Proposed Expanded Scope of Insider Trading Liability

POMERANTZ MONITOR | MARCH APRIL 2022

By Terrence W. Scudieri

On February 15, 2022, the U.S. Securities and Exchange Commission (the “SEC”) published a Proposed Rule in the Federal Register that, if adopted, will significantly expand the scope of liability for insider trading under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), by limiting the scope of the current affirmative defense provided under SEC Rule 10b5-1 (the “Proposed Rule”). In general, to qualify for the Rule 10b5-1 affirmative defense, a corporate insider may avoid liability for trading on the basis of material, nonpublic information (“MNPI”) if its trade is pursuant to a contract, instruction, or plan that is adopted prior to the insider becoming aware of MNPI (a “Plan”), which either (1) specifies the amount, price, and date of securities to be traded; (2) provides written instructions or a formula that would trigger a trade of securities; or (3) does not allow the insider to influence whether, how, or when trades are made after the Plan is effective. The Proposed Rule signals a revival of the remedial intent of the securities laws: “to insure honest securities markets and thereby promote investor confidence” (United States v. O’Hagan). Indeed, “[a] significant purpose of the Exchange Act was to eliminate the idea that the use of inside information for personal advantage was a normal emolument of corporate office” (In re Cady, Roberts & Co.).

Background

Under Section 10(b), it is unlawful to use or employ, in connection with the purchase or sale of any security, “any manipulative or deceptive device or contrivance in contravention of [the SEC’s regulations].” For decades, courts have held that insider trading on the basis of MNPI is a “deceptive device” within the meaning of Section 10(b) and Rule 10b-5.

In 1997, the Supreme Court set forth two “theories” of MNPI insider trading liability under Section 10(b) and SEC Rule 10b-5. The first, known as the “traditional” or “classical theory,” is relevant here, while the second, known as the “misappropriation theory,” does not target unlawful trading by insiders, but instead “outlaws trading on the basis of nonpublic information by a corporate ‘outsider’ in breach of a duty owed not to a trading party, but to the source of the information.”

The classical theory posits that “Section 10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his [or her] corporation on the basis of material, nonpublic information. Trading on such information qualifies as a ‘deceptive device’” within the meaning of Section 10(b) because “a relationship of trust and confidence exists between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation,” such that an insider owes a fiduciary “duty to disclose or to abstain from trading” on the basis of MNPI. This theory of liability “applies not only to officers, directors, and other permanent insiders of a corporation, but also to attorneys, accountants, and others who temporarily become fiduciaries of a corporation.”

In August 2000, the SEC promulgated Rule 10b5-1, which clarifies whether an insider’s purchase or sale of an issuer’s securities was “on the basis of” MNPI and under what circumstances such a transaction was tantamount to a “manipulative and deceptive device,” thus giving rise to liability for securities fraud under Section 10(b). In doing so, the current Rule 10b5-1(c)(1) expressly excludes from its definition such insider trades as are made pursuant to a Rule 10b5-1 “plan;” that is, pursuant to a “binding contract to purchase or sell the security” or a “written plan for trading securities” that was ostensibly adopted before an insider became aware of MNPI. These “10b5-1 trading plans are designed to allow corporate insiders to ‘plan future transactions at a time when he or she is not aware of material nonpublic information without fear of incurring liability’” (Sec. & Exch. Comm’n v. Mozilo).

Problematically, current Rule 10b5-1 trading arrangements are often abused “to conduct share repurchases to boost the price of the issuer’s stock before sales by corporate insiders” (Proposed Rule, 87 Fed. Reg. at 8688). Accordingly, the SEC has published the Proposed Rule “to address apparent loopholes in the rule that allow corporate insiders to unfairly exploit information asymmetries.”

Three Key Proposed Changes

The Proposed Rule offers several amendments. This article addresses three of the most beneficial proposed changes for investors: the Proposed Rule would (1) add a 120 day mandatory “cooling off” period before any trading can commence under a Rule 10b5-1 trading arrangement after its adoption, cancellation, or modification; (2) require officers and directors to certify in their SEC filings that they are not aware of any MNPI before adopting a Rule 10b5-1 trading arrangement; and (3) require each issuer to disclose in their annual reports whether it has adopted insider trading policies and procedures, and to disclose such policies and procedures (or the lack of such policies and procedures and the reasons why).

First, at present, there is no mandatory waiting period between the time an issuer adopts a Rule10b5-1 plan and when an officer or director makes a trade pursuant to that plan. The Proposed Rule would prohibit officers and directors from making any trades pursuant to a Rule 10b5-1 plan within 120 days of adopting, cancelling, or modifying such a plan (Proposed Rule, 87 Fed. Reg. at 8689 90). This change is critical, as it should work to solve the current problem of insiders adopting a Rule10b5-1 plan and making trades pursuant to that plan on the same day.

Second, at present, there is no current requirement that officers or directors certify their ignorance of any MNPI before invoking a Rule10b5-1(c) affirmative defense. The Proposed Rule would require officers and directors to certify, at the time of the adoption of the trading arrangement,” that “they are not aware of [MNPI] about the issuer or its securities” and that “they are adopting the [Rule 10b5-1 plan] in good faith and not as part of a plant or scheme to evade [Section 10(b) or Rule 10b-5]” (Proposed Rule, 87 Fed. Reg. at 8691). If adopted, this change may provide an additional basis for Section 10(b) liability.

Third, at present, there is no requirement that issuers disclose in their SEC filings whether they have enacted policies and procedures to protect MNPI from misuse by insiders. The Proposed Rule would require all issuers to disclose (1) their insider trading policies and procedures in their annual SEC reports and (2) whether an issuer, officer, or director used a Rule 10b5-1 trading plan during a reportable quarter in their quarterly SEC reports (Proposed Rule, 87 Fed. Reg. at 8693 94). If adopted, this change may provide an additional basis for Section 10(b) liability.

Conclusion

The Proposed Rule would make many positive changes, and investors are encouraged to review it in full. The SEC is accepting public comments until April 1, 2022, after which it is expected to adopt a Final Rule.