The increased focus of regulators, media and private litigants on insider trading has recently expanded to a new target: Rule 10b5-1 trading plans (10b5-1 plans), which are intended to invoke the affirmative defense against insider trading claims provided by Exchange Act Rule 10b5-1 for trades executed pursuant to a written plan that meets specific requirements.1

10b5-1 plans are best known as devices to allow company insiders to buy or sell securities pursuant to a pre-arranged instruction without facing automatic liability for insider trading. When properly implemented, the rule enables both investors and issuers to execute trades, even when they know material nonpublic information, so long as the trades are made pursuant to a plan established when the investor or issuer did not have inside information. These protections can extend beyond the diversification needs of individual company executives. For example, trades made by hedge funds pursuant to stop-loss and trailing-stop orders may be protected from insider trading liability if the orders are designed and implemented in accordance with Rule 10b5- 1's parameters. And the protections of Rule 10b5-1 are not limited to publicly-traded stocks. Private equity funds and other distressed debt investors and investment managers can also benefit from Rule 10b5-1, such as by using a 10b5-1 plan to make future acquisitions of company debt without running afoul of insider trading restrictions. The protection of the affirmative defense is not absolute, however, and those trading under the auspices of even a properly adopted 10b5- 1 plan have to be careful not to undermine their protection.

Rule 10b5-1 provides that an individual or entity with access to inside information can legally trade company securities when, prior to becoming aware of material non-public information, that person or entity entered into a binding contract to purchase or sell a security, instructed another person to purchase or sell the security, or adopted a written plan for trading the securities. The contract or plan must also meet specific requirements regarding the terms of the trade, such as amount, price, and date of the purchase or sale, and cannot permit the insider to exert influence over future trades.

When it was first introduced, Rule 10b5-1 was criticized as both too onerous and too generous.2 Some commenters suggested that the rule needed a "catch-all" defense to allow an investor to prove that inside information was not used in executing a trade,3 while others posited that the carve-outs of Rule 10b5-1(c) were ripe for abuse due to a lack of disclosure requirements.4 Criticism continued after the regulation was implemented in 2000, including in a 2006 study that concluded that trades made pursuant to 10b5-1 plans outperformed the market.5 In late 2012 and early 2013, a series of articles in The Wall Street Journal turned the spotlight on 10b5-1 plans and, after analyzing thousands of company executives' 10b5-1-plan trades, reported that insiders frequently achieved above-market returns.6 Just recently, a New York Times article questioned whether a company was manipulating its public disclosures to increase the profitability of its chief executive's 10b5-1 plan.7

Some of these articles drew the attention of federal prosecutors and securities regulators, who began focusing investigations on 10b5-1-plan trading.8 The interest in potential abuses of 10b5-1 plans has also expanded to private litigants and players in bankruptcies. For example, following the Chapter 11 bankruptcy filing of Cengage Learning GP I LLC (with affiliates, "Cengage"), debt acquisitions by Apax Partners L.P. (with affiliates, "Apax") and Cengage pursuant to 10b5-1 plans became the focus of an inquiry into possible insider trading.9 The inquiry ultimately determined that the trading had not violated insider trading restrictions, and the proposed restructuring (which enables Apax to maintain its equity interest in Cengage obtained through the debt-trading) recently cleared a major hurdle with the bankruptcy court.10

The recent attention to 10b5-1-plan trading – and Apax's experience in the Cengage bankruptcy – bring to mind Robert Burns' warning that even the best-laid plans may go awry. The protections of Rule 10b5-1 are not a safe harbor but an affirmative defense, which means that the investor bears the legal burden of establishing that trades pursuant to a 10b5-1 plan are protected.11 Ensuring that such trades are defensible in the face of a subsequent lawsuit or investigation commenced with the benefit of 20/20 hindsight is no easy task. Likewise, managing 10b5-1 plans to promote defensibility without defeating the purpose of the plan – facilitating liquidity – requires a delicate balance. This article examines the lessons that can be learned from Cengage and Apax and recommends practices that may enhance the defensibility of a 10b5-1 plan.

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Originally published by Hedge Fund Law Report.

Footnotes

1 By comparison, allegations of insider trading in connection with trading activities have arisen in the context of more traditional "special relationships," such as the fiduciary relationship between a corporate insider and company shareholders (i.e., the "classical" theory of insider trading) or the relationship of trust and confidence between a non-insider who receives material nonpublic information from another (i.e., the "misappropriation" theory of insider trading).

2 For a more comprehensive discussion of the risks of insider trading in the context of distressed debt investments, see Daniel H.R. Laguardia and K. Mallory (Tosch) Brennan, "Navigating the Insider Trading Risks in Distressed Debt Trading," The Hedge Fund Law Report, Vol. 5, No. 20 (May 17, 2012).

3 See SEC v. Barclays Bank PLC, 07-cv-4427 (S.D.N.Y. May 30, 2007).

4 See In re Washington Mutual, Inc., 461 B.R. 200 (Bankr. D. Del. 2011).

5 See Stipulation and Agreed Order Appointing Mediator, In re Motors Liquidation Co., et al., f/k/a General Motors Corp., et al., Adv. Proc. Case No. 12-09802, Dkt. No. 241 (June 27, 2013).

6 See generally id.

7 Report of Richard D. Feintuch, Independent Director of Cengage Learning GP I LLC, prepared by counsel, Sept. 13, 2013, at 34.

8 Id. at 25-26, 31.

9 Id. at 70.

10 Id. at 64.

11 Glaser v. The9, Ltd., 772 F. Supp. 2d 573, 592 (S.D.N.Y. 2011) (internal citations omitted); In re Gildan Activewear, Inc. Sec. Litig., 636 F. Supp. 2d 261, 272 (S.D.N.Y. 2009) (trades pursuant to 10b5-1 trading plan "undermine[] any allegation that the timing or amounts of the trades [were] unusual or suspicious"); Elam v. Neidorff, 544 F.3d 921, 928 (8th Cir. 2008) (sales pursuant to Rule 10b5-1 plans "can raise an inference that the sales were prescheduled and not suspicious") (internal quotations omitted).

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