Insider trading policies are implemented by issuers and govern the trading conduct of corporate insiders. These policies exist to protect insiders against claims of insider trading. They also help protect the issuer from claims of reckless conduct with respect to such trading. These policies regulate when an insider may trade in the company’s securities. For example, most policies proscribe insiders from trading during the time leading up to the end of the quarter when financial information regarding the company’s impending earnings release is becoming known by company insiders.
Section 10(b) of the Exchange Act and related Rule 10b-5 proscribes, among other things, the purchase or sale of a security of an issuer on the basis of material nonpublic information in breach of a duty of trust or confidence that is owed directly, indirectly or derivatively, to the issuer of that security or the shareholders of the issuer, or to any other person who is the source of the material nonpublic information. Under Rule 10b5-1, the SEC seeks to resolve a judicial conflict over the definition of what "trading on the basis of" means. Some circuits ruled that the requirement of "trading on the basis of" was shown by "possession" of the information, while others ruled it is shown by "use" of the information. Rule 10b5-1 is meant to resolve this issue. The SEC in Rule 10b5-1 now defines "on the basis of" as mere "awareness" of the material nonpublic information when the person made the trade. Thus mere "possession" of the information, and not the "use" of it (i.e. specifically impacting a trading decision), is all that is required.
The new rule extends the reach of insider trading regulation, but the rule also specifies new affirmative defenses. The affirmative defenses are available if the person making the purchase or sale demonstrates that: (1) before he became aware of the information he had entered into a binding contract to purchase or sell the security, (2) instructed another person to purchase or sell the security, or (3) adopted a written plan for trading securities.
The rule then provides that the contract, instruction or plan (I refer to all three as a "Plan") specify: the amount of securities (number of shares or a specified dollar value), the price (the market price on a certain date, a limit price, or a particular dollar price), and the date of the transaction (specific day on which a market order is to be executed, or in the case of a limit order, a day of the year in which the limit order is in force). In the alternative, the Plan can include a written formula, an algorithm, or a program, for determining such parameters; or the Plan must not permit the person (i.e. the insider) discretionary influence over how, when or whether to make such purchases or sales, provided such person effecting such transactions (i.e. the broker) was not aware of the material nonpublic information at the time of the trade.
There are also requirements designed to prevent circumvention. For example, the insider is precluded from altering or deviating from the Plan by changing the amount, price or timing of the transactions. An insider can, however, modify the Plan. The insider cannot enter into or alter a hedging transaction or position with respect to such securities, and the Plan must be entered into in good faith and not as part of a plan or scheme to evade the insider trading prohibitions. An insider in possession of inside information can terminate his Plan (which provided for purchases or sales) and this would not be prohibited insider trading as the termination of the Plan is not a purchase or sale of a security. However, this may place prior implemented trades prescribed by the Plan at risk from affirmative defense treatment by application of the good faith provision.
The issuer or the insider can design a Rule 10b5-1 Plan. The issuer can also develop a general Plan, with the specifics to be provided by the insider. Banks and brokerage houses also have their standard Plans that they make available to their customers. In any event, a Plan should address certain fundamental issues. For instance, the Plan should specify through representations made by the insider that he is adopting the Plan while not in possession of material nonpublic information, and it should provide limits regarding his communications with his broker. In fact, the Plan could specify that all instructions will be in writing or the insider can use two brokers, one to implement the Plan (with curtailed communications) and one that handles the remainder of his portfolio. The Plan should be adopted when the company’s insider trading policy permits trading (i.e. when there is no black-out period because of an impending earnings release, etc.), and the prescribed commencement of trading should be delayed by several months to provide further support to the establishment of the affirmative defense.
The Plan can provide procedures for its modification, but such modifications should be conducted under the same conditions required at the time of Plan adoption. The Plan should automatically terminate upon certain events, such as the insider’s death, and could grant the issuer the right to freeze operation of the Plan during the issuer’s capital market transactions or other corporate contingencies. To provide the insider with the opportunity to change his investment objectives periodically, the Plan can provide for automatic termination each year, which would be followed by the adoption of a new Plan embodying the changed objectives. As an aside, the insider will still be required to file Form 4s with the SEC detailing the trades. He should comply with Rule 144 regarding his control securities, and may also desire to comply with Rule 10b-18, a safe harbor to anti-manipulation proscriptions (if he could be deemed an affiliated purchaser).
Issuers and their counsel can now design insider trading policies to provide insiders with the opportunity to implement trading operations throughout the year. The insiders’ programmed trading can now occur during periods that would otherwise have been foreclosed by the issuer. If an insider needs to diversify his holdings, and the issuer is savvy at investor relations, the insider could implement a Plan with periodic selling, and the issuer can provide a press release and a Current Report 8-K detailing the underlying diversification reasons for the insider’s sales. As another application of the Plan as an investor relations tool, the issuer could encourage its insiders to implement a Plan providing for periodic automatic purchasing, sending a positive signal to the market.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.