All companies, directors and executives should take note of the warning in a March 8, 2007 speech, Linda Chatman Thomsen, the Director of the SEC’s Division of Enforcement.  In that speech, Ms. Thomsen stated that the SEC is “looking at” trading conducted under Rule 10b5-1 Plans by company executives, and looking at those trades “hard.”  She explained that “[w]e 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.”

Executives frequently have access to material, non-public information and are prohibited from acting on that information by buying or selling shares.  The SEC enacted Rule 10b5-1 in 2000 to permit an executive who has possession of insider information to buy or sell securities pursuant to a previously adopted written trading plan.  17 C.F.R. § 240.10b5-1.  The SEC created this “safe harbor,” as Ms. Thomsen explained, “to give executives regular opportunities to liquidate their stock holdings – to pay their kid’s college tuition, for example – without risk of inadvertently facing an insider trading inquiry.”

Specifically, Rule 10b5-1 provides an affirmative defense to the charge of insider trading if a plan is adopted before the executive becomes aware of the material non-public information.  The Plan must:  specify the amount of securities to be purchased or sold and the price at which, and the date on which, the securities are to be purchased or sold, or include a written formula or algorithm, or computer program, for determining the amount of securities to be purchased or sold and the price at which, and the date on which, the securities are to be purchased or sold; or not permit the person to exercise or to have any subsequent influence over how, when, or whether to effect purchases or sales. 

The Rule also states that the affirmative defense will not apply if the person who entered into the Plan altered or deviated from the Plan (whether by changing the amount, price, or timing of the purchase or sale), or entered into or altered a corresponding or hedging transaction or position with respect to those securities

In December 2006, Alan D. Jagolinzer, an Assistant Professor at Stanford University’s Graduate School of Business, released a study entitled “Do Insiders Trade Strategically Within The Sec Rule 10b5-1 Safe Harbor?”  Professor Jagolinzer examined over 100,000 trades conducted by over 3,000 executives participating in Rule 10b5-1 Plans and concluded that the trades by those executives outperformed the trades by executives who did not participate in such a plan almost 6%. 

In her March 8, 2007 remarks, Ms. Thomsen cited the Stanford Study and pointed to a Business Week article that discussed the results of the magazine’s examination of information available on another database.  Ms. Thomsen stated that the studies “suggest that the Rule [10b5-1] is being abused.”  This is similar to the onset of the stock option backdating scandal where, in late 2005 and early 2006, the Wall Street Journal noted that academic studies suggested options backdating at a number of companies.  By the end of 2006, over 140 companies were under investigation for alleged backdating of stock options and several companies and their executives were named in high profile civil and criminal actions.  Ms. Thomsen’s comments raise a very real issue – executives who participate in Rule 10b5-1 Plans could be next. 

At least one company may already be facing this issue.  On March 3, 2007, New Century Finance Corporation disclosed in filings that federal prosecutors and securities regulators are investigating, among other things, certain stock sales.  As the New York Times reported, the company’s shares have fallen more than 53 percent since the start of the year.  According to the company, in a very short period in late February and March 2007, it was contacted by the regulatory arm of the New York Stock Exchange, the United States Attorney’s office in Los Angeles and the SEC about trading.  Vikas Bajaj and Julie Creswell, Authorities Investigate Big Lender, N.Y. Times, March 3, 2007 at C1.  While it is unclear what stock sales investigators are looking at, a review of the SEC Form 4’s indicate that between August and November 2006, Founder Edward Gotschall sold over 500,000 shares for more than $12 million under a Rule 10b5-1 Plan adopted on June 15, 2006 and Founder Robert Cole sold 150,000 shares for more than $6 million under two Rule 10b5-1 Plans adopted on September 15 and June 15, 2006 (although neither had sold any shares for the prior six months). 

Ms. Thomsen’s comments suggest that the next enforcement target may be Rule 10b5-1 Plans, meaning that a once safe harbor may no longer be safe.  It would be prudent for companies and their executives to carefully review any Rule 10b5-1 Plans, as well as any trades made under those Plans, particularly those in advance of or after news releases.  

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SEC Enforcement Trends:  Insider Trading 

Insider trading is more than a traditional area of emphasis by enforcement, it is clearly a high priority that should be of concern at least to corporate officers and directors who may periodically have transactions in company shares.  Earlier this month the SEC brought what may be its most significant insider trading case since the days of Ivan Boesky, Dennis Levine and Michael Milken in the late 1980’s.  In SEC v. Guttenberg, et al., No. 07 CV 1774 (S.D.N.Y Mar. 1, 2007), the complaint alleges that since 2001 several participants, including among others, three hedge funds and two broker-dealers, traded using inside information misappropriated by a UBS executive to trade ahead of UBS analyst recommendations and that several securities industry professionals and a hedge fund traded using inside information misappropriated by an attorney at Morgan Stanley to trade ahead of corporate acquisition announcements (see blog posting 3/2/07).  This action follows Congressional hearings last fall in which Congress reviewed the SEC’s enforcement efforts in the area and Enforcement Chief Linda Thomsen emphasized that the SEC would continue to be aggressive in the area despite difficult proof problems with the cases (see blog posting 3/5/07).

The aggressive posture of the agency is reflected not only in the Guttenberg case, but also in cases brought in 2006 and in comments made by Ms. Thomsen in a recent speech.  For example, in SEC v. Rocklage, 2006 WL 3290965 (1st Cir. Nov. 14, 2006), the SEC filed an insider trading action against the wife of a corporate CEO and her brother.  The key question on a motion to dismiss was whether the SEC had adequately alleged deception in pleading the cause of action.  The complaint claimed that the CEO told his wife material non-public information about the company, expecting her to maintain its confidentiality.  Later that day the CEO and his wife had a second conversation about the corporate information.  At the conclusion of that discussion the wife informed her husband that she intended to tip her brother under an pre-existing arrangement pursuant to which she had agreed to inform him of any key events at the company so he could trade.  Although the CEO urged his wife to keep the information confidential, she tipped her brother who traded on the next trading day and prior the public announcement of the company news.  The defendants argued that the case should be dismissed because the SEC failed to adequately plead the key element of deception, contending that the wife’s disclosure of the secret deal with the brother eliminated any deception. The district court rejected this contention and the First Circuit affirmed.  The Circuit court held that the complaint pled deception because the wife did not disclose the deal with her brother in the first conversation when her CEO husband informed her about the corporate information believing that the information would remain confidential.  The SEC also took an aggressive legal position in the Martha Stewart insider trading case, SEC v. Stewart, et al., 03 Civ. 4070 (RJH) (S.D.N.Y. Aug. 7, 2006).  There the SEC charged that Ms. Stewart was illegally tipped and traded on inside information when her Merrill Lynch broker told her that the former Chairman of ImClone was selling his shares causing Ms. Stewart to sell her ImClone shares.  According to the complaint, the broker breached his duty to the shareholders of Merrill Lynch.  That theory varies from the traditional insider trading theory where the insider (or tipper) breaches a duty to the shareholders whose stock is traded.  Stewart and Rocklage suggest that the SEC is willing to take very aggressive positions in insider trading cases.

During 2006 the SEC also brought a series of cases based on the misuse of clinical information.  In these cases a pharmaceutical companies typically received material information about a product from the FDA which was used by an insider, tippee or consultant to trade prior to the public announcement.  Examples of these cases include the following:

SEC v. Thomas J. Bucknum, (D. Mass. Jan. 12, 2006).  Director consented to injunction and payment of over $2 million in disgorgement and prejudgment interest and a penalty of $969,232 where he placed order to sell stock, went to board meeting and learned material negative information about a company drug and then reaffirmed the sell order which was executed prior to company news announcement.

 SEC v. Sanjiv S. Agarwala, (S.D. Cal. Feb. 16, 2006).  Doctor/consultant consented to injunction and payment of $14,784 in disgorgement, $498 in prejudgment interest and a penalty of $29,568 where complaint alleged insider trading based on advance knowledge of FDA position on drugs. 

SEC v. Alexander J. Yaroshinsky, (S.D.N.Y  March 28, 2006).  Court ordered asset freeze against drug executive where complaint alleged he traded based on advance knowledge of FDA position on drug tests.

SEC v. Marnie L. Sharpe and Leonard P. Leclerc, (N.D. Cal. May 2, 2006).  Action against daughter and father alleging she learned of favorable drug information prior to public announcement from friend at the company and tipped father who traded.  Father and daughter consented to injunction and payment of over $120,000 in disgorgement and penalties.   In 2007 the SEC will undoubtedly continue to be aggressive in bringing insider trading cases. 

This point is clearly demonstrated by the recent SEC v. One or More Unknown Purchasers of Call Options for the Common Stock of TXU Corp., Civil Action No. 07C1208 (N.D. Ill. Mar. 2, 2007) case brought earlier this month (see post of 3/5/07).  Key issues for corporate officers, directors and others in this area involve the question of spring-loaded and bullet-dodging options, as previously discussed in Part V of this series on backdated options (see post of 3/7/07).  An emerging issue in the insider trading area that will be of concern to many directors and officers is the use of 10b-5-1 plans.  This rule was issued to create a safe harbor for executives to trade shares using essentially a pre-set mechanical formula.  Enforcement Chief Linda Thomsen noted in a recent speech, however, that the staff is taking a “hard” look at these plans to determine whether they are being abused.  Her comments were prompted by a recent academic study suggesting that executives using the safe harbor are achieving higher than expected returns on stock transactions.  It was this kind of academic study that touched off the current options scandal.  Accordingly, directors and officers should beware that the once safe harbor of 10b-5-1 may no longer be safe (more on this later in another post).  Ms. Thomsen’s comments, along with the SEC’s recent cases, suggest that the agency will continue to be very aggressive in this area.  All of this suggests that it would be prudent for issuers to review carefully their compliance programs on insider trading and that any director, officer or other corporate insider carefully review the arrangements under which they trade in company shares – even if the transactions are under the once, but perhaps no longer, safe harbor of 10b-5-1.

Trial of Former Qwest CEO Joe Nacchio Begins
Additionally, the trial of former Qwest CEO Joe Nacchio begins on Monday, March 19, in the federal district courthouse in downtown Denver.  The blog, <>  will provide daily coverage of the trial.  Faculty and students will rotate through the eight week trial with the expectation that there will be at least two posts each day the trial is in session (the trial will not be held on Friday).  Primary materials on the case can also be found at the DU Corporate Governance web site


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