United States: Protect Your Rule 10b5-1 Plans From Attack: Best Practices

Last Updated: February 18 2019
Article by John D. Hancock

Some regulators and investors are expressing concerns about abuse of Rule 10b5-1 plans. Last July, Representative Maxine Waters introduced the "Promoting Transparency Standards for Corporate Insiders Act," which would require the SEC to study whether Rule 10b5-1 should be amended to restricted multiple plans, require a waiting period before making trades under a plan, and limit how often plans can be modified or canceled. In December, the Council of Institutional Investors cited this act in a letter to the SEC arguing for even more restrictions on Rule 10b5-1 plans.

As supporting evidence, the CII cited a Rule 10b5-1 plan under which Intel's CEO sold $39 million of stock only weeks before Intel announced a flaw in its computer chips. The plan had been amended shortly before the sale and, apparently, after Intel management was aware of the flaw.

It seems a refresher on Rule 10b5-1 plans may be in order, since in this situation the rule would likely not offer Intel's CEO any protection.

Rule 10b5-1 plans only provide an affirmative defense to a claim of insider trading, and anyone seeking to rely on the rule bears the burden of demonstrating that he or she has satisfied every requirement of the rule. The person must demonstrate that the plan was established at a time that he or she was not aware of any material nonpublic information. The plan must prohibit the person from exercising any influence over how, when or whether to make trades, and any alteration or deviation from the terms of the plan (including by making opposite-way hedging transactions) would invalidate the plan. Moreover, the plan must be entered into in good faith and not as part of a scheme to trade on the basis of inside information.

If Intel's CEO actually knew about the chip flaw when he amended his Rule 10b5-1 plan, he would face an uphill battle using that plan to defend himself.

Using a Rule 10b5-1 plan effectively requires careful planning and thoughtful consideration at the time of implementation. Executives seeking to take advantage of the rule should consider following the CII's recommendations and other best practices:

  • Establish the plan during an open trading window. Executives are more likely to be able to prove that they were not aware of inside information during an open window.
  • Forestall trading under the plan for a specified period. Plans that delay trades for a period of time – the longer, the better – undermine the argument that the plan was a scheme to take advantage of a short-term informational advantage. The CII recommends a three-month delay, a common practice.
  • Use a single trading plan. Using multiple, overlapping plans makes it more difficult to establish that each plan was entered into in good faith. A pattern of creating and terminating plans may be suggestive of an insider trading scheme, rather than a straightforward path to diversifying the executive's portfolio through regular stock sales.
  • Adopt a plan that can be followed. To qualify for the Rule 10b5-1 defense, trades must be executed in accordance with the terms of the plan. Plans should be easy for brokers to implement; a plan that is too complex increases the risk that trades will violate the plan and render the defense unavailable.
  • Use a separate broker. To protect trading under Rule 10b5-1, a person must demonstrate that he or she did not "exercise influence" over that trading. By using a separate broker tasked solely with implementation of the plan, an executive can avoid communicating with that broker during the term of the plan, making it easier to demonstrate that he or she did not seek to influence any trading under the plan. The executive can then communicate freely with his or her regular broker without having to worry that those communications might jeopardize the plan.
  • Use a qualified broker. Because of the importance of strict compliance with the rule, executives should use a brokerage firm with deep experience in implementing Rule 10b5-1 plans and related protocols. For example, a good firm will readily offer assistance with reporting trades promptly under Section 16 of the Securities Exchange Act.
  • Avoid the temptation to change the plan. The longer a plan is in effect, the stronger the argument becomes that trades under the plan were not made on the basis of inside information. A single annual plan is stronger than four quarterly plans.
    • Interestingly, the CII argues against frequent cancellations of Rule 10b5-1 plans. While we agree that numerous short-term plans involving multiple amendments make it harder to argue that courts should accept a Rule 10b5-1 defense, we think executives should be free to cancel plans at any time. Cancelling a plan is simply choosing not to trade; there would be no counterparty who could be harmed by any informational advantage that an insider might have. Of course, establishing a new plan promptly after cancellation could raise doubts about the validity of the new plan.
  • Don't trade outside the plan. Trades outside the plan, particularly opposite-way trades, create a risk that courts will view those trades as hedges or modifications of the trades made under the plan, which would render the Rule 10b5-1 defense unavailable.

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