Rule 10b5‐1 Trading Plans and Insiders' Incentive to Misrepresent

• Date: 01 June 2010
• DOI: http://doi.org/10.1111/j.1744-1714.2010.01096.x
• Published date: 01 June 2010
• Author: Stanley Veliotis

Rule 10b5-1 Trading Plans and

Insiders’ Incentive to Misrepresent

Stanley Veliotis

n

INTRODUCTION

Insider trading has long been regulated by the federal securities laws. The

primary vehicle has been Rule 10b-5,

1

the anti-fraud provision promul-

gated under authority granted to the Securities and Exchange Commis-

sion (SEC) in Section 10(b) of the Securities Exchange Act of 1934

(Exchange Act).

2

In 2000, the SEC added Rule 10b5-1

3

to define insider

trading as ‘‘on the basis of ’’ nonpublic information even if the information

was not used in the decision to trade. Rule 10b5-1(c) provides an affirma-

tive defense for transactions under a trading plan that meets its require-

ments (a ‘‘10b5-1 plan’’). The affirmative defense is available if, at a

time when the insider had no material nonpublic information, the insider

r2010, Copyright the Author

Journal compilation r2010, Academy of Legal Studies in Business

313

American Business Law Journal

Volume 47, Issue 2, 313–359, Summer 2010

n

Assistant Professor of Business, Fordham University Schools of Business. Ph.D., University of

Connecticut; LL.M., New YorkUniversity School of Law; J.D., Fordham University School of

Law; B.B.A., Baruch College.

I thank Dan Cahoy, Robert Bird, Ann Morales Olaza

´bal, Amy Dunbar, John Phillips, Pa-

tricia McCoy, Gim Seow, Myojung Cho, John Shon, Mauro Viskovic, and the anonymous

reviewers for comments on earlier drafts or portions of this article, and I thank Adarsh Ga-

neriwalla and Cameron Arnold for research assistance.

1

17 C.F.R. § 240.10b-5 (2009). This article does not address the question of whether insider

trading should be regulated. For a recent summary of the decades-old debate over whether

insider trading may actually provide benefits such as market efficiency,see Alexandra Padilla,

How Do We Think About Insider Trading? An Economist’s Perspective on the Insider Trading Debate

and its Impact, 4 J.L. ECON.&POL’Y239, 239–46 (2008). See generally Robert A. Prentice & Dain

Donelson, Insider Trading as a Signaling Device,47AM.BUS. L.J. 1 (2010).

2

15 U.S.C. § 78j(b) (2006).

3

17 C.F.R. § 240.10b5-1 (2009).

commits to the future trades that otherwise might then be subject to insider

trading charges.

4

The substantive limits of the 10b5-1 plan affirmative defense are un-

clear. In some cases, insider trading is the primary violation of Rule 10b-5.

In other cases insider trading serves as evidence of scienter, or the neces-

sary culpable state of mind, in a broader Rule 10b-5 securities fraud case.

The drafters of Rule 10b5-1 and courts in many published decisions in-

volving 10b5-1 plans have not clearly considered the different implications

of 10b5-1 plans in these two settings. This article does so.

Theoretical economics-based research identifies the incentives for a

firm’s stock-selling insiders to misrepresent the firm’s condition so as to

optimize the payoff from their stock sales.

5

Empirical economics-based re-

search provides evidence of insiders optimizing proceeds from their stock

sales, while also providing evidence that insiders seek to avoid litigation in

connection with their sales.

6

However, this literature has not yet fully ad-

dressed the effect of insider selling under 10b5-1 plans. This article ad-

dresses this gap and criticizes the extent to which 10b5-1 plans encourage a

firm’s insiders

7

to strategically time truthful disclosure and misrepresent

the content of disclosure,

8

often to a further extent than if the sales oc-

curred without the use of 10b5-1 plans.

An example of the incentive context at the heart of this article is when

a chief executive officer (CEO) or chief financial officer (CFO) orchestrates

misrepresentations in periodic financial statements, press releases, or

4

17 C.F.R. § 240.10b5-1(c) (2009).

5

See, e.g., PATRICIA M.DECHOW &CATHERINEM. SCHRAND,EARNINGSQUALITY 51 (2004), available

at http://www.cfapubs.org/doi/pdf/10.2470/rf.v2004.n3.3927?cookieSet=1; Oren Bar-Gill &

Lucian Arye Bebchuk, Misreporting Corporate Performance 3 (Harvard Law and Econ. Discus-

sion Paper No. 400, 2003), available at http://ssrn.com/abstract=354141; Patrick Bolton et al.,

Pay for Short-term Performance: Executive Compensation in Speculative Markets,30J.C

ORP.L.721,

730–32 (2005).

6

See Part IV.A infra.

7

This article addresses activities of a firm’s insiders, not outsider traders or the firm as an

insider. See generally Carol B. Swanson, Insider Trading Madness: Rule 10b5-1 and the Death of

Scienter,52KAN.L.REV.147, 169 (2003) (describing various types of insider trading cases).

8

Because strategic timing has been addressed by others, this article focuses on misrepresen-

tation, although the two activities share common incentives under Rule 10b5-1(c). Part II.B

infra summarizes the strategic timing issue, as well as another loophole identified by com-

mentators, known as the selective termination option. The incentive to misrepresent disclo-

sure content (the focus of this article, as detailed infra Part IV) can be seen as a third loophole.

314 Vol. 47 / American Business Law Journal

conference calls shortly before a sale occurs under their 10b5-1 plan. Rule

10b5-1(c) shields the insider from liability for a primary insider trading

violation of Rule 10b-5 related to the insider information advantage of

knowing the basis and accuracy of those statements. Under the rule, this

result applies even though the insider empowered himself with this self-

created information. Equally critical, however, is the concern that the

courts’ views of 10b5-1 plan selling make a plaintiff ’s case more difficult

when insider sales are offered as evidence of scienter in a broader case of

misrepresentation. The reported decisions have failed to appreciate two

important items. First, an insider’s desire to maximize proceeds from a

stock sale exists whether or not a sale occurs under a 10b5-1 plan and

whether or not the insider had the requisite state of mind at plan adoption.

Second, a sale under a 10b5-1 plan and an insider’s actions leading up to

the planned sale are more likely to be indicative of scienter than nonplan

sales because plan sales are, by their very nature, planned. By contrast,

nonplan sales are more ambiguous, in that they may have been the result

of an innocent decision made after an alleged misrepresentation occurred.

This article proceeds as follows. Part I briefly discusses Rule 10b-5,

with a focus on the scienter requirement, and insider trading under the

federal securities law. Part II details Rule 10b5-1 and briefly describes

other criticisms and concerns related to the rule raised by the law academe,

empirical researchers, the business press, and the SEC. Part III considers

existing case law that has substantively addressed defendants’ trading un-

der 10b5-1 plans, and which, in the main, has evidenced a tendency to

heavily discount insider sales under 10b5-1 plans as evidence of scienter.

Part IV details the incentive for insider sellers, especially those now selling

under a 10b5-1 plan, to misrepresent. Part V provides recommendations,

including a suggested amendment to Rule 10b5-1 and guidance to courts,

litigants, and scholars considering fraud claims against insiders who sold

under 10b5-1 plans.

I. RULE 10B-5 AND INSIDER TRADING

Rule 10b5-1 is a recent addition to Rule 10b-5. This part first reviews Rule

10b-5, including the requirement of scienter in Rule 10b-5 cases. It then

discusses insider trading law, including how insider trading may be a pri-

mary violation of Rule 10b-5 or may instead provide evidence of scienter in

a broader Rule 10b-5 case.

2010 / Rule 10b5-1 Trading Plans and Insiders’ Incentive to Misrepresent 315