Comments On Proposed Rule 10b5-1

Originally submitted to the Securities & Exchange Commission during its rulemaking proceedings (file No. S7-31-99) April 28, 2000


I am a member of Wilson Sonsini Goodrich & Rosati, P.C., in Palo Alto, California (www.wsgr.com). I counsel public companies on securities law obligations and defend them, and their directors and officers, in shareholder class action lawsuits and before the Commission. I submit these comments on Rule 10b5-1, not on behalf of any clients or my Firm. Specifically, I address the "trading plan" and "trading instruction" defenses to Rule 10b5-1 insider trading liability set forth in proposed § 240.10b5-1(c). Generally speaking, this portion of the proposed Rule provides an affirmative defense to insider trading liability if an insider's stock sales (or purchases) were made in accordance with a pre-existing trading plan or set of trading instructions that was adopted in good faith (i.e., without knowledge of material nonpublic information, and not as part of a scheme to avoid insider trading liability). I write in support of these plans, but suggest that they be accompanied by commentary that would limit the potentially counterproductive effect of these provisions in private securities lawsuits.

At the outset, I applaud the Commission for addressing this topic. I have a great deal of respect for the Commission and its Staff. In my opinion, that the Commission has an important role in clarifying rules that have been left so unclear by private securities litigation that the employees, officers, and directors of public companies - the overwhelming majority of whom are honest and wish to comply with the law - do not know what to do.

This lack of clarity is particularly troubling in the case of "insider" stock sales. Many commentators have recommend that companies pay their employees, officers and directors in stock-based forms of compensation in order to maximize shareholder value:

Everything else being equal, the compensation scheme that would most effectively align management interests with those of shareholders, and hence the most efficient allocation of resources, would be entirely stock price based. In recent years this point has been given increasing attention in the discussion of how to improve the performance of U.S. corporations. It would be the most attractive package to shareholders and management alike because a portion of the gains from more efficient allocation would be available to each. /FN 1/

Indeed, the Commission has recognized and accommodated the commonplace nature of officer stock sales. In 1991, it amended its regulations to allow officers to immediately exercise stock options, by ruling that such transactions are exempt from the regulation of short-swing profits under Securities Exchange Act § 16(b). /FN 2/ In 1992, the Commission revised executive compensation disclosure rules to require, inter alia, disclosure of the estimated value of stock option grants to top executives. /FN 3/ The Commission also announced plans to use its authority to propose safe harbor rules for the required valuation of employee stock options and derivative securities. /FN 4/ All of these actions recognize that stock options are a form of compensation, granted and exercised in the ordinary course of business. In addition, in 1996, the Commission amended Rule 16b-3 to exempt other types of stock transactions between corporations and their officers and directors from short-swing regulation. /FN 5/ Significantly, the Commission premised the amended rule on the theory that transactions in company stock between an issuer and its officers and directors "are intended to provide a benefit or other form of compensation to reward service or to incentivize performance." /FN 6/

Thus, stock sales - especially from the exercise of stock options - reflect a crucial form of compensation, especially among the high technology companies whose growth has been fueling the economy. /FN7/ Yet all too often - and notwithstanding the salutary effects and legislative history of the Private Securities Litigation Reform Act of 1995 /FN 8/ - courts have permitted what are, to my way of thinking, unreasonable inferences from the sale of stock in pleading and proving private securities fraud claims. While the Ninth Circuit has afforded some comfort to companies based in my part of the world, see In re Silicon Graphics, Inc. Securities Litigation, 183 F.3d 970, 986-87 (9th Cir. 1999) (rejecting all-too-easy inferences of fraud), there can be no assurance that its wisdom will be followed. This is particularly true of those courts that have adopted so-called "motive and opportunity" standard for pleading scienter, notwithstanding the intellectual absurdity of that position and the fact that it explicitly was rejected in the course of enacting the Reform Act. For insiders based in companies located within the ambit of those courts, the judicial message appears to be, "you must be stupid to accept stock-based compensation - unless you are so greedy that you never sell any stock (i.e., you retain all of it in the hope that the stock price will continually increase), if the stock price declines after you sell, you will be called a crook."

In sum, as the private securities law currently stands, honest employees, officers and directors run the risk of being penalized for doing exactly what they should be doing: obtaining part of their compensation by selling stock. My concern with the proposed Rule 10b5-1 is that I fear that the trading plan defenses will be used, however unjustifiably, to make it even more risky for employees, officers and directors to sell stock. This is because the proposed Rule addresses only insider trading cases (and perhaps only those cases brought by the Commission). /FN 9/ A private plaintiff may contend that an officer's knowledge of a pre-existing trading plan adopted at the Commission's suggestion provides a "motive" to inflate the stock price for the purposes of pleading or proving a Rule 10b-5 claim for making false or misleading statements. If such an argument were allowed, it would negate the salutary effects of such plans envisioned by the Commission.

I certainly trust that courts will give great weight to the Commission's determination (assuming that the proposed Rule is adopted) that for its own enforcement purposes, it does not regard pre-planned trades as evidence of trading "on the basis of" inside information. However, in order to forestall the misinterpretation of the trading plan defense, I would welcome an explicit statement in the commentary to the Rule that in the Commission's opinion, the good faith adoption of a trading plan should not be used as evidence of fraud.

Should the Commission be disinclined to consider this request, I respectfully suggest that it reconsider in connection with a topic for which it has requested comment: whether persons intending to adopt trading plans be required to consult with counsel. /FN 10/ Such a requirement, which imposes costs, make sense only if it provides concrete benefits to insiders. Here, the Commission's requirement that a trading plan be adopted "in good faith" is key. Under this provision, the trading plan defenses apply only if the plan was adopted before the seller became aware of material nonpublic information, and only if the plan was not adopted to avoid the insider trading prohibitions of the proposed Rule. /FN 11/ If an insider consults with counsel to insure that he or she is acting in good faith - that is, after consulting with counsel, declares that at the time of adoption of the plan, he or she is not aware of any material nonpublic information and is not entering into the plan in order to avoid insider trading liability - then he or she should be protected, even in a private securities fraud lawsuit, from an allegation that the plan provides a motive to defraud or evidences intent to defraud. And if the counsel with whom the insider consults is the company's counsel, the company should be exculpated from any allegation that it knew that the insider's (subsequent) sales were made while in possession of material nonpublic information, or evidenced an intent to defraud.

I also would like to raise another point regarding the relationship between the proposed Rule and private securities litigation. The proposed Rule characterizes a trading plan as an "affirmative defense" to liability. I have no doubt that in most circumstances, the Commission would inquire into and acknowledge the existence of a trading plan in deciding whether to initiate enforcement proceedings at all - especially if that plan was disclosed in SEC filings. But in a private lawsuit, a trading plan's status as an "affirmative defense" would be used to weaken its import at the pleading stage. While some affirmative defenses (such as the statute of limitations) may be raised at the pleading stage, plaintiffs would challenge the ability of a court to recognize a trading plan at that stage, even if the plan was disclosed in SEC filings - just as plaintiffs have challenged the admissibility of SEC Form 4s to prove trading patterns or the lack of trading. Thus, I would welcome a statement to the effect that if a company or insider discloses the existence of a trading plan, and the subsequent trades fall within a pattern consistent with the plan, this should be prima facie evidence that the trades were made according to the plan.

I also have two technical comments:

1. Proposed § 240.10b5-1(c)(1)(i)(B) ("Subsection (B)") defends trades if the seller "[h]ad provided instructions to another person to execute a purchase or sale of the security for the instructing person's account, in the amount, at the price, and on the date which that purchase or sale was executed." Proposed § 240.10b5-1(c)(1)(i)(C) ("Subsection (C)") defends trades if the seller "[h]ad adopted, and had previously adhered to, a written plan specifying purchases or sales of the security in the amounts, and at the prices, and on the dates which the person purchased or sold." As it stands, Subsection (B) is worded in terms of a single trade, while Subsection (C) is worded in terms of multiple trades. This suggests that a trading "plan" - that is, a pre-determined pattern of multiple or periodic trades - falls within the exclusive ambit of Subsection (C). The comments to Subsection (B), however, contemplate the use of trading plan. /FN 12/ It should be made clear that this is the case. This is particularly important because it appears that the distinction between the two Subsections is that in (B), an insider instructs someone else (i.e., a stockbroker) to make a trade, while in Subsection (C), the insider makes the trade himself or herself. The majority of persons probably would want to implement a trading plan by giving instructions to their stockbroker. Moreover, this option would better serve the Commission's interest, because it would further divorce the timing of a trade from the insider's discretion and knowledge.

2. It should be made clear that a trade is executed on a "date" set forth in a pre-existing plan if it occurs within a range of days allowed by the plan. A trading plan should not need to specify in advance the exact date of a trade, so long as the planned trading range is not selected in advance by the insider based on his or her material nonpublic information. The use of a trading range is particularly appropriate if Subsection (B) is used, and a stockbroker (not the insider) is given the discretion to set the exact trading day(s) within the time span allowed by the plan.

I thank the Commission for its time and effort.


FOOTNOTES

/1/ Merritt B. Fox, Securities Disclosure in a Globalizing Market: Who Should Regulate Whom, MICH. L. REV. 2498, 2548-49 (Aug. 1997); see also Michael J. Jensen and Kevin J. Murphy, CEO Incentives--It's Not How Much You Pay, But How, 68 HARV. BUS. REV. 138, 141 (1990) (to maximize corporate performance, senior executives should own a substantial amount of company stock); Linda E. Rappaport, Achieving Synergies in High Tech Transactions: the People Factor, Practising Law Institute Corporate Law and Practice Course Handbook Series, PLI Order No. B4-7193, 985 PLI/Corp 73, 77 (Apr. 1997) ("Options, particularly those that vest over time, motivate employees and align their interests with those of the stockholders of the corporation.").

/2/ 17 CFR § 240.16-6(b) (effective May 1, 1991).


/3/ See James E. Heard, Executive Compensation: Perspective of the Institutional Investor, 63 U. CINN. L. REV. 749, 752-53 (1995).


/4/ Securities Act Release No. 33-7250 (34- 36643, IC-21625) (Dec. 28, 1995).


/5/ SEC Release No. 34-37260, 1996 WL 290234 (May 31, 1996) (announcing amended Rule 16b-3).


/6/ Id. at 3.


/7/ See Rappaport, 985 PLI/Corp at 77 ("In the high tech industry, stock options are a standard method of compensating executives and a company's technical employees, including its engineers and scientists."); Michael S. Melbinger, Stock Compensation Plans Get a Boost from RRA §93, 22 TAXATION FOR LAWYERS 206, 206 (Jan./Feb. 1994) ("Stock-based compensation arrangements are central to virtually all publicly held, and many privately held, employers."); Patrick J. Straka, Executive Compensation Disclosure: The SEC's Attempt to Facilitate Market Forces, 72 NEB. L. REV. 804, 806-807 (1993) (finding that over 90% of companies offer options as significant part of incentive compensation).


/8/ In the debate on the Reform Act, Senator Boxer introduced an amendment that would have excluded defendants from invoking the Safe Harbor if a complaint alleged that a corporation had sold $1 million in stock, or an officer had sold $50,000 in stock, during a purported class period. 141 CONG. R S9150, S9156 (June 27, 1995) (introducing Amend. 1480). Senator Dodd explained that the amendment relied on the invalid assumption that all officer or director stock sales are inherently suspicious, and that such an ideology was contrary to the philosophy of the Reform Act:

When you talk about any officer or any director who purchased or sold a material amount of equities and who financially benefited from the forward-looking statement in it, that is, to me, trying to put too much in this with a lot of assumptions made that I do not think are necessarily borne out by the actions. To assume there is inherently something illegal, that it is an assumption of an illegal act for someone to exercise an option, and that action becomes a presumption of guilt in this context, then stripping away safe harbor, I think, goes too far . . . .

But the mere fact that some director exercises an option, that then the whole safe harbor process collapses, the Senator has connected a lot of dots here on the basis of some assumptions. That, to me, is exactly what we are trying to avoid.

Id. at S9161. Senator Dodd also explained that such inferences were contrary to public policy because they would discourage stock-based compensation:

But at this juncture, when we have tried to get directors to buy stock--it is one of the things we have tried to do over the years in our committee, purchase stock and get involved--I would have to say today, if this amendment were adopted, the last thing you would want to do is become even a purchaser. Forget a seller; the amendment says even purchasing stock here . . . My advice to anyone in that category, if this amendment were to be adopted, would be to stay away from this. I would stay entirely away from this. It would have absolutely the countereffect as we try to get people to acquire this stock. You are subjecting yourself to some very dangerous situations.

Id. Senator D'Amato further noted that small companies, in particular, would be subject to unwarranted litigation if the amendment passed:

Any small company that pays a director with stock options will be effectively excluded from the safe harbor. All the plaintiff would have to do is allege wrongdoing to bring a suit, which will open up this whole area to continued litigation.

141 CONG. R S9199, S9201 (June 28, 1995). The Senate rejected Senator Boxer's amendment.

/9/ See Proposed Rule: Selective Disclosure and Insider Trading, Releases Nos. 33-7787, 34-42259, etc. (Dec. 20, 1999) (Internet copy), page 15 of 42 ("Proposed Rule 10b5-1 is designed to address only the use/possession issue in insider trading cases under Rule 10b-5. As the Preliminary Note states, the Rule does not modify or address any other aspect of insider trading law, which has been established by case law under Rule 10b-5.").

/10/ Id. at 16.

/11/ Proposed § 240.10b5-1(c)(1)(i)(C)(2).

/12/ Id. at 15 (Subsection (B) applies "to an insider who instructs his or her broker to execute a plan to sell stock in accordance with Rule 144 at the expiration of the required holding period."); see also id. ("the Rule would permit him or her to complete the previously instructed sales plan . . .").

© David Priebe 2016