Beginning October 23, 2000, new Rule 10b5-1 adopted by the Securities and Exchange Commission will afford unprecedented certainty to public companies in planning and carrying out stock repurchase programs and to corporate insiders in planning and carrying out personal trading programs without the risk of violating insider trading law. The new rule explicitly provides that an individual or entity buying or selling securities while aware of material, nonpublic information does not violate Rule 10b-5 under the Securities Exchange Act of 1934 (the SEC's principal insider trading prohibition) if the buying or selling is in conformity with a binding contract, instruction or written plan put into place at a time when the trader was not aware of material, nonpublic information. See SEC Release No. 33-7881 (August 15, 2000).
Rule 10b5-1 provides important new flexibility for issuers and insiders to use qualifying contracts, instructions or plans to carry out purchase strategies and meet foreseeable liquidity needs despite the inevitable ebb and flow of material, nonpublic information. Public companies should review and reconsider their insider trading policies in light of the new rule, including possible elimination of mandatory window-period restrictions for trading under contracts, instructions or plans meeting the requirements of Rule 10b5-1. Some public companies are planning to assist insiders in putting Rule 10b5-1 plans in place to meet their foreseeable trading needs. Some may also announce those plans publicly so that the market knows in advance of ensuing trades that it might otherwise view as opportunistic and indicative of undisclosed information.
Issuers and insiders should consult with counsel and exercise great care, however, in relying on new Rule 10b5-1 for several reasons:
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in order to meet the requirements of Rule 10b5-1, binding contracts, instructions and written plans must lock in the amount, price and dates of future trades or delegate discretion for determining amount, price and dates to a third-party precisely as provided under the rule.
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The ability to modify provisions once locked in is limited, and modification or termination of arrangements may be very risky.
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although Rule 10b5-1 may help issuers and insiders avoid liability under Rule 10b-5, it does not eliminate other relevant securities law requirements and prohibitions. Buying and selling in reliance on Rule 10b5-1 must also be designed to comply with the reporting and short-swing profit rules under Exchange Act Section 16, the limitations on insider selling imposed by Rule 144 under the Securities Act of 1933, the anti-manipulation safe-harbor for issuer repurchase programs under Exchange Act Rule 10b-18, the restrictions on bidding, buying and other activity during a distribution under Exchange Act Regulation M, tender offer regulations, reporting obligations on Schedules 13D and 13G and other provisions.
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the new liability avoidance provisions of Rule 10b5-1 are affirmative defenses. If the government can prove an individual or entity was aware of material, nonpublic information at the time of a purchase or sale, the burden of proving that trading was pursuant to an adequate contract, instruction or written plan will be on the trader. Compliance must be well documented and capable of proof in court.
Rule 10b5-1: possession versus use
The SEC adopted Rule 10b5-1 to resolve an issue of insider trading law that had become somewhat unclear in recent federal circuit court opinions: in order to prove that trading is "on the basis of" material, nonpublic information, as required for an insider trading violation under Rule 10b-5, is it sufficient for the government to prove that the trader knowingly possessed the information or must it also prove that the trader actually used the information in trading? The SEC has maintained that proof of knowing possession suffices, but two recent circuit court opinions indicated that use was the ultimate issue (although possession created a strong, but rebuttable, inference of use). Rule 10b5-1 attempts to resolve this issue by providing that a person trading securities while "aware" of material nonpublic information has used or traded "on the basis of" that information as required for an insider trading violation under Rule 10b-5.
The awareness-equals-use rule is subject to two important affirmative defenses aimed at showing that the information was not a factor in the trading decision. One defense makes it legal to purchase or sell securities even when a person is aware of material nonpublic information so long as the trades are made in conformity with a binding contract, instruction or written plan put into place at a time when the trader was not aware of such information. The other defense protects a trading entity from insider trading liability if it has adopted reasonable policies and procedures to ensure that there is an information barrier (or Chinese Wall) preventing the person making investment decisions on behalf of the entity from knowing material nonpublic information that someone else involved with the entity might know.
Binding contract, instruction or written plan defense
In order for this affirmative defense to be available with respect to a transaction or series of transactions:
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the issuer or other trader must prove that before becoming aware of the information, the issuer or trader had (1) entered into a binding contract to make such trade or trades, (2) instructed another person to make the trade or trades for his or her account, or (3) adopted a written plan for trading pursuant to which such trade or trades were made. Although Rule 10b5-1 does not specify that binding contracts or third-party instructions have to be in writing (like a plan), in order to meet the burden of proving the defense, we would strongly advise that an issuer or insider planning to rely on the defense use a written contract or instruction.
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such contract, instruction or plan must either: (a) specify, or include a formula, algorithm or computer program for determining, the "amount" and the "price" of the securities to be traded and the "date" of the trade or trades, or (b) permit the trading person to exercise no influence over how, when or whether to effect purchases or sales.
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the purchase or sale must occur pursuant to the terms of the contract, instruction or written plan.
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the issuer or insider must enter into the contract, instruction or written plan in good faith and not as part of a plan or scheme to evade the prohibitions of Rule 10b-5.
Terms of contract, instruction or written plan
Rule 10b5-1 defines "amount" to mean either a specified number of securities (e.g., 5,000 shares of common stock) or a specified dollar value of securities (e.g., $230,000 worth of convertible debentures). The SEC also indicated in the adopting release that the amount of securities to be sold may be made by reference to an independent fact. For example, a contract may call for the sale of enough securities to pay a specified college tuition bill or loan balloon payment. "Price" is defined to mean a particular dollar price or the market price on a particular date, or a limit price. "Date" means the specific day on which the order is to be executed or, in the case of a limit order, any day on which the limit order is in effect. The SEC discusses "formula, algorithm and computer program" in very broad terms in the release. Trading based on a market index, market segment or group of securities is discussed as being within the meaning of trading pursuant to a formula.
Third-party discretion
In lieu of specifying amount, price and date, the contract, instruction or plan may vest authority in a third-party, such as a securities firm or financial institution, to designate all or some of such terms. To comply, however, the issuer or insider must have no ability to exercise subsequent influence over purchase or sale decisions by the third-party. In addition, the third-party must not itself be aware of the material, nonpublic information when it exercises its discretion. Securities firms and financial institutions exercising third-party discretion on behalf of issuers or insiders under Rule 10b5-1 contracts, instructions or plans will rely on the Chinese Wall defense to permit the segment of the firm or institution responsible for exercising discretion to continue making trading decisions if another segment of the firm or institution is aware of any material, nonpublic information.
Modification, termination and good faith
In order for trading to be "pursuant to" the contract, instruction or plan, the issuer or insider must not have altered or deviated from it or entered into or altered a corresponding or hedging transaction or position. The SEC indicates in the adopting release that an issuer or insider may modify a contract, instruction or plan so long as the modification is made in good faith and at a time when the issuer or insider is not aware of material nonpublic information. The SEC does not, however, discuss in the adopting release what it means for a contract, instruction or plan to be entered into in "good faith." Repeated modifications of a contract, instruction or plan could put into question the good faith element. Neither the rule nor the adopting release discuss an issuer or insider terminating a contract, instruction or plan. Although termination of a contract, instruction or plan is probably permitted (and could be viewed as a form of modification), putting such an arrangement in place and then terminating it (based on the market or for other reasons) would also clearly put into question the good faith of the issuer or insider, not only with respect to the terminated contract, instruction or plan, but also with respect to a subsequent arrangement and overall intentions.
The impact of Rule 10b5-1
We expect that Rule 10b5-1 will have an important impact on Corporate America. Written trading plans are likely to become increasingly common to permit management and other employees of public companies some level of continuous access to the market without window-period restrictions and without fear of insider trading liability. Written contracts, instruction and plans should also be considered in connection with issuer repurchase plans in order to permit such plans to operate on a continual basis with minimal impediments under Rule 10b-5.
October 23, 2000