SEC Rule 10b5-1, codified at , is a

regulation Regulation is the management of complex systems according to a set of rules and trends. In systems theory, these types of rules exist in various fields of biology and society, but the term has slightly different meanings according to context. Fo ...

enacted by the

United States Securities and Exchange Commission The United States Securities and Exchange Commission (SEC) is an independent agencies of the United States government, independent agency of the United States federal government, created in the aftermath of the Wall Street crash of 1929. Its ...

(SEC) in 2000. The SEC states that Rule 10b5-1 was enacted in order to resolve an unsettled issue over the definition of

insider trading Insider trading is the trading of a public company's stock or other securities (such as bonds or stock options) based on material, nonpublic information about the company. In various countries, some kinds of trading based on insider informati ...

, which is prohibited by

SEC Rule 10b-5 SEC Rule 10b-5, codified at , is one of the most important rules targeting securities fraud in the United States. It was promulgated by the U.S. Securities and Exchange Commission (SEC), pursuant to its authority granted under § 10(b) of the Secu ...

. Different courts of appeals had come to different conclusions about what constituted insider trading under Rule 10b-5 — specifically, whether someone could be held liable for insider trading simply by trading while in possession of inside information, or whether a

trier of fact In law, a trier of fact or finder of fact is a person or group who determines disputed issues of fact in a legal proceeding (usually a trial) and how relevant they are to deciding its outcome. To determine a fact is to decide, from the evide ...

must find that the person actually used that inside information when making the trade.

"Possession" versus "use"

Paragraph (a) of the Rule essentially repeats the holding of the

United States Supreme Court The Supreme Court of the United States (SCOTUS) is the highest court in the federal judiciary of the United States. It has ultimate appellate jurisdiction over all U.S. federal court cases, and over state court cases that turn on question ...

in '' United States v. O'Hagan'', , which defines

under the misappropriation theory. It states, in full, that Paragraph (b) addresses the unsettled "possession" versus "use" issue, stating that a person violates

Rule 10b-5 SEC Rule 10b-5, codified at , is one of the most important rules targeting securities fraud in the United States. It was promulgated by the U.S. Securities and Exchange Commission (SEC), pursuant to its authority granted under § 10(b) of the Secu ...

simply by trading while in "possession" of

inside information Insider trading is the trading of a public company's stock or other securities (such as bonds or stock options) based on material, nonpublic information about the company. In various countries, some kinds of trading based on insider informatio ...

. It states, in full, that In other words, under 10b5-1(b) a person could be liable for insider trading simply by possessing inside information regarding a given

security Security is protection from, or resilience against, potential harm (or other unwanted coercion). Beneficiaries (technically referents) of security may be persons and social groups, objects and institutions, ecosystems, or any other entity or ...

, breaching a fiduciary duty to the source of the information, and then trading it with a self-serving intent, even if the trade would have been made anyway. See 'United States v. O'Hagan'', 521 U.S. 642, 652 (1997). But it is unlikely the SEC will detect or particularly care about a small trade that would have occurred anyway. A large trade or series of trades that reap unusual benefits for a trader, however, will likely be detected, and it would be difficult to prove that the material non-public information did not contribute to the decision to make the trade.

Affirmative legal defense for planned trades

In paragraph (c), however, the SEC created an

affirmative defense An affirmative defense to a civil lawsuit or criminal charge is a fact or set of facts other than those alleged by the plaintiff or prosecutor which, if proven by the defendant, defeats or mitigates the legal consequences of the defendant's ...

to any charge of insider trading, "designed to cover situations in which a person can demonstrate that the material nonpublic information was not a factor in the trading decision." The provision allows an affirmative defense to insider trading when the trade was made pursuant to a contract, instructions given to another, or a written plan that " d not permit the person to exercise any subsequent influence over how, when, or whether to effect purchases or sales" (10b5-1(c)(1)(i)(B)(3)), and where the plan (or contract or instructions) was created before the person had inside information. For example, a CEO of a company could call a broker on January 1 and enter into a plan to sell a particular quantity of

shares In financial markets, a share (sometimes referred to as stock or equity) is a unit of equity ownership in the capital stock of a corporation. It can refer to units of mutual funds, limited partnerships, and real estate investment trusts. Sha ...

of his company's

stock Stocks (also capital stock, or sometimes interchangeably, shares) consist of all the Share (finance), shares by which ownership of a corporation or company is divided. A single share of the stock means fractional ownership of the corporatio ...

on March 1, find out terrible news about his company on February 1 that will not become public until April 1, and then go forward with the March 1 sale anyway, saving himself from losing money when the bad news becomes public. Under the terms of Rule 10b5-1(b) this is insider trading because the CEO "was aware" of the inside information when he made the trade. But he can assert an affirmative defense under Rule 10b5-1(c), because he planned the trade before he learned the inside information.

First-ever indictment and conviction for insider trading based on use of a Rule 10b5-1 plan

In March 2023, in the first-ever indictment for

based on an executive's use of a Rule 10b5-1 plan, the Department of Justice charged

Terren Peizer Terren Scott Peizer (born July 31, 1959) is an American businessperson who was convicted of insider trading and securities fraud. He worked as a junk bond salesman at Drexel Burnham Lambert. He testified against his former boss Mike Milken in ...

with one count of engaging in a

securities fraud Securities fraud, also known as stock fraud and investment fraud, is a deceptive practice in the stock or commodities markets that induces investors to make purchase or sale decisions on the basis of false information. Peizer was the CEO and chairman of Ontrak. Ontrak shares, which had traded at $85.21 in February 2021, were trading at under $1.00 since July 2022. In addition, the

U.S. Department of Justice The United States Department of Justice (DOJ), also known as the Justice Department, is a federal executive department of the U.S. government that oversees the domestic enforcement of federal laws and the administration of justice. It is equi ...

announced

criminal charge A criminal charge is a formal accusation made by a governmental authority (usually a public prosecutor or the police) asserting that somebody has committed a crime. A charging document, which contains one or more criminal charges or counts, can t ...

s of securities fraud against Peizer, charging that thereby he had avoided $12 million in losses, and he was arrested. On January 31, 2024, a superseding indictment was filed, 2024 charging Peizer with additional counts of securities fraud and insider trading. The case was heard in the

U.S. District Court for the Central District of California The United States District Court for the Central District of California (in case citations, C.D. Cal.; commonly referred to as the CDCA or CACD) is a federal trial court that serves over 19 million people in Southern and Central California, m ...

before U.S. District Judge Dale S. Fischer. Peizer was convicted after a nine-day trial on June 21, 2024, and could face up to 65 years in prison.

A possible loophole: canceling plans

After Rule 10b5-1 was enacted, the SEC staff publicly took the position that canceling a planned trade made under the safe harbor does not constitute insider trading, even if the person was aware of the inside information when canceling the trade. The SEC stated that, despite the fact that 10b5-1(c) requires trades to be irrevocable, there can be no liability for insider trading under Rule 10b-5 without an actual securities transaction, based on the U.S. Supreme Court's holding in ''

Blue Chip Stamps v. Manor Drug Stores ''Blue Chip Stamps v. Manor Drug Stores'', 421 U.S. 723 (1975), was a decision by the United States Supreme Court, which ruled that only those suffering direct loss from the purchase or sale of stock had standing to sue under federal securities l ...

'', 421 U.S. 723 (1975). This staff interpretation raises the possibility that executives can exploit this safe harbor by entering into 10b5-1 trading plans before they have inside information while retaining the option to later cancel those plans based on inside information. Although paragraph (c)(1)(i)(C) does deny the affirmative defense to offsetting or hedged transactions, in that case there would still be an actual trade (whichever of the offsetting trades was not canceled) that could constitute insider trading and violate Rule 10b-5. The SEC's position is that there can be no insider trading without a trade, so that a person could cancel a planned trade based on inside information and avoid liability. Although technically any plan that is cancelable does not come under the 10b5-1 safe harbor, proving that an executed trade was hypothetically cancelable might be very difficult. A few academic commentators have written about this issue, arguing that insiders can make systematically above-market profits by using 10b5-1 plans that they are still able to cancel. One empirical study has found that insiders using 10b5-1 plans do in fact make above-market profits (the paper also alludes to other potential loopholes that might explain this result), and another has found that the presence of publicly announced 10b5-1 plans has economic effects on securities markets that are generally associated with insider trading. Others contend that rather than timing trades, executives may time news or press releases to move the stock before a 10b5-1 plan sale.

SEC reaction

Noted in a speech by

Linda Chatman Thomsen Linda Chatman Thomsen (born April 1, 1954) is an American attorney who was director of the Division of Enforcement for the U.S. Securities and Exchange Commission from 2005 until early 2009. Since arriving at the SEC in 1995, she worked under fo ...

, then the SEC chief enforcement officer, the SEC was investigating why 10b5-1 trades appear to outperform the market. Allegations of improper 10b5-1 trades were noted during the insider trading trial of Joseph Nacchio, former Qwest CEO. There are also preliminary investigations into 10b5-1 trades by

Angelo Mozilo Angelo Robert Mozilo (December 16, 1938 – July 16, 2023) was an American mortgage industry banker who was co-founder, chairman of the board, and chief executive officer of mortgage giant Countrywide Financial until July 1, 2008. Mozilo retir ...

from

Countrywide Financial Countrywide is one of the UK's largest integrated property services group including residential property surveying, a collaboration of estate agents, and corporate services. It employs circa 8,500 personnel nationwide, working across 650+ estate ...

. The SEC sent a

Wells Notice A Wells notice is a letter that the U.S. Securities and Exchange Commission (SEC) sends to people or firms at the conclusion of an SEC investigation that states the SEC is planning to bring an enforcement action against them. The notice informs t ...

to Mozilo in May 2009, suggesting intent to pursue civil charges in relation to alleged illegal trades through his 10b5-1 plan. On March 25, 2009, the SEC staff revised its interpretative guidance regarding the circumstances under which the affirmative defense in Rule 10b5-1(c) is available. In particular, the staff followed the approach previously urged by some commentators to clarify (1) that the cancellation of a 10b5-1 plan could call the good faith of other, executed plans into doubt and (2) that the Supreme Court's decision in ''

'', 421 U.S. 723 (1975), did not affect the SEC's ability to bring an enforcement action against a would-be insider trader who canceled a trading plan and did not trade in a particular transaction because a subsequent decision, '' Merrill Lynch, Pierce, Fenner & Smith, Inc., v. Dabit'', 547 U.S. 71 (2006), made clear that ''Blue Chip Stamps'' dealt only with the implied private right of action for violations of Rule 10b-5 and not the "in connection with" requirement for all Rule 10b-5 violations. Beginning April 1, the SEC will require a minimum 90-day cooling-off period for most executive trading plans.

References

{{reflist Rule 10b5-1 Rule 10b5-1