SEC Rule 10b5-1 seemed like a win-win situation for executives and the investing public.
The commission adopted the rule in 2000 to give a safe harbor from insider trading charges to executives who create a plan to automatically buy or sell stock at routine intervals. So for instance, an executive who needs to liquidate $30,000 worth of stock holdings each August to pay a child's college tuition can set up a trust to sell a certain number of shares each year on July 15. The trades would not attract insider-trading charges--even if they occurred during a blackout period--because they were scheduled and planned for at a time when the executive didn't have material, non-public information that would prohibit him or her from making a trade. Thus, a 10b5-1 plan prevents insider trading while not overly restraining an executive's ability to liquidate his or her stock holdings. At least that's how the plans are supposed to work.
But late last year, Alan D. Jagolinzer, a professor at Stanford, analyzed the returns 3,426 executives earned on 10b5-1 plans and found something strange--sales under the plans "systematically follow positive and precede negative firm performance, generating abnormal forward-looking returns larger than those earned by non-participating colleagues." To put it more plainly, many 10b5-1 users are either getting very lucky or manipulating their plans to capitalize on inside information.
The situation has eerie echoes of the backdating scandal that swept corporate America last year. And the SEC and shareholders are taking notice.
"We're looking at this hard," said the SEC's director of enforcement Linda Chatman Thomsen in a March speech at the 2007 Corporate Counsel Institute. "We want to make sure that people are not doing here what they were doing with stock options. If executives are in fact trading on inside information and using a plan for cover, they should expect the safe harbor to provide no defense."
And if this issue turns out anything like the backdating scandal, shareholder suits and derivative actions are soon to follow.
Shareholders fired the first shots in April when the Louisiana Municipal Police Employees Retirement System (LAMPERS)--which gained a reputation as an activist investor after suing companies such as CVS and Reliant Energy for breaching fiduciary duties and securities fraud--sued in Delaware Chancery Court to force Countrywide Financial Corp. to turn over its books and records regarding stock options and employee stock sales.
Countrywide attracted media attention when its CEO Angelo Mozilo used a 10b5-1 plan to sell more than $50 million worth of Countrywide stock earlier this year. Many of his trades involved options he exercised and then sold for a profit on the same day. The details of Mozilo's 10b5-1s are not public, but the company did disclose in regulatory filings that Mozilo amended one of his 10b5-1 plans Feb. 2--around the time Countrywide and other mortgage lenders were coming under scrutiny for subprime lending.
Some investors aren't willing to believe the profits Mozilo made on his 10b5-1 following that amendment were merely amazing luck. LAMPERS, for one, wants to know more. While it says it doesn't have any evidence of wrongdoing by Mozilo or others, it wants access to Countrywide's books so it can determine whether executives are abusing options.
But a strange twist to this issue is that even if Mozilo did profit from amending his 10b5-1 plan, it's not clear whether he violated the SEC rule.
"10b5-1 is a relatively new rule and the courts and SEC haven't interpreted it," says Robert Plotkin, a partner at McGuireWoods. "There are a lot of ambiguities about it that haven't been tested."
Although 10b5-1 is somewhat unclear in terms of what conduct it specifically prohibits, there are some activities that experts say raise red flags.
First, the GC should take notice if any employee creates multiple 10b5-1 plans. Although the SEC does not cap the number of plans an insider may create under the rule, implementing more than one plan can create an appearance of manipulation or bet hedging.
"Having multiple plans with different brokers that trade on different schedules is not what the SEC had in mind," Plotkin says. "If one person has several plans, the GC should ask why this is necessary and find out what objective it serves."
Another form of potential abuse is amending or terminating plans during blackout periods or repeatedly suspending and restarting plans. Again in this instance, the SEC rule does not explicitly restrict the time or manner in which insiders may stop or change their 10b5-1 plans. But if executives make changes to plans during a period when they would not be allowed to buy or sell stock on the open market, they expose themselves to allegations of trading on non-public information. Even during open trading windows, repeated amendments to a plan run contrary to the spirit of the rule.
"The idea of a 10b5-1 plan is that it is a long-term trading plan that operates independent of swings in information about a company," says Michael Trager, a partner at Arnold & Porter.
A third area of concern is when insiders create 10b5-1 plans that go into effect right away. The concern there is that insiders will start new plans to capitalize on an event, such as a product launch, that they have reason to believe will occur in the near future. Again, the SEC has not delineated a minimum lag time between creation of a plan and the first trades under it, but most experts say there should be a minimum of 30 days. That ensures that executives don't try to shield themselves from liability for insider trading by conducting trades under a sham 10b5-1 plan.
Unfortunately, such abuses are somewhat difficult to detect because executives are not required to disclose the details of their plans to the SEC. Therefore most companies don't have a good grasp of how executives are using these plans. That can be a big mistake.
"If abuses come to light, that's a reflection on the company's internal controls," Plotkin says. "You also could be setting yourself up for shareholder class actions for securities fraud, breach of fiduciary duty or failure to exercise proper business judgment."
Given those risks, it's imperative that general counsel take control of 10b5-1s to prevent abuses of the sort that gave rise to the dozens of pending shareholder class actions over backdating.
"In-house counsel should review all 10b5-1 plans," Plotkin says. "They should approve the creation of plans at the outset and also approve any cancellations, modifications or new adoptions."