Time to rescind the Get Out of Jail Free card afforded executives by 10b5-1 plans

By now, the story is familiar: A company announces either good or bad news and its stock price goes up or down, only for investors to later learn that around the same time, corporate insiders sold millions of dollars of their company stock holdings, often for the first time in years. It happened at Eastman Kodak, Moderna Therapeutics, and, more recently, at government contractor Emergent BioSolutions, whose share price fell over 50% from February 2021 to April 2021, coinciding with its announcement of negative financial results and COVID-19 vaccine production problems. Just before that period of bad news, for the first time in over four years, its CEO Robert G. Kramer sold a substantial amount of his company stock for proceeds of over $10 million.

These transactions have something in common besides their fortuitous timing: They were all the result of an SEC rule that was meant to prevent insider trading on the basis of material nonpublic information. The SEC rule, formally known as 10b5-1, covers what are known as “trading plans,” and requires that executives pre-arrange for specific amounts of stock to be sold at specific times according to pre-established criteria. Notably, the rule does not require disclosure of the substance of the plans to investors, and executives can cancel the plans at any time and enter into as many plans as they want.

The theory was that if these plans are adopted when insiders are not in possession of material nonpublic information, they would prevent illegal insider trading. To encourage their use, the Rule provides those who adopt a 10b5-1 plan a “safe harbor” that serves as an affirmative defense to claims of insider selling.

Over the past year, such plans have garnered mounting scrutiny from federal regulators, including SEC Chairman Gensler, and lawmakers. Several recent peer-reviewed studies and hearings in Congress have demonstrated that rather than prevent insider trading, executives use these plans to obtain financial windfalls—the exact opposite of the Rule’s purported intent. The focus thus far has been on whether these plans are being used to promote (not prevent) insider trading on material nonpublic information by encouraging executives to sell before bad news is disclosed, and whether the plans ought to continue to operate as get out of jail free cards when they mask such improper insider selling.

But there is another serious risk that has not garnered enough attention: the risk that 10b5-1 plans create an incentive for company insiders to continue to hide bad news from investors and prop up stock prices by making false and misleading positive statements in advance of planned trades. In addition to corporate insiders’ decisions to sell, there should be heightened scrutiny of corporate insiders’ decisions to speak to investors around the time of planned sales. After all, an executive who knows that they have pre-planned trades on the horizon, or trades that their plan will execute at a certain price, may have an improper motive to reap as much money as possible by keeping the company’s stock price as high as possible.

One way in which investors demonstrate motive in securities fraud cases is by alleging that executives made unusual or suspicious trades based on factors such as their profits, timing, and percentage of holdings sold. But despite the fact that 10b5-1 plans were created as an affirmative defense against allegations of insider trading, courts in these separate securities fraud cases have also routinely allowed company insiders to rely on their 10b5-1 plans to defeat an inference of a motive. As long as an insider has a 10b5-1 plan adopted before the start of a fraudulent scheme, courts almost always find that stock trades pursuant to the plan weigh against an inference that defendants knowingly or recklessly misled investors based on a motivation to inflate the stock price to maximize profits.

Potential changes are on the horizon. The flood of recent massive insider sales has prompted the SEC to call for restrictions on trading plans—for instance, a cooling-off period between when the plan is adopted and when trades can begin—as proposed recently by SEC Chairman Gensler. The House of Representatives also recently passed a bill directing the SEC to carry out a study of potential amendments to Rule 10b5-1, including requiring issuers to adopt a window during which insiders are allowed to trade.

While these proposed changes are a step in the right direction, they fall short of fixing the problems inherent in the 10b5-1 safe harbor. To protect investors, ensure that these plans are not being manipulated for the benefit of insiders, and garner the protection of the safe harbor in litigation, the law should be modified to require that it be public whether a 10b5-1 plan exists and include the date it was entered into; all 10b5-1 plans be approved by a company’s compensation committee; and most critically, the owner of the plan must be blind to the dates and/or strike prices for purchases and sales set forth in their plan, so that they are not incentivized to improperly keep material news from investors.

The Rule’s safe harbor must also be modified to make clear that it is applicable only to claims of insider selling, and does not automatically negate well-pled allegations of motive in securities fraud actions. Although not a panacea, such changes would go a long way to ensuring that 10b5-1 plans are not used by executives to financially benefit themselves at the expense of investors or to hide material information from the market.

Laura Posner is a partner at Cohen Milstein and a member of the firm’s securities litigation & investor protection and ethics & fiduciary counseling practice groups. She was previously the top securities regulator in New Jersey. Megan Kinsella Kistler, associate at the firm and member of the firm’s securities litigation & investor protection practice, represents institutional and individual shareholders in derivative lawsuits and securities class actions. She is a former federal prosecutor.