The other shoe may have dropped. Yesterday, the client alert below spoke of the SEC's increased scrutiny of 10b5-1 plans. We also mentioned that the state treasurer of North Carolina had requested the Commission to investigate the use of 10b5-1 plans by Angelo R. Mozilo, the chief executive officer of Countrywide Financial Corp. Whether or not Mr. Moore's letter was the cause, the Wall Street Journal reported today that the Commission has opened an informal investigation into stock sales by Mr. Mozilo. This action by the Commission reinforces the conclusions of this alert that great care needs to be taken in the establishment and use of Rule 10b5-1 plans.
Since Rule 10b5-1 was enacted in October 2000, corporate insiders have extensively used plans contemplated by the rule to establish trading programs that might not have previously been entered into for fear of insider trading liability. While often termed a "safe harbor," Rule 10b5-1(c) actually provides an affirmative defense to an allegation of insider trading. 10b5-1 prohibits the purchase or sale of a security on the basis of material, non-public information. But the purchase or sale will not be deemed to be made on the basis of material, non-public information if the person making the transaction demonstrates that before becoming aware of the information, he or she had (a) entered into a binding contract to purchase or sell the security, (b) instructed another person to purchase or sell the security for the instructing person's account or (c) adopted a written plan for trading securities. The rule then goes on to describe the essential characteristics of such a plan, including the requirement of a written formula to be used to determine the amount of securities to be purchased or sold.
But comments this year by Linda C. Thomsen, the director of the SEC's Division of Enforcement, suggest that the Commission may be scrutinizing these plans with a much more critical eye than it had in the past. The Commission has previously charged individuals with abusing the protection afforded by 10b5-1 plans (witness the prosecutions of Ken Lay and Joe Nacchio) but those were relatively small issues in much larger prosecutions. Now, however, the state treasurer of North Carolina, Richard H. Moore, hopes that he has given the Commission a high-profile test case. In an October 8 letter to the SEC, Mr. Moore asked the Commission to investigate the use of 10b5-1 plans by Angelo R. Mozilo, the chief executive officer of Countrywide Financial Corp. Mr. Mozilo allegedly established a plan on October 27, 2006 and then established another plan on December 12, 2006. He then revised the latter plan on February 2, 2007. The second plan and its modification allowed Mr. Mozilo to increase the total number of shares to be sold. Many of these sales came in the months prior to the recent issues surrounding the sub prime mortgage market. In a statement, Mr. Moore said that the "SEC needs to take a hard look at this situation."
While it is not known whether the SEC will investigate Mr. Mozilo's activities, there is no doubt that the Commission is very much aware of potential abuse of 10b5-1 plans. In March of this year Ms. Thomsen indicated that the SEC was in fact taking a hard look at several issues surrounding these plans, a sentiment she repeated as recently as October 10 in a speech to the National Association of Stock Plan Professionals.
The SEC's enforcement interest in these plans accelerated following the publication of a study by Alan Jagolinzer, an assistant professor at Stanford University's Graduate School of Business. His paper analyzed a significant number of transactions carried out pursuant to 10b5-1 plans (information mostly taken from SEC Form 4 and 8-K filings). The study found that on average, sales by participants generated "abnormal trade returns" and that "a substantive proportion of selected 10b5-1 plan initiations are associated with pending adverse news disclosure, and that participants terminate sales plans before positive shifts in firm returns." Whether Mr. Jagolinzer's empirical results are accurate, and whether his conclusions are well founded, there seems little doubt that his findings have generated a significant amount of interest in possible abuses of 10b5-1 plans.
Using 10b5-1 plans to reduce the risk of potential liability makes sense, but given its public pronouncements, it would be naive to think that the Commission will ignore actions that fly in the face of plan requirements. Constant modifications and terminations, trading very shortly after the establishment of a plan, significant trading outside of the plan, and other activities could well, in the current atmosphere, trigger an SEC inquiry or result in a loss of the protection provided by the rule. Indeed, a focus on these plans might be a natural progression from the Commission's well publicized campaign on option backdating. If an inquiry is triggered, of course, it is imperative to have counsel versed in dealing with the Commission to assist. Even absent such oversight, it is crucial for a participant to be well versed in the requirements set out by the rule.About Buchanan's Securities Litigation Practice Group
The attorneys in our group have wide experience in representing corporations, their officers and directors in SEC enforcement proceedings, hostile takeover litigation, shareholder class and derivative actions, and SEC and NASD investigations. We have represented professional service firms, including commercial banks, underwriters, accounting firms and brokerages, in actions related to the federal securities acts, broker/dealer consumer actions, insider trading allegations, and all manner of securities arbitrations overseen by the NASD, NYSE and other SROs.
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