pursue civil charges in relation to alleged illegal trade 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, 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.