When corporate officers sell their own stock at prices inflated by misrepresentations, it is reasonable to assume that those sales reflect a fraudulent motive. Defendants in securities fraud cases often rely on “trading plans” entered into under Rule 10b5-1 of the Securities Exchange Act, which create pre-determined transaction plans, to rebut the suspicion of a fraudulent motive.
Legitimate concerns about the validity of this defense were upheld in a June jury verdict against the former CEO of Ontrak Inc. and reflected in the Securities and Exchange Commission’s expanded rules for more detailed trading plan disclosures. Civil courts should address these concerns and severely limit the use of trading plans as a defense in securities fraud cases.
Rule 10b5-1 trading plans “allow corporate insiders to set a schedule for selling stock over time.” Trading plans are common in private securities litigation, where plaintiffs allege that insiders were motivated to “make a misrepresentation to sell their own stock at a profit” while inflating the stock price due to their fraud. By claiming that all of the sales alleged by plaintiffs were made pursuant to these trading plans and not at the defendants’ discretion, defendants seek to “infer that the sales were planned in advance and not suspicious.”
As some courts have noted, this defense should not be absolute because the trading plans could be “entered into or strategically altered to take advantage of an inflated stock price or insider information,” according to a 2021 ruling from the Southern District of New York. The insider trading conviction of former Ontrak CEO Terren Peizer is a prime example of how unscrupulous insiders could take advantage of their trading plans.
As explained in a press release about the ruling, Peizer “created Rule 10b5-1 trading plans to sell stock before (negative) news became public and to conceal the fact that he was trading on the basis of inside information.” The ruling underscores that 10b5-1 plans can be used to commit fraud and should not serve as the basis for a motive defense.
The problem was further exacerbated by the fact that Rule 10b5-1 plans were often undisclosed or only vaguely described. Aware of this potential for abuse, the SEC adopted rule changes in late 2022 designed to increase the transparency of Rule 10b5-1 plans.
Before the changes, company insiders were not required to disclose basic details of the plans, including when they entered into those plans. However, under the changes, companies must disclose any trading plans that insiders entered into during the previous quarter, as well as the material terms of those plans. Insiders who disclose stock transactions must also disclose whether the transaction was made as part of a trading plan and, if so, the date of the plan.
These changes are a step in the right direction. Plaintiffs in securities fraud cases should take advantage of this increased transparency to consider whether the mere existence of a trading plan indicates that the insiders lacked a motive to commit fraud.
Unfortunately, many court decisions prior to the 2023 disclosure changes relied on opaque information about trading plans to conclude that the existence of a trading plan precluded an inference of motive. These cases are often cited as orthodoxy and pose a challenge to plaintiffs even in cases where details of the plans were intended to mitigate or preclude the use of a trading plan as a defense.
Using the enhanced disclosures now required, plaintiffs’ attorneys should examine quarterly filings for the period in question to determine whether defendants entered into trading plans after making the false statements. The plans, particularly if they were developed close to the time the alleged false statements were made, could show that insiders used a 10b5-1 plan to sell stock while the price was inflated. Such facts would support rather than disprove a fraudulent motive.
But even if the trading plans predated the misrepresentation, neither plaintiffs nor courts should assume that the mere existence of the plans precludes motive. The U.S. Court of Appeals for the Tenth Circuit explained in a 2022 case that “a defendant who knows the timing of his 10b5–1 plan may be motivated to make material misrepresentations prior to a proposed sale that affect the stock price to his advantage or trigger a sale at a particular price.”
This is an obvious but critical observation – leaders know the pattern of their trading plans and can still exploit the timing to profit from nonpublic information. Plaintiffs can also challenge existing case law that recognizes trading plans as a defense by linking the timing of misrepresentations to planned sales.
For their part, courts should give credence to such allegations of motive and, given the plans’ potential for abuse, carefully examine the provisions of any Rule 10b5-1 trading plans submitted by defendants before concluding that they preclude the inference of motive.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Information about the author
James A. Harrod is a partner at Bernstein Litowitz Berger & Grossmann and has experience conducting complex litigation in federal courts and representing institutional investors in securities fraud cases.
Timothy G. Fleming is a partner at Bernstein Litowitz Berger & Grossmann and focuses on securities fraud, corporate governance and shareholder rights litigation on behalf of institutional investors.
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